Country Report Uruguay
After years of very high growth, Uruguay’s economy is 'cooling off' as exports and domestic demand growth rates are both slowing. Uruguay remains susceptible to weak economic conditions in the near region, in particular in Argentina and Brazil.
Author: Dragos Aftoni
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 growth pattern
The relatively high level of growth of recent years was underpinned by high levels of foreign direct investment and a relatively high level of productivity growth. This bodes well for Uruguay’s medium-term growth prospects, even as growth is likely to slow down a bit in the near-term.
(-) High level of dollarization
The degree of dollarization of the financial system is high, as both public debt 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 debt lowers near-term financial risks. Ample FX reserves also 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.
1. Economic growth is further slowing down
After several years of high growth, the Uruguayan economy has been gradually “cooling off”. The first quarter of 2015 showed a modest GDP rise by 0.6% q-o-q in seasonally adjusted terms, as domestic demand growth slowed. Q1 2015 was the seventh consecutive quarter in which growth decelerated. According to the five-year budget of the current administration (2015-2019), GDP growth will ease to 2.5% y-o-y in 2015, following tighter fiscal and monetary policies. Net exports contributed to growth in Q1, as export volume growth was much higher than import volume growth, after a period of relatively weak export growth 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 main trading partners, Argentina, Brazil and China. A reduction of dependence on neighbouring countries in recent yearimply however lower negative spill-overs than in the past. Slower growth in China is expected to affect Uruguay to a lesser extent, as the prices of agricultural commodities (Uruguay’s main 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
After 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 expenditure reductions alone. As a result, revenue improving measures (e.g. lowering minimum income contribution threshold, limit VAT exemptions and review business tax exemptions) are also needed. A delay in tightening fiscal policy beyond 2015 would leave net debt on a steeper upward trend, raising the possibility of more severe fiscal adjustment later, especially if external shocks were to raise the debt burden. Although the budget deficit remains substantial up to 2019, it remains manageable. As a result, the public debt 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 first 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 effect on price pressures. However, other factors will prevent a rapid fall in inflation, including 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 greater 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.
Uruguay is one of the richer countries of Latin America, the size of the population and the economy is relatively small. According to the Corruption Perception Index of Transparency International, it is the least corrupt country of Latin America. Income inequality, though substantial, is low by Latin American standards, and Uruguay’s politics are relatively consensual. The country has democratised successfully after a 12-year period of military rule ended in 1985. Uruguay has a free market economy characterized by an export-oriented agricultural sector, a well-educated work force, and high levels of social spending. Following financial difficulties in the early 2000s, economic growth averaged 8% annually during 2004-2008 and decelerated to 2.6% in 2009 following the global financial crisis in that year. Nevertheless, the country managed to avoid a recession and keep positive growth rates afterwards, mainly through higher public expenditure and investment. GDP growth reached 8.9% in 2010 but slowed in 2012-2014, the result of a renewed slowdown in the global economy and in Uruguay's main trade partners, Argentina, Brazil and China. Uruguay’s economic linkages with neighbouring countries Argentina and Brazil have in relative terms become less important, but remain strong with respect to inbound tourism, foreign direct investments as well as exports. Uruguay’s exports predominantly exist of agricultural products, in particular livestock/beef, agriculture and dairy products. Other important economic sectors are the financial sector, tourism sector and ports. Substantial investments in renewable energy in 2012 have started reducing the country’s dependence on oil imports and the volatility of the public sector balance.