Uruguay: Staff Concluding Statement of the 2017 Article IV Mission

December 7, 2017

1. Uruguay has hit the sweet spot in 2017. With stronger GDP growth, the increase in unemployment since 2012 has come to a halt. A relatively tight monetary policy stance and an appreciating exchange rate have contributed to a notable decline in inflation, bringing it within the central bank’s target range for the first time in seven years. The current account balance has been improving and is now in surplus, while the government has reduced its fiscal deficit and continues to be able to access international markets on favorable terms. In addition, the country has maintained its strong record in promoting social inclusion, including gender equality.

2. The authorities are in a position to consolidate the macroeconomic gains of 2017 and to address medium-term growth bottlenecks. With a positive outlook for growth in the near term, both fiscal and monetary policy should be kept tight, in order to secure a stable and sustainable path for public debt as well as lower inflation within the target range. With a benign global environment, and building on Uruguay’s strong institutions and social cohesion, it is a good time to focus on medium-term priorities, in particular, reinforcing sources of growth and policy anchors.

Recent Developments

3. Since the Spring of 2016, the immediate benefits from the authorities’ prudent policies have been reinforced by appreciation pressures. From April through October 2016, strong investor interest resulted in a nominal appreciation of the peso vis-à-vis the U.S. dollar, which reduced tradable goods inflation, and boosted real wages and (wage-linked) pensions and consumption through 2017.

4. As a result, inflation has declined to 6 percent, while growth is projected to rise to more than 3 percent in 2017. Monetary policy effectively tightened between mid-2016 through the first quarter of 2017, as nominal interest rates remained fairly stable while inflation came down. Since then, interest rates have fallen, with short-term real rates moderating to 2–3 percent, which is in line with the guidance offered by a calibrated Taylor rule. Real GDP is projected to double its growth rate, from 1.5 percent in 2016 to 3.1 percent in 2017, driven largely by private consumption and net exports (with an exceptionally strong tourist season)

5. Fiscal adjustment is proceeding. Fiscal policy has been countercyclical in 2017, with higher income taxes partly offset by rising pension and health care costs, and we project the overall deficit to decline to 3.3 percent of GDP.

6. While the exchange rate has appreciated, the current account has turned positive in 2016 and 2017 .The bilateral real exchange rate versus Argentina depreciated over this period even as the multilateral real exchange rate appreciated by 12½ percent between April 2016–July 2017. The diverging real exchange rate trends vis-a-vis Argentina versus the rest of the world are mirrored in diverging pressures on the current account. The increased competitiveness against Argentina has supported a rapid and strong increase in tourism inflows. The real appreciation relative to the rest of the world has weakened export competitiveness for many agricultural and manufacturing products (even if output remained strong, in part owing to good harvests). After Uruguay managed to diversify its export products and destinations over the past decade and a half—which has greatly diminished its vulnerability to recurrent shocks in neighboring countries—a prolonged loss of competitiveness could put these gains at risk.

7. Reflecting the unusually strong current account, staff’s preliminary assessment is that the external position is stronger than consistent with fundamentals . The current account is expected to maintain a surplus of more than 1½ percent of GDP in 2017. The current account improvement has reflected the surging net tourism from Argentina, the decline in oil import prices in 2015 and 2016 and a sharp decline in inward FDI. Staff estimates that this current account balance is 1-3 percent of GDP stronger than the justified by fundamentals (after adjusting for the impact of the overvaluation of the Argentinean peso and depending on the inclusion of merchanting activities). In contrast, our real effective exchange rate model—which does not depend on an assessment of the current account position—points to a 14 percent overvaluation of the peso. These varying results illustrate the complications of assessing the real exchange rate in case of diverging pressures on competitiveness.

8. Financial flows have remained volatile. In late 2016 through early 2017, a large drop in nonresident holdings of government and central bank paper (by more than $1 billion) due to one-off portfolio adjustments by a single investor could have resulted in sharp depreciation pressures on the peso, if not for an offsetting portfolio shift by Uruguay’s pension funds into local currency, which continued through the third quarter of this year. More generally, local and nonresident investor interest in the peso has been strong. The central bank intervened to accommodate these large portfolio shifts, adding US$3 billion to its stock of net reserves in the first three quarters of 2017. Concerning other capital flows, since August 2016, a tax amnesty in Argentina has led to the orderly withdrawal of about US$2 billion in nonresident foreign-currency bank deposits.

