On February 20, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Uruguay, and considered and endorsed the staff appraisal without a meeting.²

The Uruguayan economy continues to decelerate gradually. Real GDP growth is estimated to have softened to a still robust 3.25 percent in 2014 from 4.5 percent in 2013, mostly reflecting the moderation in domestic demand growth amid a less favorable external environment. Weak economic conditions abroad have continued to weigh on Uruguay’s current account, particularly on the services side. At the same time, the surge in inflows to the local securities market abated and the Uruguayan peso has depreciated towards levels broadly consistent with fundamentals.

Inflation remains above the central bank’s 3–7 percent target range. After being pushed to near 10 percent in early 2014 by food price shocks and the pass-through of peso depreciation, consumer price inflation receded to 8.25 percent at the end of the year, in part due to subdued increases in administrative prices and one-off measures to ease inflation. Above target inflation reflects a shrinking but still positive output gap, upward shocks to food and fuel prices in 2010–13, and pervasive backward-looking wage indexation that embedded these shocks.

Monetary policy has been tight while fiscal policy has been slightly expansionary in 2014. The peso yield curve remained 400–600 basis points above inflation and credit growth has slowed markedly. Public sector spending continued to grow faster than real GDP in 2014, but the budget approved for 2015 will generate a fiscal withdrawal of about 0.75 percentage point of GDP, mostly by slowing spending.

Bank resilience indicators are generally strong, but less so than a few years ago. In particular, foreign currency credit to borrowers in the nontradables sector has increased as a share of total credit, banks’ capital buffers have declined somewhat, and the share of nonperforming loans has inched up in 2014, albeit from a low level. Deposit dollarization remains elevated.

Economic activity is projected to decelerate further but remain solid. The pass-through of lower global oil prices to end-user prices will be gradual, as part of the windfall from lower oil prices will initially be used to shore up the operating balance of the state-owned petroleum enterprise. The programmed fiscal tightening and continued weak external conditions will outweigh the positive impact of reduced gasoline prices on domestic demand, with growth shifting down to about 2.75 percent in 2015. Inflation is projected to decline gradually to within the target range over the medium term as monetary policy remains tight, the output gap closes, and retail prices for gasoline decline. Net public debt is projected to crawl up to 43 percent of GDP in 2019 from 36.5 percent in 2013, with the primary balance remaining below the level required to keep debt constant.

Key risks to the outlook relate to uncertainties regarding global and regional economic growth and U.S. monetary policy normalization. The strong liquidity buffers of the private and public sectors would facilitate an orderly adjustment to external shocks. Nevertheless, the high shares of nonresident-holdings of public debt and foreign currency denominated bank credit to borrowers in the nontradables sector could present vulnerabilities.

Executive Board Assessment

The Uruguayan economy is decelerating gradually after a decade of strong and inclusive growth. Export receipts are growing at a markedly lower clip than a few years ago and domestic demand growth is slowing towards a more sustainable pace. At the same time, inflation remains above the target range and the primary fiscal balance has weakened further in 2014.

The external environment presents risks as well as opportunities. As a small open economy that exports mostly agricultural products and has nonresidents holding a relatively high share of its public debt, Uruguay is exposed to the risk of lower global growth and tighter global financial conditions. At the same time, the recent drop in global crude oil prices will provide a welcome opportunity to improve the overall fiscal and balance of payments positions and reduce inflation.

Uruguay’s strong liquidity buffers would allow an orderly adjustment in the event of adverse external shocks. Public debt maturity is high, reserves comfortably exceed prudential benchmarks, and banks and the public sector have ample U.S. dollar liquidity. However, above-target inflation would leave little room for a countercyclical monetary policy response, and a primary balance that is insufficient to keep net public debt around its current level would limit the policy space to deploy discretionary stimulus.

A multi-dimensional disinflation strategy is needed to bring inflation to the mid-point of the target range. Such a strategy would involve maintaining a monetary policy stance tight enough to keep inflation on a downward trend, moving towards tighter fiscal policy, a reduction in the backward-looking component of wage setting to temper inflation persistence, and bolstering the central bank’s influence on inflation expectations through well-crafted communication efforts. Enhanced central bank autonomy would also be beneficial.

The upcoming five-year budget is an opportunity to reinforce fiscal sustainability. Improving the primary fiscal balance by about 2 percent of GDP over the medium term would help ensure that net public debt is put on a firmly declining path. The improvement in the fiscal balance could be achieved by keeping spending growth moderately below potential GDP growth over the next five years and modestly increasing revenues.

Financial regulation and supervision are solid, but could benefit from fine-tuning in some areas. The exposures to exchange rate depreciation risks bear continued close monitoring. There is scope to strengthen risk weights for foreign currency loans to unhedged borrowers, incorporate greater exchange rate stress into the supervisory stress tests, and require banks facing capital shortfalls in the stress tests to submit contingent capital plans for the approval of the Superintendency of Financial Services. In addition, measures to assist financial deepening could enhance growth and social inclusion.

A key challenge is to bolster strong growth in the medium run in order to continue deepening Uruguay’s social gains. The commitment of the incoming government to boost infrastructure investments, revamp secondary education and skill formation for the youth, and foster an innovation-friendly business environment is welcome.