Uruguay - Staff Concluding Statement of the 2019 Article IV Mission

December 17, 2019

Context: Enviable achievements but challenges emerged

1. Uruguay is in an enviable position in many respects. The country enjoys a well-functioning democracy, political stability, strong governance and institutions, and a high degree of social cohesion. Following a decade and a half of robust growth, it also boasts high per capita income, and low rates of poverty, inequality, and informality. Thanks to prudent supervision and regulation, the financial sector remains resilient despite regional financial market volatility.

2. But imbalances have emerged, and external developments remain a headwind. Growth, investment, and labor participation have been on a declining trend in recent years, and internal imbalances (higher fiscal deficits, rising unemployment) have accumulated. Debt has increased and inflation remains outside of the target range. At the same time, external position has remained robust, with the current account fluctuating at around zero and sufficient reserve buffers. In the past, Uruguay has taken advantage of the benign global conditions, including high commodity prices and robust external demand. Such favorable conditions, however, are no longer present, with sluggish global and regional growth, subdued commodity prices, elevated uncertainty, volatile capital flows, and bouts of financial turmoil in neighboring Argentina, although low global interest rates provide breathing space.

3. The political and domestic economic landscape over the next few years present an opportunity for addressing Uruguay’s economic challenges. The new government, which assumes office in March 2020, will have a post-election mandate and will be helped by a growth boost from the construction of a new paper pulp plant and oncoming public-private partnership (PPP) projects. In addition, there is consensus across the political spectrum regarding key challenges.

4. The authorities should use this opportunity to reverse the accumulation of imbalances and undertake reforms to safeguard achievements and ensure continued income convergence. They should reduce debt and bring inflation towards the mid-point of the target range. They should also leverage Uruguay’s institutional advantages to further improve the fiscal and inflation targeting frameworks and implement structural reforms. A revival of productivity growth is critical to sustain the coverage of the welfare state and ensure fairness across generations. In this context, action is needed to improve education outcomes, youth employment, private investment and the efficiency of state-owned enterprises, as well as to ensure adequate pensions for future generations.

Recent Developments : Softened Economy

5. The economy softened, and inflation remained above target. Economic activity began to decelerate in 2018Q2, and the annual growth in the first half of 2019 was around zero percent. Consumption stagnated and the expected rebound in capital formation—following years of underinvestment—failed to materialize. On the positive side, exports have been recovering from their 2018 trough, and the current account balance has fluctuated at around zero. Inflation increased to 8½ percent in November, outside of the target range, despite a negative output gap, due to both temporary factors and above-target expectations.

6. Spillovers from Argentina have been limited to the real sector and exchange rate channels, thanks to robust financial sector and ample reserve buffers. Tourism receipts from Argentina dropped by 34 percent in the first half of 2019 compared with the same period in 2018. The authorities allowed the exchange rate to adjust in an orderly manner, with the peso depreciating against the U.S. dollar by 17 percent since end-2018. Intervention was geared to addressing disorderly market conditions and was two-sided. Reserves declined from US$15.6 billion in December 2018 to US$14.3 billion in December 2019 (25 percent of GDP). The financial sector—which had markedly reduced its exposure to Argentina prior to the onset of the crisis—remains robust, and sovereign spreads are contained at low levels. With the depreciation of the currency, however, deposit dollarization has edged up.

7. Fiscal balances deteriorated substantially. As the economy slowed, revenues declined, and current expenditures continued to increase. The budget for 2020—the last to be prepared by the current government—gives up on the achievement of the 2.5-percent-of-GDP deficit target and instead foresees a fiscal deficit for the consolidated public sector (CPS) of 4.6 percent of GDP in 2019 (excluding the cincuentones transactions) and 3.8 percent of GDP in 2020. [1] The underlying fiscal balance has deteriorated since the budget projections. As of October, the twelve-month CPS deficit (excluding the cincuentones transactions) stood at 4.6 percent of GDP, aided by the impact of a debt management operation in September (0.3 percent of GDP) and by lower interest payments from the central bank. [2] Excluding the impact of the debt management operation, the CPS deficit (excluding the cincuentones transactions) would have been 4.9 percent of GDP. The authorities have successfully issued longer-term bonds at favorable rates to cover their financing needs.

8. The authorities and the IMF switched the focus of fiscal reporting for Uruguay from the CPS to the non-financial public sector (NFPS) . The NFPS-based reporting includes all the components of CPS except the central bank and provides a more appropriate and clear measure of the underlying fiscal situation. [3] The authorities continue to transparently communicate all the details of the fiscal accounts, including the impact of cincuentones on fiscal outturns. In this context, the IMF’s fiscal analysis is based on the NFPS fiscal aggregates excluding cincuentones transactions, while WEO data present the NFPS fiscal aggregates including cincuentones.

