Uruguay and the IMF

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Uruguay—Letter of Intent, Memorandum of Economic Policies, and Technical Memorandum of Understanding

Montevideo, August 4, 2002

The following item is a Letter of Intent of the government of Uruguay, which describes the policies that Uruguay intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Uruguay, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. Despite the augmentation of the SBA and progress made in the implementation of the program, continuing disruption in the region has contributed to an acceleration of the deposit outflows from the banking system in recent weeks. Outflows were particularly strong in the domestic banks that rely on the central bank for liquidity support. This support has driven down international reserves and the margin for reserve loss that had been built into the program has been utilized.

2. Against this background, the government has adopted a number of measures aimed at: (i) providing a permanent solution to the difficulties faced by domestic banks and (ii) ensuring the sustainability of the public finances and the debt over the medium term. These measures are described in the attached Memorandum of Economic Policies.

3. In support of these enhanced efforts, the Government of Uruguay requests: (i) a further augmentation of its Stand-by Arrangement in an amount equivalent to SDR 376 million; (ii) the cancellation of the remaining access available under the Supplementary Reserve Facility (SRF) component of the Stand-By Arrangement, equivalent to SDR 257.4 million and that these resources be made available under the arrangement in the credit tranches instead; and (iii) the rephasing of remaining amounts under the arrangement to allow for a purchase equivalent to SDR 603 million upon approval of this request.

4. The government requests a waiver of the non-observance of the continuous performance criterion on net international reserves and a waiver of non-applicability for the performance criteria on the combined public sector balance, the general government expenditure and the nonfinancial public sector gross debt. In addition, we request that the end-August performance criteria be eliminated and that all other performance criteria be modified as indicated in Table 1. Furthermore, we request the modification of the schedule for program reviews as indicated in Table 3.

5. We are confident that the initiatives set out here and the additional support from the international financial organizations will be sufficient to stabilize the situation quickly, while setting the basis for a durable resumption of economic growth. Nonetheless, the government stands ready, in consultation with the Fund, to take whatever additional measures necessary to ensure the success of the program.

Sincerely yours,

Julio de Brun
Central Bank of Uruguay
Alejandro Atchugarry
Minister of Economic and Finance
Republic of Uruguay

Memorandum of Economic Policies

I. Background and Macroeconomic Framework

1.  The situation in Uruguay's banking system has not evolved as envisaged in the program. Following the announcement of the augmentation of the SBA, the rate of deposit outflow was halved from the large outflows recorded in May, but the respite proved to be brief (2-3 weeks). Dollar deposits outflows accelerated in July, especially in the domestic banks that rely on the central bank for liquidity support. Several factors contributed to this outcome, including the continued financial turmoil in the region, and some political events in the country. Outflows from domestic banks accounted for the majority of withdrawals in recent weeks, exceeding US$100 million per day in recent days. Since domestic banks are the ones that rely on central bank for dollar liquidity support, the acceleration in outflows from these banks implied a rapid decline in net international reserves and the margins for reserve loss built into the program were utilized. Gross international reserves have declined to about US$650 million from US$3 billion at end 2001 and may decline further as the bank holiday is lifted.

2.  Against this background, and in the context of the new plan described below, we have revised our macroeconomic framework. Despite an emerging recovery in exports (export value rose at annual rate of 11 percent in May-June), we are now projecting real GDP to fall by 11 percent in 2002 and further by 4.5 percent in 2003, although economic activity is projected to start growing in the second half of 2003. The exchange rate, which was allowed to float in June, stabilized quickly after the initial post float jump from about UR$17.30 to UR$19.0 (8 percent). It has depreciated sharply in recent weeks to a range between UR$25 to UR$30. Inflation is likely to accelerate to about 40 percent during 2002 and, after peaking in 2003 at about 50 percent, will decline gradually thereafter. Reflecting the weakness of domestic demand and the recovery of exports, the external current account balance will shift into a surplus of 1.5 percent of GDP in 2002 from a deficit of 2.5 percent of GDP in 2001, and will remain broadly at that level in 2003.