Outlook and Risks

9. Staff expects the recovery to continue. Growth is projected to remain somewhat above its 3-percent potential rate in 2018 and 2019, supported by planned investment in rail infrastructure, and the output gap is projected to approach zero. Inflation is projected to pick up to 6½ percent by end-2017 and is subsequently expected to edge down to about 6 percent.

10. This largely benign outlook is subject to nontrivial upside and downside risks . On the upside, the authorities have reached agreement, in principle, with the Finnish company UPM on a possible foreign investment in Uruguay’s third paper pulp-processing plant—which would be the largest FDI project in the country ever and could boost confidence and growth further, especially during the construction phase. Downside risks include a prolonged loss of competitiveness There is also risk of dampened investor interest in emerging markets. A reversal of the recoveries in Argentina and Brazil, or a significant slowdown in China would undermine investment and growth. These forces could also trigger a correction of the real exchange rate in Argentina which, in turn, could result in depreciation pressures in Uruguay.

11. The country has the ability to weather conceivable short-term shocks. Uruguay’s large buffers—gross reserves of the central bank, liquid financial assets, and contingent credit lines at international financial institutions—would allow the country to weather potential short-term shocks relatively unscathed. Allowing the exchange rate to adjust in response to shifts in economic fundamentals offers another important shock absorber.

POLICY RECOMMENDATIONS

Keeping Inflation Low

12. Given the expected demand pressures, some monetary tightening would be appropriate in order to bring inflation close to the middle of the central bank’s 3-to-7 percent target range. The recent moderation of nontradables inflation and inflation expectations confirm the favorable prospects for enhancing price stability. The multi-year wage agreements reached in 2015–17—which put nominal wage increases on a declining path through 2018—are expected to help anchor nontradables prices and temper inflation inertia. Our baseline projection of gradually falling inflation is predicated on prudent monetary policies, with short-term real interest rates staying above 2½ percent.

13. The transmission of monetary policy has been constrained by the volatility of short-term interest rates, wage indexation, and the high degree of dollarization and low level of peso credit.

• Strengthening the policy signal. While the monetary stance has been broadly appropriate and inflation is on a downward trend, short-term interest rates have been relatively volatile. The authorities have regularly adjusted the reference range for money growth and allowed the actual monetary expansion to deviate from it, informed by interest rate developments. The authorities should (i) continue to closely monitor and accommodate changes in money demand; and (ii) explore options to reduce the volatility of short-term interest rates further, for example by using standing facilities to create an interest rate corridor.
• Utilizing the 2018 wage round. Continued moderation of annual nominal wage growth in the 2018 (multi-year) wage agreements will be important for anchoring inflation over the medium term (and real wage restraint could also help stem the trend decline in employment). Removing the remaining provisions that involve backward-looking wage indexation in case of higher-than expected inflation would be another step to reduce inflation inertia.
• Keeping inflation within the target range would support central bank credibility and could set the stage for broader efforts towards de-dollarization . Complementary policies to build on the gains in macroeconomic stability could include; for example, (i) using prudential regulations (e.g., by maintainingg higher reserve requirements on foreign currency deposits); and (ii) promoting that prices for domestic transactions are quoted in local currency.

A Flexible Exchange Rate

14. Sizeable and abrupt portfolio shifts by financial institutions have posed risks of exchange market disorder that can justify the recent interventions in the exchange market. In addition to portfolio inflows by nonresidents, significant portfolio shifts by domestic pension funds into pesos added to upward pressures on the exchange rate. The central bank accommodated these portfolio adjustments by buying foreign currency directly in exchange for peso letras (central bank paper). Without these interventions, the relatively small exchange market would have likely experienced disorderly conditions, involving undue exchange rate volatility.

15. Exchange rate flexibility should remain an important stabilizer for the Uruguayan economy in the face of shocks . Interventions should be limited to countering disorderly market conditions. Interventions also cannot substitute for necessary structural reforms to enhance the economy’s productivity and flexibility, and thereby competitiveness. Clear communications are important to ensure that the interventions do not undermine the credibility of the central bank’s commitment to reducing inflation.

Reconciling Fiscal Consolidation and Investment Support

16. With the approved 2018 budget, the authorities’ deficit objective is within reach. Staff estimates that the cumulative structural fiscal effort during the current government period (2015–17) has amounted to 1.3 percent of GDP—split between years 2015 and 2017 (with minimal adjustment in 2016). The 2018 budget envisages a decline in the overall deficit from 4.0 percent of GDP in 2016 to 2.9 percent in 2018, and reaffirms the government’s commitment to reducing the deficit to 2.5 percent of GDP by 2019. However, the higher import fees for goods for consumption (by 3 percentage points, estimated to yield 0.1 percent of GDP) are not helpful, as they go against Uruguay’s ongoing trade integration efforts.

