IMF says Uruguays growth increase is up 700% in 2016
The International Monetary Fund (IMF) on Thursday says Uruguay’s growth increase is up 700% this year to 0.7%, a substantial increase from the 0.1% estimated in October, underlining the country’s resilience to the problems of its big neighbors Argentina and Brazil.
Uruguay has demonstrated considerable resilience in the face of recessions in its two large neighbors. Prudent macroeconomic policies, strong institutions, and success in diversifying its markets and products within the dominant agriculture and forestry sectors have helped stabilize the economy. Furthermore, the country has maintained strong financial buffers that complement the flexible exchange rate in absorbing external shocks.
Nonetheless, no country is an island, and the Uruguayan economy has slowed significantly since end-2015 . Faced with this slowdown, the authorities avoided an overly contractionary policy stance in 2016, keeping fiscal policy fairly neutral. But room for countercyclical policies is limited , and the fiscal package for 2017 is projected to be pro-cyclical (if considered in isolation), as further delaying structural fiscal consolidation could jeopardize Uruguay’s hard-won credibility with international investors, and potentially force a tougher adjustment down the line. Given the low growth and announced fiscal plans, the current monetary stance seems appropriate. However, the authorities should stand ready to tighten monetary policy in 2017 as needed to help guide inflation towards the target range. In the medium term, solidifying the economic and social achievements of the past decade will require structural reform to boost diversified and inclusive growth. While several key prerequisites for this are in place, such as a trusted public sector and a high degree of social stability, gaps will need to be addressed in transportation infrastructure, skills formation, and the provision of credit for private sector investment.
I. Recent Developments, outlook and risks
1. Uruguay is demonstrating resilience in the face of sharp recessions in its large neighbors. With both Argentina and Brazil in deep recession in 2016, Uruguay’s projected growth of 0.7 percent is a marked departure from yesteryears when growth remained close to the average of its two neighbors. GDP growth is projected to exhibit a modest recovery to about 1.1 percent in 2017, as the external environment strengthens, together with private consumption. However, the planned contractionary fiscal stance may impose a drag on overall domestic demand.
5. Risks to the outlook are both external and domestic:
- External risks. Although Uruguay’s regional economic ties have lessened, a slower-than-expected recovery in Argentina and Brazil could weigh on the economy, as could weaker-than-projected growth in China. Moreover, a tightening in global financial conditions could weaken growth across the region and raise Uruguay’s cost of financing. The high share of nonresident holdings of public debt could also pose some external risk, although maturities are long.
- Domestic risks. If the recovery in 2017 were weaker than expected, the authorities could face a difficult trade-off between their fiscal consolidation plan and avoiding a strongly pro-cyclical fiscal stance that would exacerbate the slowdown. On the other hand, a potential large foreign investment (about 7 percent of GDP) in a third pulp mill presents an upside risk to growth.
6. Uruguay’s strong liquidity buffers and the flexible exchange rate should enable an orderly adjustment to shocks.
- Public sector financing risks are limited by sizeable liquid financial assets, buttressed by the government’s access to contingent credit lines at international financial institutions.
- The authorities’ willingness to allow the exchange rate to adjust in response to shifts in economic fundamentals has been key to absorbing external shocks.
- The BCU’s gross reserves are ample relative to standard prudential benchmarks and could help cushion severe external shocks.
II. POLICY RECOMMENDATIONS
Implementing fiscal consolidation
7. Implementing the authorities’ fiscal consolidation path will be critical to put net debt on a downward trajectory. The government avoided an overly pro-cyclical fiscal stance in 2016, while locking in the required fiscal adjustment for 2017. The announced measures are expected to have a lasting effect on the primary balance. As growth rebounds, staff projects the primary surplus to exceed 0.5 percent of GDP in 2019, allowing for a gradual reduction in gross and net public debt.
Making monetary policy more effective in curbing inflation13. Inflation is projected to decline gradually, supported by a negative output gap and the ongoing wage discussions. Confronting inflation remains a priority, and is a precondition for de-dollarization, which would in turn improve the transmission of monetary policy. The new wage agreements offer a valuable opportunity to achieve a lasting reduction in inflation, as they are set in nominal terms, which should reduce inflation persistence, and as they include nominal wage increases that are lower for each subsequent year, gradually reducing cost pressures. Current staff projections foresee inflation moving into the 3–7 percent target range by 2019. Securing the expected gradual decline in inflation would be especially important at this juncture, as surprise inflation could jeopardize sustained progress in reshaping the wage regime.
15. There is scope to enhance the effectiveness of monetary policy in the medium term.
- Reduce inflation persistence further. New wage agreements typically include backward indexation after 12 months or more to offset possible real wage losses. While a longer adjustment delay would be helpful in avoiding indexation in response to temporary price shocks, the full elimination of indexation provisions would be advisable as expeditiously as possible.
- Strengthen the policy framework. Money demand has proven difficult to predict. This warrants a careful monitoring of changes in money demand to avoid an unduly relaxed policy stance. The authorities could also usefully explore options to reduce the volatility of short-term interest rates, for example by using standing facilities to create an interest rate corridor, as a more stable short-term yield curve could strengthen the policy signal and serve as a reference for developing peso debt instruments and derivatives.
16. The flexible exchange rate should remain the key mechanism to absorb external shocks. Exchange rate movements since early 2015 helped cushion the downturn and support competitiveness, as neighboring countries experienced similar depreciation pressures. Interventions in the exchange market should be used parsimoniously to counter disorderly market conditions, and not to counter trends driven by fundamentals.Promoting financial development and maintaining stability
17. The ongoing steadfast implementation of the 2014 Financial Inclusion Law promises to help increase peso deposits and competition in the peso market.Private banks can capitalize on the generalization of payroll deposit accounts to increase their peso funding, and boost the peso credit market.
18. Market deepening and prudential policies to encourage domestic currency deposits and loans could support de-dollarization. The financing of public infrastructure projects could be designed to foster the development of new capital market instruments in peso, including for retail investors. On the regulatory side, reinstating differentiated reserve requirements on peso and foreign currency deposits could encourage banks to favor peso deposits. Supervision should remain alert to monitoring banks’ exposures, and containing stability risks.
Supporting Inclusive Growth
19. Social policies and transfers have played a significant role in reducing poverty and inequality in Uruguay. Uruguay stands out as the country with the largest drop in the Gini coefficient in Latin America over the past decade. This reflects both government guidelines to bolster low wages, and increased redistribution through income taxes and transfers. Greater income equality can add to countries’ long-term growth potential. However, looking ahead, further redistributive policies may be constrained by their fiscal costs, and should be designed with careful consideration of their impact on labor supply and incentives to seek training
22. New free trade agreements and progress in international integration could contribute to potential growth. Given the diversification of Uruguay’s export markets, and its focus on highly regulated and protected agricultural products, ensuring beneficial market access will be critical. The recent trade agreement with Chile, which complements the 1996 agreement between Chile and Mercosur, and the possible conclusion of trade negotiations between Mercosur and the European Union, should benefit Uruguay’s exports.
The mission thanks the authorities for the warm hospitality, the open discussions, and the quality of the engagement.
IMF Communications Department