Uruguay: Uruguay Economy Profile

After years of very high increase, Uruguay’s economy is “cooling off” as exports and domestic request increase rates are both slowing. Uruguay remains susceptible to weak economic conditions in the near region, in particular in Argentina and Brazil.

Strengths (+) and weaknesses (-)

(+) Strong institutions

Uruguay’s public institutions are relatively strong. The country, for example, has a much lower level of corruption than its direct neighbours.

(+) Strong underlying increase pattern

The relatively high level of increase of recent years was underpinned by high levels of foreign direct investment and a relatively high level of productivity increase. This bodes well for Uruguay’s medium-term increase prospects, even as increase is likely to slow down a bit in the near-term.

(-) High level of dollarization

The degree of dollarization of the economy is high, as both public deficit and deposits are mostly denominated in USD, but this is mitigated by a healthy banking system. In addition, the high average maturity of the public deficit lowers near-term financial risks. Ample FX reserves as well provide cover and allow the central bank to intervene to soften FX shocks.

(-) Vulnerability to external shocks

Uruguay’s small, open, agricultural exports based economy, is exposed to volatility of commodity prices and the global/financial economic environment. Vulnerability to Argentina has gradually decreased but remains elevated, primarily for the tourism sector.
Key developments

1. Economic increase is further slowing down

Next several years of high increase, the Uruguayan economy has been gradually “cooling off”. The initial quarter of 2015 showed a modest GDP rise by 0.6% q-o-q in seasonally adjusted terms, as domestic request increase slowed. Q1 2015 was the seventh consecutive quarter in which increase decelerated. According to the five-year budget of the current government (2015-2019), GDP increase will relieve to 2.5% y-o-y in 2015, following tighter fiscal and monetary policies. Net exports contributed to increase in Q1, as export volume increase was much higher than import volume increase, next a period of relatively weak export increase in 2013 in 2014. Given the country’s degree of openness, economic activity still remains susceptible in the near term to external developments, such as softening of commodity prices and economic developments of the major trading partners, Argentina, Brazil and China. A reduction of dependence on neighbouring nations in recent yearimply however lower negative spill-overs than in the completed. Slower increase in China is expected to affect Uruguay to a lesser extent, as the prices of agricultural commodities (Uruguay’s major export products) are unlikely to fall as much as those of oil or metals (which are import products for Uruguay).

2. Modest short term narrowing of the fiscal budget deficit

Next winning the October 2014 presidential elections, former president Tabaré Vazquez again took office in March 2015. The government aims to consolidate the public finances, but narrowing the fiscal deficit will necessitate a moderation of central government’s discretionary spending and lower public investments, which is likely to meet resistance. The relatively rigid structure of public spending (pensions, social assistance and wages spending cannot be cut easily) makes it hard to reach budget deficit targets (2.5% of GDP by 2019) through spending reductions alone. As a result, revenue improving measures (e.g. lowering minimum gain contribution threshold, limit VAT exemptions and review business tax exemptions) are as well needed. A delay in tightening fiscal policy beyond 2015 would leave net deficit on a steeper upward trend, raising the possibility of additional severe fiscal adjustment later, particularly if external shocks were to raise the deficit burden. Although the budget deficit remains substantial up to 2019, it remains manageable. As a result, the public deficit ratio is not expected to deviate considerably from its current level (63% of GDP) in the mid-term.

3. Inflation expectation still not anchored

Despite aggressively tightened monetary policy, the inflation levels are still high (annual inflation in the initial half of 2015 amounted to 8.5% y-o-y) and remain above the central bank’s target range of 3-7% in the mid-term. Lower commodity prices (particularly oil imports), a further tightening monetary and fiscal policy combined with a slower pace of economic activity are expected to have a dampening result on price pressures. However, other factors will prevent a rapid fall in inflation, inclunding a tight labour market, weak monetary policy credibility (reflected in persistently high long-term inflationary expectations) and a high level of wage indexation. As a result, inflation is expected to remain high in the mid-term, but to gradually trend down below 7% around 2018/2019.

4. Peso depreciation exposes vulnerabilities

The Uruguayan peso depreciated by 22.2% against the USD in the year ending in July 2015, in line with the appreciation of the USD against other currencies. The USD, which had weakened as a result of quantitative easing in the US, has started to appreciate since mid-2014 vis-à-vis other (major) currencies and is likely to continue this path as the monetary policy in the United States will be gradually normalized. Further peso depreciation would put pressure on disinflationary efforts and/or could raise the default rate on FX loans to unhedged borrowers, which account for almost one third of total bank credits to the private sector. A comprehensive set of regulations aimed at mitigating FX related credit risks is in place, ensuring that banks periodically assess the payment ability of borrowers under real currency depreciations of 20%-35% and hold better cushions against FX loans to unhedged borrowers. Uruguayan banks and the public sector have ample U.S. dollar liquidity. Thanks to its large stock of foreign exchange reserves, the central bank can intervene to soften exchange rate shocks.