17. It would be prudent to try to reach the 2019 deficit target earlier, and to reverse the reduction in public investment. Historically, election years—such as 2019—have seen higher spending and deficits. However, if the authorities save the revenue windfalls from a stronger-than-expected recovery and ensure the steadfast implementation of the spending allocations in the budget, it should be possible to achieve their 2.5-percent-of-GDP fiscal deficit objective already in 2018, with limited additional effort, and helped by lower interest costs. Separately, given Uruguay’s well-documented infrastructure gaps, the authorities are advised to reorient budget spending from the public wage bill to investment, and accelerate the preparation of PPPs (without relaxing safeguards). Furthermore, and regardless of the financing modality, it will be important to assess carefully the costs and benefits—including potential synergies—of each project, as well as of incentives to attract private investment.

18. To reduce public debt vulnerabilities, the authorities have successfully capitalized on financial markets’ benign view of the country. In mid-2017, following the notable decline in inflation, Uruguay issued nominal-peso bonds in the global market. The resulting longer local-currency yield curve can also assist in the pricing of long-term peso-denominated financial contracts, such as life insurance and pensions. In addition, the implicit liability stemming from future deficits of the defined benefits pillar of the pension system should be carefully assessed and controlled.

19. As the end of the government term approaches, amending the existing fiscal rule could strengthen confidence in the sustainability of Uruguay’s public finances. A continuation of present fiscal plans would stabilize gross and net debt as a share of GDP. However, the government’s fiscal commitment only covers its term, which runs out in 2019. An enhanced fiscal rule could: (i) include further safeguards to limit the use of escape clauses; (ii) constrain annual deficits (or net debt increases) specified in structural terms to allow for the operation of automatic stabilizers; and (iii) be anchored on a medium-term objective for the level of debt.

20. Uruguay’s state-owned enterprises (SOEs) have to be carefully managed. SOEs require strong governance to avoid the accumulation of quasi-fiscal costs. Now that ANCAP is brought back to financial soundness, a transparent formula for passing through changes in international oil prices to the domestic fuel prices would promote efficiency in the use of fuel and remove fiscal risks—which can be alleviated only partly though hedging oil import prices.

A More Functional Financial Sector

21. Bank credit remains weak, and has not served as an engine for growth. The extensive dollarization and a high degree of market segmentation render bank credit expensive and limited, especially in the peso market, where it could be most beneficial to nascent business ventures.

22. The ongoing implementation of the 2014 Financial Inclusion Law should help the banking sector to expand its reach. The law is expected to increase the supply of peso funding and access to credit by consumers and small businesses. At the same time, the use of new capital market instruments to finance public infrastructure, including through PPPs, and expected regulatory changes to facilitate the issuance of bonds by medium-sized private enterprises (rather than relying on self-financing), can help develop domestic financial markets, and promote competition within the financial system.

23. Maintaining the stability of the banking sector is a priority . Banks’ operating costs are high; non-performing loans have risen (but remain moderate); and bank profitability declined in the wake of the peso appreciation in 2016 (since most banks were long in U.S. dollars). Nonetheless, stability risks to the banking system remain limited, as evidenced by the authorities’ stress tests, and supported by rising capital-asset ratios. Supervision should continue to closely monitor banks’ exposures. The recent steps to implement Basel III—including the phased introduction of the 2.5-percent capital conservation buffer, capital surcharges for larger banks, and of liquidity ratio regulations—are useful risk-mitigation measures.

Enhancing the Business Climate

24. Uruguay’s business climate is backed by the country’s strong institutions and stability. Furthermore, the country has become increasingly integrated in world markets. The country has shifted to renewable sources for its power supply, and has developed connections for exporting excess supply to Argentina and Brazil. It is also implementing a comprehensive care system that supports women’s participation in the broader economy.

25. Ambitious structural reforms could help maintain robust medium-term growth against the background of a declining workforce due to population aging . Reforms should aim to (i) improve both educational attainment and the quality of education—for instance, via enhancing teacher qualifications and expanding vocational training; (ii) facilitate further economic integration with the countries in the region and elsewhere by upgrading the country’s transport and logistic infrastructure, and promoting new free trade agreements; and (iii) enhance the flexibility of labor markets, to facilitate shifts to relatively productive sectors and firms and to ensure that wage increases reflect productivity improvements;.

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