Outlook and Risks : Expected Recovery but Sizable Risks

9. The economy’s long-term growth potential is estimated at around 2–2.5 percent, taking account of (i) low and falling investment and (ii) declining labor force participation, partly reflecting demographic trends. Since 2015, growth averaged at about 1½ percent, compared with an average of about 5 percent during 2006–14.

10. At the same time, the outlook has improved. Staff projects growth to rebound from an estimated 0.5 percent in 2019 to 2.1 percent in 2020 and 2.5 percent in 2021, as investment projects ramp up, offsetting possible adverse spillovers from Argentina. Growth is expected to decline after 2021 as these investments run their course—but the level of real GDP is expected to be permanently higher by around 1 percent due to the productivity impact. Inflation is expected to remain at around 8 percent next year and then to decline gradually towards the upper limit of the target range as temporary factors wear off and wage increases follow the declining path agreed in the last round of negotiations.

11. Uruguay’s external position is broadly consistent with fundamentals and desirable policy settings . Staff projects the current account deficit to widen, as tourism receipts from Argentina settle at a lower level, and large investment projects and economic recovery raise imports. After the completion of the paper-pulp plant, exports are expected to increase.

12. There are sizable upside and downside risks. On the downside, economic developments in Argentina remain an outsized risk, even though the likelihood of direct financial spillovers is small. A host of global factors (trade disruptions, lower growth, abrupt declines in risk appetite, large swings in energy prices) and of local ones (loss of credibility due to insufficient fiscal adjustment or delayed reforms and PPP projects) may undermine the expected recovery and limit medium-term growth. On the upside, the growth boost from investment projects may be larger than expected, given the uncertainty about possible indirect effects.

Policies: Safeguarding Sustainable and Inclusive Growth

A. Maintaining Fiscal Sustainability

13. Under baseline projections, despite an expected improvement in fiscal balances, debt is expected to rise. Staff projects the NFPS overall deficit (excluding cincuentones) to gradually decline from estimated 4.1 percent of GDP in 2019 to 3.9 percent of GDP in 2020 and settle at around 3.1 percent of GDP. [4] This reflects a cyclical improvement of tax revenues and state-owned enterprise profits, as well as some measures to contain expenditures (amounting to about 0.9 percent of GDP), given the political consensus on the need for fiscal adjustment. In addition, availability payments related to PPP projects are expected to reach ½ percent of GDP by 2024. NFPS debt is expected to increase from an estimated 67 percent of GDP in 2019 to 68 percent of GDP in 2024. [5]

14. While gross financing needs are manageable, fiscal space is diminishing. Large financing needs for 2020 are expected to be met in the context of coordinated public-sector asset-liability management, stable local currency funding from domestic institutions, the authorities’ pre-financing policy, and sufficient buffers (in the form of nonfinancial-public-sector liquid assets and contingent credit lines). Sovereign risk spreads remain contained, but the fiscal position has worsened, debt is elevated, and downside risks are sizable. Despite improvements, the shares of foreign-currency debt and of nonresident holdings remain relatively high, leaving debt vulnerable to exchange rate pressures and changes in risk sentiment. As a result, Uruguay’s fiscal space—the room for discretionary fiscal policy without endangering the debt sustainability—is at risk.

15. There is a need to introduce a credible adjustment plan starting from 2020 to put debt on a firm downward path. Current fiscal trends, if they continue, could undermine debt sustainability and investor confidence. Given sizable downside risks, bringing debt to its 2012–14 levels (about 10 percentage points of GDP lower than currently) over the longer term would place Uruguay comfortably within the range of investment-grade peers and rebuild space to accommodate future negative shocks without endangering sustainability.

16. Given the expected growth support from large investment projects, there is room to frontload the fiscal adjustment. Bringing the NFPS primary deficit from its current level of 1.7 percent of GDP to a surplus of 0.9 percent of GDP by 2024 would stabilize debt. Additional adjustment is needed to tilt down the debt ratio. On average, a ½-percent-of-GDP adjustment per year would reduce debt by about 10 percentage points in 10 years. In the absence of negative shocks and to the extent that growth picks up, the authorities will have more scope to deliver a higher adjustment for the next couple of years. This would help reduce debt faster (including through lower future interest payments), ease the economic impact of the adjustment and reduce the adjustment needs going forward. If upside risks materialize, windfall revenues resulting from the demand boost should be saved to both stabilize the economy and use the opportunity to reduce debt during good times.

