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Uruguay: Staff Concluding Statement of the 2018 Article IV Mission

December 12, 2018

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

1. Uruguay’s economy remains resilient, reflecting its strong institutions, prudent policies, and large buffers. In a deteriorating external environment, Uruguay has successfully differentiated itself from its neighbors, thanks to progress in export market diversification, a prudent and coordinated public-sector asset-liability management, pre-financing of sizeable external financing needs, lower banking sector vulnerabilities, and ample reserves. As a result, public sector borrowing costs have remained subdued despite significant depreciation pressures, and although growth has slowed, it remains positive.

2. Maintaining its resilience and differentiated status is a priority in the more turbulent regional and global context. Uruguay is well positioned to weather the worsening external environment. Nevertheless, maintaining its resilience will hinge on the credibility of economic policies. This calls for actions to strengthen the fiscal and monetary anchors by putting debt on a firm downward trajectory and reducing inflation to within the target band. Over the medium term, the authorities should use Uruguay’s institutional advantages to improve the fiscal and monetary policy frameworks and implement further structural reforms to support growth, and as well as safeguard the social gains of the past decade. Policies should be targeted to improve low investment, address declining employment, and strengthen educational outcomes.

Recent Developments

3. After a strong 2017, growth has moderated. Economic activity grew by 2.4 percent in the first half of the year, after expanding by 2.7 percent in 2017. While consumption has continued to support domestic demand, private investment has remained sluggish. On the production side, manufacturing activity has remained weak, excluding the impact of the reopening of the oil refinery. Furthermore, a severe drought in the first quarter led to lower yields of summer crops (particularly soybeans). Labor market outcomes are weak, with unemployment fluctuating between 8 and 9 percent.

4. Inflation has risen above the target range, partly reflecting temporary factors. In 2017, inflation fell to 6.6 percent, ending up within the central bank’s 3-to-7-percent target range for the first time since 2010, due to earlier monetary policy tightening and peso appreciation. However, it has exceeded the target since May 2018 and currently stands at 8 percent reflecting the impact of drought, peso depreciation, and higher fuel prices. Despite the reduction in monetary indicative references (in July and October), staff estimates that monetary conditions are not yet sufficiently tight, given that real short and medium-term rates remain lower than the guidance offered by Taylor rules and neutral rates (while they can increase further as monetary policy works through its lags). At the same time, medium-term inflation expectations are somewhat above the target range.

5. Fiscal deficit reduction has stalled, and the time to reach the target of 2.5 percent of GDP has been extended to 2020. In 2017, the overall fiscal deficit (which includes the central bank interest payments) was 3.5 percent of GDP, an improvement of 0.3 percentage points relative to 2016. The current budget envisages a deficit of 3.3 percent of GDP in 2018 (up from a previous objective of 2.9 percent of GDP) and 2.8 percent of GDP in 2019 (up from 2.5 percent of GDP). This relaxation is an appropriate counter-cyclical measure, and if these objectives and the new 2020 target were met, public debt would decline gradually. Although, the 12-month rolling fiscal deficit stood at 2.9 percent of GDP, excluding the effects of transactions related to cincuentones, it amounted to 3.8 percent of GDP in October, suggesting that attainment of the 2018 objective, which does not include these transactions, is difficult.

6. The current account has weakened but remains in surplus. The current account has posted surpluses since 2016—although recent revisions reduced them—reflecting the record tourism inflows from Argentina, a slowdown in imports associated with weak investment, and a lower oil import bill. The surplus shrunk in the second quarter of 2018 (to 0.2 percent of GDP from 0.7 percent of GDP in 2017) because of higher oil prices, lower exports to neighboring countries facing difficulties (tourism to Argentina and goods to Brazil), lower agricultural exports due to the drought, and negative investment income.

7. Capital inflows, also affected by the inclusion of the merchanting activities, have been volatile. More recently, the high-frequency data point to portfolio outflows as seen in many emerging markets. The authorities ably took advantage of favorable financing conditions through mid-2018 by issuing bonds in global markets at long maturities.

