MercoPress. South Atlantic News Agency

Uruguay cuts basic rate and eases credit to sustain US dollar

Central bank president Mario Bergara

Uruguay surprised markets with a 175 basic point rate cut to 6.25% from 8.00% amid expectations of lower inflation. The central bank also decided to reduce the inflation target fluctuation for the next 18 months from 3 to 7%, to 4% and 6%.

The bank is expected to announce this week the timetable for a considerable reduction in technical reserves for the banking system thus liberating more funds for loans and access to credit.

“The reduction in the basic interest rate is in accordance with macro-economic variables and the decision to further lower inflation. The rate remains prudently positive in real terms since it is slightly higher than the expected inflation”, said Central bank chairman Mario Bergara.

“We perceive an increase in the demand for money because of the improved economy and also for seasonal reasons”, said Alberto Graña head of the Central bank Economic Policy and Markets.

The measure is also expected to have an impact on the foreign exchange rate, since the Uruguayan peso has been sustainedly appreciating against the US dollar, thinning competitiveness to the country’s exports as domestic costs become higher in US dollars.

However Bergara downplayed the foreign exchange aspect saying that it was one more of the “several criteria”, not even the most relevant, in the determination of the exchange rate.

Private analysts were surprised by the significant magnitude of the cut and anticipated that the whole package of measures will in effect have a short term impact on the exchange rate, “modest and possibly transitory” but will help to ease downward pressure on the US dollar.

“I believe the immediate impact could be a slight relief for the US dollar, but on the long term the US currency will continue to deteriorate. It’s a global tendency”, said economist Rafael Mantero.

Bergara said that the Central bank will continue to try and “soften, mitigate the US dollar volatility” but active participation is not indefinite, “simple a balancing effort”.

The Uruguayan Central bank is also expected to decide an eight point drop in the banking system technical reserves for deposits in Uruguayan pesos and ten points for those in US dollars. They currently stand at 20% and 15%.

“This means that as of next January banks will have an additional 200 million US dollars in pesos to loan”, said Graña. And regarding reserves reduction in US dollars, this means that between January and June there will be “1.3 billion US dollars more in the system”.

The reductions are going to be gradual during the comings months until completed the established targets.

Another issue not openly mentioned is the “carry-trade” global phenomenon which is pumping funds from developed countries, where interest rates are virtually zero, to developing markets such as Brazil and Uruguay where the basic rates were considerably higher. The same inflow of funds helps appreciate local currencies thus further increasing yields when local currencies are converted back into US dollars.

Obviously the mechanism continues to work handsomely as long as the US dollars inflow remains strong and rates in developed countries remain rock bottom.