II. Strengthening the Banking System

3.  The previous strategy for dealing with the banking situation, which was based on a strengthening of the macroeconomic framework combined with significant financial support, was insufficient to restore confidence of depositors. A bank holiday was declared on July 30, to allow for the finalization of a revised strategy aimed at addressing the problems. The revised strategy has three elements: (i) a comprehensive restructuring of public banks and liquidation of insolvent banks, (ii) the extension of the maturity of dollar time deposit liabilities of public banks, and (iii) steps to preserve the payments system through the full backing of sight and savings deposits in domestic banks.

4.  A comprehensive restructuring of domestic banks is being implemented. The mortgage bank (BHU) will be transformed immediately into a non-bank housing institution bringing forward the restructuring plan, which will be supported by accelerated disbursements from the World Bank. Its deposits will be transferred to the other public bank, the Banco República (BROU). BROU will be recapitalized, and new legislation has been submitted to congress that will subject BROU to the supervisory directives of the Central Bank of Uruguay which is expected to be approved by end-October 2002.

5.  At the same time, insolvent private domestic banks not recapitalized by shareholders will be closed on August 5 and their liquidation process will start, including Banco Montevideo/Caja Obrera, Banco Comercial, and Banco Crédito. This process will be conducted in close consultation with Fund management. The remaining private domestic and international banks, whose liquidity situation is much stronger, will continue to operate freely and will be expected to continue honoring their deposits with their own resources.

6.  To halt the deposit outflow while the situation of the domestic banking system is fully resolved and confidence is restored to the banking system, a bill (the law for the Fund for the Stabilization of the Banking System (FSBS), see attachment) is being approved on [August 4], authorizing BROU and BHU to extend the maturity of their dollar time deposits for a period of one to three years. Re-scheduled deposits will earn a small premium over risk-free market interest rates and depositors will be provided with the option of exchanging their deposits with bank bonds. These bonds will be freely tradable in the secondary market and may be used to cancel debts at its face value which were contracted with BROU and the BHU before July 30, 2002.

7.  The government has assigned a high priority to the preservation of a functioning payment system. For this purpose, all peso deposits and sight and saving dollar deposits are free of restrictions, including the sight and saving deposits of the domestic banks to be closed on August 5. In addition, except for time deposits of public banks, the deposits of all remaining domestic and international banks that will reopen after the bank holiday are not subject to any restrictions.

8.  To generate the required level of confidence to keep the payments system intact the government is providing full backing for the sight and savings deposits at public banks and the sight and savings deposits of the closed domestic banks to be paid through the BROU. The government believes that this can be secured through additional financial support and the acceleration of the pipeline disbursements from international sources. It is estimated that some US$1.5 billion would be needed. In view of the timing of the expected disbursements from these institutions, a bridge loan was arranged to allow for the lifting of the bank holiday on August [5] and the reopening of banks. These financial resources would be paid into a special account at the central bank set up under the FSBS law. The funds to back sight and saving deposits will not be part of the international reserves used for other purposes. Funds not used to support banks will be invested in highly liquid and secure international assets to be reported daily to the International Monetary Fund and will be subject to periodic special audits.

9.  To finance the program over the next 18-month period as well as the fiscal deficit, a replenishment of international reserves, and the cost of beginning to pay reprogrammed deposits in 2003, the authorities will rely on the resources already committed by international financial institutions, further augmentations of these resources that have been requested, some recovery of loans from domestic banks, as well as other measures. The augmentation amounts to US$830 million, including US$500 million by the IMF and US$330 million from the World Bank and the IDB, bringing the total amount committed by IFIs to US$3.6 billion during this period, including about US$2 billion from the IMF and about US$1.7 billion from the World Bank and the IDB.

10.  In this connection, the government is committed to recover the financial assistance to domestic Uruguayan banks provided under the interim mechanism for the Fund for Fortifying the Banking System (FFSB) as managed by the Steering Committee (SC) setup for this purpose. Recovery of resources from these banks would help reconstitute the international reserves at the central bank.

