Public Information Notice No. 05/77

Public Information Notice: IMF Executive Board Reviews Uruguay's Performance Under Past Fund-Supported Programs

June 15, 2005

On March 18, 2005, the Executive Board of the International Monetary Fund (IMF) discussed the ex post assessment of Uruguay's longer-term involvement with Fund-supported arrangements.¹

Background

Uruguay has undertaken broadly prudent macroeconomic polices over the last decade. An exchange rate-based stabilization in the 1990s successfully reduced inflation, though it resulted in some real exchange rate appreciation. The real economy has been importantly influenced by developments in the region, especially in Argentina. Since 1996, Uruguay has had a series of Stand-By Arrangements with the IMF that were treated mostly as precautionary. In 2002, Uruguay faced its most severe financial crisis, with widespread illiquidity and insolvencies in the domestic banking system, a sharp depreciation of its currency followed by high inflation, and a doubling of the public debt-to-GDP ratio to about 100 percent. This triggered activation of purchases under the existing Fund arrangement and approval of a new one, which was augmented twice, making it the largest Fund arrangement as a share of a country's GDP. The economy has rebounded strongly since the crisis, and inflation has returned to single digits. However, substantial vulnerabilities remain, reflecting the high debt burden and widespread dollarization.

The ex post assessment concludes that continued Fund involvement will likely be needed, and that exit from Fund financial support in the future will depend on the ability to tap international capital markets, which in turn will hinge on a forceful program aimed at fiscal consolidation and fostering sustainable growth. Achieving these objectives will require a wide range of structural reforms, notably in the tax and financial sector areas.

Executive Board Assessment

Executive Directors considered that, on the whole, the series of precautionary arrangements had helped buttress the authorities' commitment to prudent macroeconomic policies and secure political support for difficult reforms. In retrospect, however, deep-rooted vulnerabilities—notably in the banking system and the fiscal accounts—should have been tackled more forcefully to build a larger cushion against shocks. Moreover, the gradual, consensus-building approach to structural reforms had led to slow progress in needed areas. These weaknesses constrained economic performance and the ability of the Uruguayan economy to withstand the external shocks in late 2001 and early 2002, leading to the deep financial crisis and recession of 2002. Directors regretted that the arrangements did not manage to address the vulnerabilities in the banking system in a more timely manner. Many Directors stressed, in this regard, that precautionary arrangements should be subject, to the same standards as regular arrangements, in terms of both program conditionality and compliance.

Directors noted that both the magnitude and the nature of the 2002 crisis, with large withdrawals of dollar deposits from the banking system, required a somewhat novel approach in its resolution, involving support of the central bank's lender of last resort function in a highly dollarized economy. They observed that while the strategy employed, combined with an exceptional access to the Fund's resources, had eventually halted the banking crisis, a comprehensive approach had been adopted only after a few months. Directors considered that Uruguay's experience pointed to the need for early implementation of comprehensive and strong programs, addressing simultaneously the intertwined difficulties in the banking system, the external accounts, and the fiscal position. They broadly agreed that the move to an exchange rate float—though a close call—had been a decisive and reasonable course of action, but noted that the rationale for floating should have been explained fully in subsequent staff reports. Directors acknowledged that the debt exchange, which extended bond maturities by about five years, brought welcome breathing room, although the debt remains high and will require strong fiscal policies and structural reforms to promote growth in order to bring the debt down rapidly over the medium term.

Directors agreed that Fund financial support had been instrumental in stabilizing the Uruguayan economy following the deep financial crisis, although most considered that a larger access combined with stronger measures would have been desirable at the start of the program. They commended the authorities for the successful implementation of the Fund-supported program and for the rapid economic recovery that has ensued. Directors observed that, while much progress has been made in the structural area, in particular with regard to banking resolution and restructuring, vulnerabilities remain substantial, stemming largely from the high levels of public debt and dollarization. At the same time, Directors regretted that several important fiscal reforms had not been undertaken as programmed.

Directors agreed that Uruguay still faces significant challenges in setting the economy on a durably higher growth path, which call for continued commitment by the authorities to macroeconomic stability and growth-enhancing structural reforms, as well as intensive engagement by the Fund. They considered that financial support from the Fund would remain critical, particularly in light of Uruguay's large external payment obligations coming due in the next few years, although some Directors emphasized that a successor arrangement should entail an exit strategy from Fund resources. They also pointed to the need to adhere strictly to the exceptional access framework. Directors underscored the need for a strong program to create the conditions for improved access to capital markets at reasonable spreads, and progressively reduced exposure to the Fund in tandem with Uruguay's ability to tap international financial markets.

Directors emphasized that a successor Fund-supported program should seek to further reduce the country's macroeconomic vulnerabilities and set the basis for a sustained increase in private investment and growth. This would require continued fiscal consolidation, aimed at generating sufficiently large primary surpluses to restore medium-term debt sustainability, while safeguarding social spending. To this end, Directors encouraged the authorities to undertake the necessary reforms to simplify the tax system, strengthen the tax administration, reform the special pension funds, and improve the budget framework and procedures. Directors also stressed the need to reduce the role of the state and encourage competition. Further reforms in the banking system and enhancement of prudential regulations and supervision remain immediate priorities, with a view to restoring sound credit flows and reducing vulnerabilities resulting from dollarization and nonresident deposits. Measures should also be taken to increase the independence of the central bank and of the banking supervision function, as well as to enhance flexibility in the areas of trade and labor markets. A clear communications strategy would help ensure broad-based consensus needed for moving forward with difficult reforms.