17. A combination of measures will be needed. A transparent public information and communication strategy would help build consensus around the selected measures.

a. A sustainable adjustment would require limiting the increase in current expenditures. If, for example, current expenditures increase with inflation—rather than increasing with or faster than nominal GDP—debt would decline by 8 percentage points by 2024 relative to the current levels. However, given expenditure rigidities, such as in pensions, maintaining current expenditures flat in real terms may be too ambitious. In addition, careful consideration should be given to maintaining adequate provision of key public services and safety nets. In this context, a combination of measures such as keeping public wages in line with the private sector (to attract and retain talent while avoiding excessive costs), reducing public employment in non-critical sectors through natural attrition, and improving the efficiency of spending would support the adjustment.

b. Capital expenditures, at already low levels, should be preserved.

c. There is room to reduce tax expenditures— exemptions, reduced rates and tax credits—, estimated at about 7 percent of GDP. About three quarters of these expenditures are for the value added tax, where tax expenditures represent about 40 percent of collections. A cost-benefit analysis could help streamline exemptions, particularly those benefiting higher-income groups or those that have not achieved the desired outcomes. This would support the fiscal adjustment, given the rigid structure of the current expenditures, and allow the future use of exemptions as a stabilization tool in case of negative shocks.

18. Addressing growing pension spending is a priority. Uruguay boasts a comprehensive social security system, an impressive achievement and one of the pillars of the country’s social stability. With the population aging and given the already high level of pension spending (around 11 percent of GDP, about a third of total expenditures), reforms are needed to ensure sustainability and adequate retirement income for future generations. Reforms should be based on a comprehensive review of the entire system, supported by an informed social dialogue. Early action will help smooth the transition to a revised system and release resources for other priority areas.

19. The adjustment should be accompanied by introduction of a revamped medium-term fiscal framework (MTFF) . Given sizable downside risks, particularly if a gradual approach is chosen, there is a need to establish credibility of the adjustment plan from the outset. The introduction of a new MTFF, encompassing a binding fiscal rule, would enshrine credibility by introducing a fiscal anchor that ensures medium-term sustainability. It would also help rebuild the necessary fiscal space to counter negative shocks without endangering sustainability. An improved MTFF could include (i) a rolling 3-to-5-year projection period, irrespective of the government’s term to reduce uncertainty; (ii) a strengthened fiscal rule (possibly an expenditure rule combined with a debt anchor); (iii) limited use of escape clauses in exceptional circumstances; (iv) strengthened accountability mechanisms to ensure better adherence to fiscal targets; (v) regular spending reviews to increase efficiency; (vi) more frequent updates of forecasts given frequent shocks; (vii) greater budget unity by setting a spending ceiling that is binding also for autonomous (Article 220) entities; (viii) better coordination between the Office of Planning and Budget and the budget office of the Ministry of Economy and Finance (to link strategic priorities and program evaluations to budget allocations); and (ix) disclosure of risks, including those associated with PPPs. Budgetary targets should be set for the NFPS, in line with the recent shift in the focus of fiscal reporting.

B. Lowering Inflation and Reducing Financial Dollarization

20. Inflation and inflation expectations remain persistently above the top of the target range. The stance of monetary policy was tightened in October, with the indicative reference for the growth rate of the M1+ monetary aggregate lowered from 8-10 percent in 2019Q3 to 7-9 percent in 2019Q4. While interest rates have increased by about 100 basis points at the short end and by about 20 basis points at the longer end, inflation and medium-term inflation expectations have continued to increase, currently standing at 8.4 percent and 8 percent, respectively.

21. With the expected growth boost, the central bank will have the space to focus on reducing inflation towards the mid-point of the target range. If inflation stabilizes at current levels, it would leave Uruguay vulnerable to negative shocks, which could raise inflation to double digits. Accordingly, monetary indicative references should be further tightened such that real interest rates rise above the range of estimated neutral rates. This should continue until inflation and inflation expectations are firmly at the mid-point of the target range. Keeping inflation low and stable at the middle of the target range would also help support efforts to reduce dollarization and indexation and deepen financial markets and reinforce policy credibility. The authorities should also continue to use the exchange rate as a shock absorber and interventions should be reserved for addressing disorderly market conditions—as they are now—and reserve buffers should be kept above prudential norms.

22. Further enhancements to the inflation targeting framework could be considered to keep inflation low and stable at the mid-point of the target range. Conducting monetary policy is quite challenging in the presence of a high degree of dollarization, low credit-to-GDP ratio, remaining wage indexation, and frequent shocks to the exchange rate. At the same time, a low and stable inflation is key to addressing these challenges. Enhancements could focus on strategies, instruments, and communication practices. In particular, communicating a clearer hierarchy of objectives, with the primacy of price stability at the mid-point of the target range, and explaining in more detail the central bank’s reaction function would guide expectations towards the mid-point of the target range and reinforce the expectations channel.