III. Fiscal Policy

11.  The public sector financing outlook has been obscured by the problems in the banking system, the loss of international reserves, the further downgrading of Uruguay's debt by investment rating agencies and the depreciation of the exchange rate (virtually all of the debt is denominated in foreign currency). However, Uruguay has a tradition of honoring its obligations and the government, working together with the international and other financial institutions intends to put the country back on a sustainable financial path.

12.  As discussed at the time of the previous augmentation of the SBA, the government has already taken steps to strengthen the public finances in spite of the more difficult conditions faced by Uruguay, including the introduction in recent months of additional fiscal measures, some of which, such as taxes on pensions and public sector wages, will result in net reductions in government spending.

13.  To provide some stimulus to economic activity, a reduction of tax incentives for exports has been delayed and a proposal has been sent to congress to reduce the tax burden on new construction projects. To compensate for the effects of these measures, as well as the net interest cost of financial support to the banking system, the budget law proposal for 2003 included additional expenditure savings compared to the existing program, such as the restructuring of ministries, limits to budgetary credits, and a redundancy/retirement program for government employees (similar programs have been put in place in the public enterprises). In this context, the program's primary balance is now projected to shift from a deficit of 1 percent of GDP in 2001 to surpluses of 1.6 percent of GDP in 2002 and 4.2 percent in 2003. To ensure achievement of these objectives the government intends to maintain a tight grip on wage increases (including no further increases in 2002) and to limit the adjustment in pensions to that required by law. The overall deficit of the public sector is projected to be 3.4 percent of GDP in 2002 and 1.5 percent of GDP in 2003 (the program ceiling for 2002 has been adjusted accordingly).

14.  The government recognizes that the current tax structure is in need of simplification and rationalization. We have decided to bring forward the implementation of the tax reform envisaged in the program and will submit a reform proposal to Congress in October. This reform will consolidate the tax system into four taxes, VAT, excises, income, and trade tariffs. It will be prepared in the coming weeks with assistance from Fund staff with approval expected promptly and to become effective at the end of 2003. However, if approval of this reform were to take longer than expected, the government will seek approval before end-October of a proposal already in congress requesting powers to keep in place tax measures that are scheduled to expire at end-2003.

IV. Exchange Rate and Monetary Policies

15.  The government remains committed to a high degree of exchange rate flexibility, with only limited intervention aimed at ensuring orderly market conditions. Consistent with this approach, the central Bank (CBU) is working to foster the establishment of an efficient forward exchange market that would allow the private sector to better manage its exchange rate risk, while strengthening its ability to conduct monetary policy, both in terms of staffing and instruments. A number of instruments are being implemented aimed at managing peso liquidity, including short term bills and peso deposits at the central bank through daily auctions of pre-announced amounts of peso or CPI-indexed Treasury bills of different maturities. To facilitate more active use of peso operations we have also: (i) clarified that the Usury Law ceiling on interest rates does not apply to interbank transactions; and (ii) have given greater day-to-day discretion to the CBU money desk manager to conduct open market operations in pesos. Monetary targets have been modified to take into account the revision in the macroeconomic framework.

16.  In July to provide partial relief to debtors, the government launched a debt-to-debt swap for the banking system. This is a voluntary scheme that will allow bank borrowers to repay their loans using government bonds at their face value. Its scope is limited and will be implemented in close consultation with Fund management. Implementing regulations will contain the negative solvency impact on banks and steer participation mainly to distressed borrowers. To facilitate the implementation of this scheme, banks will be given forbearance on capital requirements on a one time basis. However, no further forbearance is envisaged.

V. Policies for Fostering Growth and Protecting the Poor

17.  The government remains committed to creating the basis for a resumption of economic growth despite the more difficult circumstances faced by the country as well as helping the poor. Protecting the payments system and restoring confidence in the banking system will prevent a more significant decline in economic activity and allow for a faster rebound in activity. At the same time, the government will continue with its efforts to open to private initiative activities previously reserved for the public sector and remains committed to bringing forward, as described in the letter of June 18, 2002, the introduction of new regulatory frameworks in several areas including for electricity, telecommunications, water and sewage, railroad, transportation, etc., while going forward with the granting of scheduled concessions to the private sector. The government is determined to mitigate the adverse impact of the adjustment on the poor. In particular, as agreed in the context of programs with the World Bank and the IADB, allocations for key social programs will be shielded from cuts. In addition, public work programs will be implemented as needed.