8. The peso has depreciated by about 14 percent since April, and official foreign exchange reserves have declined. In response to depreciation pressures, the central bank started to intervene in August. Overall, gross reserves declined from $17.9 billion to $15.5 billion, but at 26 percent of GDP they remain substantially above prudential norms. About $0.5 billion of this decline reflects repurchases of central bank paper to accommodate a portfolio reallocation by pension funds, in response to non-resident capital outflows, to avoid undue exchange rate volatility.

Outlook and Risks

9. Uruguay’s economy has been decoupling from regional trends. Uruguay’s business cycle is less correlated with Argentina than in the past, with smaller direct financial sector linkages and China rising as a key trading partner. Nevertheless, both Argentina and Brazil remain important counterparts, and bilateral trade flows are sensitive to exchange rate movements.

10. The near-term outlook has worsened but remains stable relative to its neighbors. Growth is expected to moderate further to 2.1 percent in 2018 and 1.9 percent in 2019. This reflects (i) a slowdown in consumption in the second half of 2018 due peso depreciation against the U.S. dollar, and to declining confidence and real wages; and (ii) a decline in tourism revenue and goods exports in the first half of 2019—due to the expected contraction in Argentina and to the appreciation of the currency against its regional partners. At the same time, the expected rebound of agriculture from this year’s drought will support growth. Further, private investment, after contracting for four years in a row, is expected to gradually recover. In subsequent years, the economy is expected to grow slightly above potential, gradually closing the output gap. The current account is expected to register a small deficit in 2018 (-0.2 percent of GDP). Staff assesses that the external position is broadly consistent with fundamentals, with the current account balance slightly exceeding its norm in 2018.

11. In 2019, inflation is expected to moderate but, at 7.5 percent, remain above the central bank’s ceiling of the target range, established by the Macroeconomic Policy Coordination Committee. As the pass-through of the depreciation and the impact of the drought wear off, the recent monetary tightening works through its lags, and the output gap widens, inflation is expected to gradually decline. Many of the of the ongoing multi-year wage negotiations are closing in line with the guidelines —which continue to eschew indexation and will put nominal wage increases on a declining path—, thereby anchoring nontradable prices and tempering inflation inertia. However, with medium-term inflation expectations above target, inflation is projected to stay at 7 percent beyond 2019, the upper limit of the central bank’s target range.

12. There are both sizeable downside and upside risks to the outlook, given the more difficult external environment and large infrastructure projects. An abrupt tightening in global financial conditions, caused by a sharp increase in international risk premia coupled with a further strengthening of the U.S. dollar, could have negative repercussions for Uruguay’s economy. A further slowdown in trading partners could also worsen the growth outlook. At the same time, prudent macroeconomic policies and strong institutions have improved Uruguay’s ability to withstand regional shocks and plans for the construction of a large cellulose plant, an associated railway system, and other infrastructure projects are a major upside risk. Over the medium-term, low investment and declining employment, if not reversed, could lower potential growth.

POLICY RECOMMENDATIONS

A. Maintaining Fiscal Sustainability

13. Excluding the impact of the transfers related to cincuentones, the authorities’ overall fiscal deficit target of 2.5% of GDP is difficult to reach by 2020 without additional measures. [1] Staff projects an overall fiscal deficit (without the cincuentones transfers) of 3.7 percent of GDP in 2018. In 2019 and 2020, the fiscal deficit is projected to decline by 0.2 percentage points per year due to a reduction in sterilization costs and lower current expenditures in line with the results of the ongoing wage negotiations. Thereafter, the overall fiscal deficit (without cincuentones) is projected to remain at 3.3 percent of GDP in the absence of additional measures.

14. Transactions related to cincuentones will improve the fiscal deficit in the near term but are estimated to weaken the government balance sheet after 5 years. In October 2018, the public pension system received a transfer of about 1 percent of GDP in the context of a law introducing changes to the pension system. These funds are recorded as revenue, consistent with IMF methodology, and thus lower the fiscal deficit. Moreover, this will also lower the stock of public debt but not significantly alter the public financing needs, as the additional revenues were placed in a trust fund ring-fenced for 6 years. Transfers will continue over the next three years, leading to further reductions in the fiscal deficit. These transactions were transparently recorded and communicated by the authorities in the relevant sections of fiscal accounts, and the authorities are presently calculating the resulting changes in the expected pension contributions and expenditures. Authorities estimate that after 5 years this operation will weaken the government’s balance sheet since the additional pension liabilities will exceed the additional revenues and that the burden on the public pension system from this operation will be about 4 percent of GDP (in net present value terms over the next 30 years).

