Country Report Uruguay
The ruling Frente Amplio won a third term in office and will now have to strike a balance between high spending needs and sound macroeconomic policies while the economy is slowing down.
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 external position
Foreign direct investment inflows have been fairly high and stable, providing a reliable source for financing the structural current account deficits. Besides, a high level of FX reserves also mitigates balance of payments risk.
(-) High level of dollarization
The financial system still has a sizeable degree of dollarization. A substantial part of the government debt is also denominated in foreign currency.
(-) Vulnerability to external shocks
As a small, open economy and an agricultural commodity exporter, Uruguay is vulnerable to external developments. The country has reduced its susceptibility to economic developments in Argentina in the past decade, but the neighbour still accounted for 60% of tourism earnings in 2013.
1. Another win for the Frente Amplio (FA)
The general elections held in October and November 2014 led to a third victory for the Frente Amplio (FA) and its presidential candidate Tabaré Vázquez. The leading coalition obtained a simple majority in congress, which will facilitate policy making. The new cabinet will be appointed in March 2015 and it is expected to follow a course of sound macroeconomic management, pro-business policies and an emphasis on social development, similar to the first term of President Vasquez between 2005-2010. However, the economic environment is less favourable this time. Besides, the leftist factions within the ruling coalition have strengthened their position during the elections and could demand more interventionist policies. Therefore, while policy is expected to remain sound, challenges might arise.
2. Economic growth slows down
Following years of good performance, economic activity in Uruguay has been moderating and improvement in 2015 should be modest. In 2014, economic growth fell from 5% in 2013 to 3.1% on the back of both domestic and external headwinds. On the domestic front, a 13% depreciation of the peso dampened private consumption and investments fell as major projects were completed. Monetary tightening to contain persistently high inflation also constrained output. On the external front, headwinds came from lower commodity prices and economic woes in Argentina and Brazil, important export markets for particularly manufacturing, logistics and tourism. In fact, lower revenues from Argentinian tourists, which in 2013 had accounted for 60% of tourism spending, pushed the services balance into negative territory for the first time in decades. Looking forward, little improvement is expected in 2015, when economic growth is forecast at 3.3%. While the opening of the Montes del Plata pulp mill in June 2014 is poised to improve output, government consumption is expected to moderate due to efforts to reduce the budget deficit. To improve economic potential, Uruguay needs to address structural competitiveness issues, such as a huge infrastructural deficit and strong wage indexation which keeps labour costs high. Nevertheless, given the country’s degree of openness, economic activity will remain susceptible to external developments. So softer commodity prices and weakness in main trading partners will weigh on economic activity in 2015.
3. Fiscal balances deteriorate, though impact should be contained
Fiscal balances have deteriorated in recent years and failure to improve them might increase Uruguay’s financing costs. Uruguay’s public deficit increased from 2.3% of GDP in 2013 to 3.5% of GDP in 2014, the highest shortfall since the bank crisis in 2002. Consequently , public debt increased by 3 ppts to 65% of GDP in 2014. While public debt is much lower and stable than in the past, having reached 122% of GDP at its peak in 2002, the level remains elevated. The main driver behind the increase in 2014 has been election related primary spending, particularly on capital investments. In Uruguay, the budget deficit is planned for a period of 5 years by each new cabinet within 6 months from appointment. The five year budget plan is revised yearly afterwards. The previous cabinet missed targets repeatedly during its term, as it increased spending on social programmes such as health insurance and pensions. For example, the original budget deficit target for 2014 was less than 1% of GDP.
Looking forward, public spending pressures will remain high on the back of electoral promises to improve the quality of education and healthcare and a huge infrastructural deficit. Given the high level of public debt and the fact that it is largely denominated in foreign currency (43% in 14Q3) and largely owned by non-residents (54% in 14Q3), further deterioration of the fiscal balances could hurt market sentiment and increase financing costs, especially as the external financing environment is becoming less benign. We do find comfort in the particularly long debt maturity profile and the still high demand for Uruguayan debt, as well as access to contingent credit lines with multilateral institutions amounting to 3.6% of GDP. The new cabinet is expected to be committed to sound macroeconomic policy and to reduce the shortfall to 2.9% of GDP in 2015. However, balancing high spending pressures with tightening fiscal policy to maintain investor confidence will be a tough balancing act.
With an estimated per capita income of USD 16,188 in 2014, Uruguay is one of the richer countries of Latin America. Uruguay’s population and its economy are relatively small. The country has relatively good public institutions. For example, 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 democratized successfully after a 12-year period of military rule ended in 1985.
Due to close financial, trade and tourism links with Argentina, Uruguay was severely hit by the 2001/2002 economic crisis in Argentina and in 2003, the country had to restructure its sovereign debt. Afterwards, its dependence on Argentina has decreased, though the tourism sector, which accounts for 3% of GDP, is still very dependent on Argentina. 60% of tourist arrivals and revenues in 2013 come from Uruguay’s South-western neighbour. Argentina is also an important FDI source. These investments are concentrated in real estate rather than productive sectors, so contagion risk is low. Uruguay’s exports predominantly exist of agricultural products, in particular livestock/beef, agriculture and dairy products. Other important economic sectors are the financial sector and tourism sector. A high level of (foreign direct) investment has diversified the economy and is expected to continue to do so in the near future. The high level of foreign direct investment is an important risk mitigant for the relatively high current account deficit.