23. Continued efforts to reduce the high degree of dollarization and indexation are welcome . The revised guidelines for wage bargaining councils—which introduced productivity considerations and delinked wages from past inflation—are an important step towards reducing indexation. Both macroeconomic and price stability are critical to reducing dollarization. In addition, continued coordinated efforts to fine-tune regulatory measures, deepen financial markets, and provide hedging opportunities would help further encourage local currency holding.

C. Financial Sector: Preserving the Resilience and Supporting Growth

24. The financial sector is resilient, but medium-term challenges remain. Thanks to prudent supervision and regulation, Uruguay’s financial sector weathered the bouts of financial volatility in Argentina well. At the same time, financial intermediation is chronically low, with wide margins between credit and deposit rates. In addition, credit markets are segmented for dollar and peso loans (with very high rates for the latter), weakening the monetary transmission mechanism.

25. The authorities are proceeding with appropriate steps to maintain financial sector resilience. Regulation on the net stable funding ratio—requiring that the liquidity profiles of bank’s assets and liabilities be aligned—became effective in December. Regulation on countercyclical buffers—requiring banks to accumulate additional capital during boom times—will be submitted for public consultation in December. In addition, investment limits for pension funds were modified to incorporate exposures to PPP projects to limit concentration risks.

26. Authorities’ efforts to deepen financial markets are welcome. These include efforts to (i) create benchmark curves; (ii) increase the liquidity of instruments in secondary markets; and (iii) foster financial inclusion and innovation, by providing free access to bank accounts, encouraging electronic transactions, and analyzing ways to improve the payments system. As a result, electronic points of sale almost doubled between 2014 and 2019, and the amount of cash withdrawals began to decline in 2018.

27. Financial regulation should aim to strike the right balance between enabling innovation and competition on the one hand and addressing challenges to financial integrity, stability, and consumer protection on the other. Since the introduction of the regulation on peer-to-peer lending, no fintech company has registered. Continued collaboration across state agencies, the central bank, and the industry would help advance the common goal of financial development and inclusion, while ensuring proper risk management.

D. Structural Reforms for Sustainable and Inclusive Growth

28. Uruguay has distinct structural strengths relative to peers . It has strong governance and institutions, a well-functioning democracy, a high degree of social cohesion, a strong commitment to free trade, as well as low rates of poverty, inequality, and informality. Its citizens enjoy a strong safety net and adequate protection of their rights. Overall, Uruguay is one of the top performers on many environmental, social, and governance (ESG) indicators (based on the World Bank’s Sovereign ESG data framework).

29. Building on these strengths, further structural reforms are needed to ensure continued income convergence and maintain social achievements for future generations . Closing infrastructure gaps is an important step but by itself will not be sufficient to raise growth to the levels seen in the past decade. A vibrant private sector is essential to support growth. To this end, Uruguay needs to improve its education outcomes and the business environment. In addition, a corporate governance reform would improve the management and efficiency of SOEs, which play a key role in the Uruguayan economy.

30. Deterioration in labor market outcomes needs to be reversed. Employment and labor force participation have been falling in key sectors, and the unemployment rate has risen, particularly among the young (to around 30 percent). Younger generations bear the brunt of the adjustment during downturns, increasing concerns about both intergenerational equity and potential insider-outsider issues. In addition, perception surveys indicate that there is room for further improvement in wage flexibility, labor-employer cooperation, and in conditions for attracting and retaining workers.

31. Policies should be geared towards delivering high and stable employment, while maintaining adequate worker protection. Changes to the wage council guidelines—which introduced productivity considerations and greater flexibility—are a step in the right direction. Further flexibility (for small firms, low-productivity regions, and during downturns) could be considered to preserve rights and provide incentives for firms to create more stable jobs and invest in on-the-job training. Better aligning wage increases with productivity would also help raise skill premium and improve incentives for further education. In addition, improvements in business-labor cooperation and continued focus on education and training to recalibrate skills could support employment. Similarly, youth unemployment should be addressed in coordination with the education reform. Continued efforts to integrate migrants and female labor into the labor market would help offset pressures stemming from population aging.

32. The increase in crime, albeit from a low base, needs to be addressed before it becomes macro-critical. In addition, in light of increasing money laundering risks, the authorities are encouraged to promptly implement recommendations of GAFILAT’s [6] AML/CFT assessment, particularly to address risks from foreign proceeds of crime.

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