Box. 1. Fund for the Stabilization of the Banking System—FSBS

I. Objectives

  • Safeguard the payment system and reestablish confidence in the viability of the Uruguayan banking system through financial support for public banks and a restructuring of time deposits.

II. Resources and Purpose

  • Resources from FSBS provided by the World Bank, the Inter-American Development Bank, and the Fund (estimated to be $1.5. billion) will be managed through a special account in the Central Bank of Uruguay (CBU). These operations will be subject to periodic audits.

  • FSBS resources will only be used to safeguard the payment system. This would be achieved by providing full backing for dollar sight and savings deposits (about $1.08 billion) at public banks (Banco República (BROU) and the Mortgage Bank (BHU). In addition, some FSBS resources (around $0.42 billion) will also be used for backing the dollar sight and saving deposits transferred from selected domestic banks which were closed as part of the bank restructuring process.

  • The law for FSBS provides for extending the maturities of time deposits falling due at BROU and BHU to between 1-3 years. Such reprogrammed deposits will bear premium interest rates payable quarterly. Deposit holders also have the option of conversion to tradable bank certificate of deposits bearing similar reprogrammed terms, which are usable to repay BROU loans at face value.

III. Modalities

  • Liquidity support from FSBS will be provided to BROU by CBU to cover sight and savings deposits of public banks in the form of a loan against high quality collateral at terms that will ensure at least cost recovery and repayment periods that will facilitate operation of the payment system.

  • All deposits of BHU will be transferred to BROU against provision of high quality collateral, to be liquidated over time within an agreed program.

  • FSBS will cover the transfer of sight and savings deposits of the selected closed domestic banks to other banks or for cash withdrawals. Recovery of such outlays will be dependent on the sharing of proceeds stemming from the liquidation of the closed banks.

  • Peso deposits of all banks and the dollar deposits of other domestics and international banks are free of restrictions. The latter have indicated to CBU their ability to meet liquidity and capital requirements which are sufficient to honor their deposit obligations.

  • In line with current bank exit policies, in the future, banks that have insufficient liquidity to meet deposit withdrawals or that are unable to meet capital requirements as a result, will be intervened and closed.

Table 1. Uruguay: Performance Criteria Under the 2002 Economic Program1
  Dec-01 Sep-02 Nov-02 Dec-02

A. Quantitative Performance Criteria (In millions of Uruguayan pesos)
1. Combined public sector balance (cumulative floor) . . . -9,600 . . . -10,950
2. General government expenditure (cumulative ceiling) . . . 23,700 29,600 32,900
3. Change in the net domestic assets of the BCU (ceiling)3,4 . . . 26,100 24,235 28,400
4. Change in currency issue (ceiling)2,3 . . . 755 985 2,650
  (In millions of U.S. dollars)
5. Net international reserves of the BCU (-decrease)3,4   -1,010 -930 -1,030
  (Stock of debt at the end of the period;
in millions of U.S. dollars)
6. Nonfinancial public sector gross debt (ceiling)4,5 7,836 8,025 8,025 8,025
B. Structural Performance Criteria        
1. Congressional approval for the extension of the May tax measures       31-Oct

Sources: Ministry of Economy and Finance; and Central Bank of Uruguay.
1As defined in the Technical Memorandum of Understanding.
2Indicative target.
3Cumulative from June 2002.
4Adjusted for upwards/downwards for any increase/decrease in disbursements from the World Bank and IDB and for any recovery for the early FSBS mechanism.
5Al l maturities. Includes leasing operations associated with ANCAP; adjusted for debt issued for recapitalization of banks.