15. While next year’s gross financing needs are manageable, Uruguay should remain vigilant in the context of increasing global financial market volatility. Under the baseline scenario, debt of the non-financial public sector is projected to reach 54 percent of GDP in 2018 and to stabilize at 53 percent thereafter. [2] Large financing needs for 2019 are expected be to comfortably met in the context of coordinated public-sector asset-liability management, stable local currency funding from domestic institutional base (particularly after this year’s introduction of wage-indexed bonds), the authorities’ pre-financing policy, and sufficient buffers (in the form of nonfinancial-public-sector liquid assets and contingent credit lines). The debt level are below the relevant benchmarks but remain elevated. Uruguay’s sovereign risk spreads were not affected by the recent exchange rate volatility episodes, but the fiscal position has worsened since then and, historically, Uruguay has been sensitive to tightening global market conditions. In addition, despite recent improvements, the share of debt in foreign currency held by non-residents remains relatively high, leaving debt vulnerable to exchange rate pressures. As a result, Uruguay’s fiscal space—the room for discretionary fiscal policy without endangering the debt sustainability—is at risk.

16. To maintain credibility and contain fiscal risks, it would be prudent to introduce measures to put public debt on a firm downward path. Delivering on the budgetary targets would reduce debt of the non-financial public sector to 49 percent of GDP in 5 years and would lower it to the average level of 2012-14 (about 44 percent of GDP) in 10 years. However, this would require 0.8 percentage points of GDP in measures until 2020 (a total adjustment of 1.2 percent of GDP) during a period of an economic slowdown and elections, which could be hard to achieve. In this context, the authorities should introduce measures of 0.3 percent of GDP in 2019 (amounting to a 0.5 percent-of-GDP of total adjustment in 2019), which would help put debt on a downward path, thereby reinforcing commitment to fiscal sustainability.

17. Fiscal adjustment could come from reducing the elevated level of current expenditures. This would allow to contain the impact of fiscal adjustment on growth. In addition, the utility tariffs should be adjusted in line with the cost structure and investment needs of public enterprises. In the medium term, further improvements in the efficiency of social spending will also be required to create space for the needed increase in capital spending.

18. Looking ahead, introducing a medium-term fiscal framework supported by a binding fiscal rule would help engrain fiscal anchor and sustainability. Under the current approach each government outlines budgetary priorities for the duration of its five-year term, leading to a lack of continuity and attendant uncertainty towards the end of the period. A medium-term fiscal framework would help strengthen multi-year fiscal discipline and achieve policy objectives with a more efficient use of limited resources. Even though the existing fiscal rule limits the annual increase in net debt, it has not been binding due to the use of escape clauses. An enhanced fiscal rule could include further safeguards that limit the use of escape clauses, be anchored on a medium-term debt objective, and focus on the nonfinancial public sector to avoid volatility associated with the liquidity management operations of the central bank.

19. Other medium-term fiscal priorities include addressing growing pension spending and maintaining the financial health of public enterprises. First, pension spending is high by regional standards, reflecting both an aging society, the welcome almost universal coverage, and constitutionally mandated wage indexation. Reforms are needed to provide adequate pensions and maintain coverage for future generations, while ensuring the sustainability of the system. Reforms should be based on a comprehensive review of the entire pension system, supported by an informed social dialogue. Early action will help smooth the transition to a revised system and reduce costs compared to a delayed response when aging pressures become more acute. Second, continued improvements in the management and profitability of public enterprises—an important component of the economy—are essential to strengthening the country’s fiscal position. In this context, ongoing efforts to enhance the governance structure, risk-management practices, and the monitoring of their performance in a more consolidated manner are welcome.

B. Lowering Inflation

20. Bringing inflation close to the middle of the central bank’s 3-to-7 percent target range is important to anchor expectations. With medium-term inflation expectations above the target range, a further depreciation of the peso in the presence of remaining widespread indexation could render convergence to the target range more difficult. In this context, to anchor inflation expectations to the middle of the target range, monetary indicative references should be further tightened such that the short and medium-term real rates increase further to within the range of staff’s estimated neutral rates.

21. In a longer-term perspective, the central bank is encouraged to further strengthen its monetary policy framework. Conducting monetary policy is challenging in the presence of a high dollarization, low credit-to-GDP ratios, and remaining wage indexation. Short-term interest rates remain volatile (due to movements in money demand), inflation expectations track actual inflation, and, in the past, inflation has persistently remained above the target range. In this context, further improvements could focus on strategies, instruments, and communication practices to enhance the commitment to achieve targets, thereby better anchoring inflation expectations. Ongoing discussions at the central bank on further enhancing communication strategies and reducing dollarization could be part of a review.

22. The exchange rate should remain the key shock absorber. Given global trends of dollar appreciation and weaker capital flows to emerging markets, the peso should continue to adjust in line with fundamentals. Interventions should be reserved for addressing disorderly market conditions, and reserve buffers should be kept above or in line with prudential norms.

C. Maintaining Financial Sector Stability and Enhancing Intermediation

23. The financial sector has fared well, but authorities should continue monitoring the quality of banks’ assets closely. Despite the regional turmoil, the financial sector has remained resilient, reflecting limited linkages to Argentina and enhanced supervision since the 2002 crisis. With the improvements in regulatory capital to risk-weighted assets ratio and bank profits, the banking sector has comfortable buffers. Given exchange rate volatility, supervision should continue to closely monitor banks' exposures. In addition, the share of nonperforming loans has increased somewhat, and, while still manageable, needs to be monitored. In this regard, the recent adoption of the regulations on net stable funding ratio—requiring that the liquidity profiles of banks’ assets and liabilities be aligned—is welcome.

24. The authorities are trying to boost financial inclusion, including by leveraging advances in financial sector technology (Fintech). Extensive dollarization and market segmentation limit bank credit and make it expensive, especially in the peso market. To improve financial inclusion, the authorities have been implementing measures that aim at promoting electronic transactions and competition in the banking sector (under the 2014 Financial Inclusion Law). Even though peer-to-peer lending remains small, the authorities have introduced regulation in this area aimed at protecting consumers and guarding against money laundering. More broadly, the authorities’ efforts to improve financial inclusion and intermediation, while limiting risks—including a successful e-peso pilot—are welcome.

D. Enhancing Inclusive Growth and Competitiveness

25. Building on Uruguay’s institutional strength, reaching the goal of continued income convergence to advanced economy levels needs further action. Uruguay has been one of the most stable countries in the region, with low income inequality and poverty. However, facing low investment and declining employment, there is consensus across the political spectrum that further efforts are needed to ensure continued income convergence. These could include creating fiscal space to close infrastructure gaps, improving financial intermediation and the business environment to support private investment, and reforming the education sector to enhance human capital. These policies will also help further enhance Uruguay’s competitiveness. Uruguay has successfully diversified its export products and destinations (mainly towards commodity-based sectors and China) and raised its global market share in many products. However, some manufacturing sectors lost market share and are sensitive to exchange rate movements. Therefore, continued efforts are needed to improve competitiveness, to further diversify export products (including towards non-commodity sectors to limit exposure to commodity price swings and supply shocks), and to improve market access through multilateral and bilateral free trade agreements.

The mission thanks the authorities for the warm hospitality, the open discussions, and the quality of the engagement.

[1] Overall fiscal balance includes the central bank interest payments.

[2] This incorporates impact of the cincuentones transactions, which will reduce the debt for the next four years (as transferred assets are mostly government debt) but increase it thereafter. In addition, the IMF and the authorities use different methodologies to calculate debt-to-GDP ratios. The IMF uses local currency for both GDP and debt (the latter converted to pesos at end-period exchange rate), while the authorities use the GDP in U.S. dollars (converted at average exchange rate) and the stock of debt in U.S. dollars. The authorities project the non-financial public-sector debt at 51 percent of GDP in 2018.

IMF Communications Department
MEDIA RELATIONS

PRESS OFFICER: Maria Candia Romano

Phone: +1 202 623-7100Email: MEDIA@IMF.org

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