Table 2. Uruguay: Prior Actions, Indicative Targets, and Structural Benchmarks
under the 2002 Economic Program

A. Prior Actions  
1. Congressional approval of the law establishing the FFSB  
2. Closing of insolvent banks and the beginning of their resolution.  
B. Structural benchmarks  
1. Weekly publication of banking data with a one-week lag. 31-Aug.
2. Evaluation of the adequacy of BROU's current regularization plan and development of a plan of compliance with all prudential regulations. 31-Aug.
3. Presentation to Congress of the reform of the pension system for the military and 31-Oct.
bank employees. 31-Dec.
4. Presentation to Congress of a comprehensive reform to rationalize and simplify the tax system. 31-Dec.
5. Presentation to Congress legislation to foster competition in the telecommunications sector 31-Dec.
6. Presentation to Congress of legislation to foster competetion in the oil sector Sources: Ministry of Economy and Finance; and Central Bank of Uruguay. 31-Dec.

Table 3. Uruguay: Proposed Availability of Purchases1
 SBA (April 2002 to March 2004) Augmented and
rephased SBA

SDR % quota

April 4, 2002    122.6   40.0 Program approval
June [...], 2002    386.1 126.0 First Augmentation approval 1
August 8, 2002    607.0 198.0 Second Augmentation approval, completion of review and observance of end-June performance criteria.2
October 20, 2002    145.2   47.4 Completion of review and observance of selected end-September< performance criteria.3
December 19, 2002    145.2   47.4 Completion of review and observance of selected end-September, observance of selected end-October, and end-November performance criteria.4
February 20, 2003    145.2   47.4 Completion of review and observance of end-December performance criteria.
May 19, 2003    145.2   47.4 Completion of review and observance of end-March performance criteria.
August 18, 2003    145.2   47.4 Completion of review and observance of end-June performance criteria.
November 18, 2003    145.2   47.4 Completion of review and observance of end-September performance criteria.
February 20, 2004    145.2   47.4 Completion of review and bservance of end-December performance criteria.
Total access 2,132.4    
Percent of quota    695.7    
Annual access (in percent of quota)    506.2    
Average annual access (in percent)    347.9    

1Of which, SDR128.7 million under the SRF.
2Augmentation equal SRD637.4 million (208 percent of quota), of which SDR 257.4 (84 percent of quota) replaces the cancelled SRF resources (EBS/02/108, Table 12).
3NIR and NDA performance criteria only.
4Combined public sector balance, General government expenditure, and No financial public sector gross debt performance criteria for end-September; presentation to Congress of the reform of the pension system of the military for end-October, and NIR and NDA performance criteria for end-November.

Technical Memorandum of Understanding

This memorandum presents the definitions of the variables included in the quantitative performance criteria annexed to the Policy Memorandum.

1. Cumulative balance of the Combined Public Sector. The Combined Public Sector comprises the Central Administration (including as defined in "Article 220" of the Constitution, Salto Grande, and the funds managed directly in the ministries (Fondos de Libre Disponibilidad), the social security system (Banco de Previsión Social), the local governments (Intendencias), the public enterprises (ANCAP, ANTEL, UTE, OSE, AFE, ANP, INC, CND and ANCO), and the quasi-fiscal balance of the Central Bank (BCU). The public sector balance, excluding valuation adjustments, will be measured from below the line on the basis of information provided by the BCU on: (a) the change in the nonfinancial public sector debt (defined below), including all short-term debt, in foreign currency and pesos; (b) change in net bank credit to the nonfinancial public sector in foreign currency and pesos; (c) other nonbank financing including privatization; and (d) the quasi-fiscal balance of the BCU (as defined below). The limit on the balance of the combined public sector will be adjusted downward (upward), i.e., the deficit would be allowed to widen (narrow), by the amount that the actual social security contributions to the private pension system exceeds (falls short) of the projected amounts in the program, specified in Schedule A.

2. The quasi-fiscal balance of the BCU is defined as interest earnings on gross international reserves, as defined below, and other earnings including those on other foreign and domestic assets minus operating expenses, commissions paid, and interest paid on domestic and foreign debt administered by the BCU.

3. Cumulative ceiling on general government expenditure applies to total (current and capital) noninterest expenditure of the central administration (includes Fondos de Libre Disponibilidad but excludes transfers to the social security system and automatic transfers to the private pension funds (AFAP), and internal transfers) and social security system (BPS).

4. Cumulative changes in net domestic assets (NDA) of the BCU is defined as the difference between currency held outside banks and net international reserves (NIR) of the BCU as defined in 5 below. The flow of NIR will be valued at the accounting exchange rate of Ur$25 pesos per US$.

5. Cumulative changes in net international reserves (NIR) of the BCU. NIR is defined as the difference between the gross international reserves and BCU reserve liabilities. Gross international reserves include all foreign exchange assets that are in the direct effective control of the BCU and are readily available for such purposes of the BCU as intervention or the direct financing of payment imbalances. Such assets may be in any of the following forms, provided that they meet the test of effective control and ready availability for use: currency, bank deposits in nonresident institutions and government securities and other bonds and notes issued by nonresidents (with a rating not below "A" in the classification of Fitch IBCA and Standard and Poor's or "A2" in the classification of Moody's). In addition, holdings of SDRs or of monetary gold would be included under gross reserves assets (provided they meet the test of effective control and ready availability of use) as would the reserve position in the IMF.

- Excluded from gross international reserves are all foreign currency claims arising from off-balance sheet transactions (such as derivatives instruments), claims on residents, capital subscriptions in international financial institutions, any assets in nonconvertible currencies, claims on any nonresident Uruguay-owned institutions, or any amounts (in all components of assets, including gold) that have been pledged in a direct or contingent way.

- Also excluded from gross reserves are foreign exchange assets in the escrow account at the BCU created to provide backing to sight and savings deposits at the public banks and the closed domestic banks (the escrow account at the BCU). Funds not used to support banks will be invested in highly liquid and secure international assets to be reported daily to the International Monetary Fund and will be subject to periodic special audits.

- BCU reserve liabilities include all foreign currency-denominated liabilities of the BCU with original maturity of one year or less to residents and nonresidents, the use of Fund resources, any net position on foreign exchange derivatives with both residents and nonresidents undertaken directly by the BCU or by other financial institutions on behalf of the BCU.

- For the purpose of the NIR calculation, (a) the gold holdings of the BCU will be valued at the accounting rate of US$42 per troy ounce; (b) liabilities to the IMF will be valued at US$/SDR rate of December 31, 2001; (c) gains or losses from gold-swaps and other operations will be excluded; and (d) non-U.S. dollar denominated foreign assets and liabilities will be converted into U.S. dollars at the market exchange rates of the respective currencies as of December 31, 2001.

6. The NIR floor will be adjusted upward (downward) by the difference between actual and scheduled disbursement by the World Bank and IDB as reflected in Schedule B below (net of amounts intended to accrue to the escrow account at the BCU created to back sight and savings deposits of public and closed banks).

7. The nonfinancial public sector gross debt refers to (a) the outstanding stock of gross debt in domestic and foreign currency owed or guaranteed by the public sector as defined in (1) above excluding the BCU.1 Debt in the form of leases will be calculated as the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.2

8. The overall nonfinancial public sector debt ceiling will be adjusted upward (downward) by (1) the upward (downward) revisions made to the actual nonfinancial public sector gross debt stock at end-2001; (2) the difference between the actual and projected amount of social security contributions that are transferred to private pension funds according to schedule A; (3) the difference between actual and scheduled disbursement by the World Bank and IDB as reflected in Schedule A below; and (4) the overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million. The overall ceiling will be adjusted upward by the magnitude of public debt issued for bank restructuring in line with the legislation governing the FSBS (Fund for the Stabilization of the Banking System).

Schedule A: Projected Social Security Contributions to the Private Pension System (cumulative from end-December 2001)
(In millions of Ur$)





Social Security Contributions 1377 2021 2447 2642

Schedule B: Planned Disbursement by the WB and IDB
(In millions of US$)
  Sept. Nov. Dec.

Disbursement of IFI's 0 119 30

1The term "debt" has the meaning set forth in point No.9 of the Fund's Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 6230-(79/140, August 3, 1979), as amended).
2The suppliers' contracts of ANTEL with equipment providers Ericsson and NEC, which predate the Fund's consideration of lease contracts for programming purposes, are expensed under goods and services as rental outlays. The lease contract of ANCAP associated with the reform and expansion of the Montevideo oil refinery is included in the calculation of the public sector debt.