MercoPress. South Atlantic News Agency

IMF top marks for Uruguay’s economy but beware of inflation and wage indexation

The recent agreement to cut/freeze some consumer prices does not address the root causes of inflation

An International Monetary Fund (IMF) mission headed by Ulric Erickson von Allmen visited Uruguay from October 22 to November 2 to conduct the country’s annual Article IV consultation. At the conclusion of the visit, Mr. Erickson von Allmen division chief in the IMF’s Western Hemisphere Department issued the following statement in Montevideo:

“Uruguay has experienced a decade of spectacular growth since its 2002 crisis. This performance is the result of prudent macroeconomic policies, important institutional reforms, and favourable external factors, and has resulted in significant welfare gains.

“Growth in 2012 has been affected by spillovers from abroad and one-off factors. Domestic demand remains buoyant, in part because of strong real wage growth. At the same time, inflation is stuck well above target. Staff expects growth at 3.5 percent in 2012 and at 4 percent from 2013 onward.

“Despite the favourable outlook, regional and global uncertainties continue to pose risks. That said, the muted links between the real sector and the small financial system, robust banks, and a lack of apparent bubbles would mitigate the effects of exogenous shocks on Uruguay’s economy. The Central Bank of Uruguay (BCU) and local banks have sizable net foreign asset positions, in addition to the government’s foreign assets and contingent credit lines. The government’s deft debt management has reduced debt vulnerabilities significantly.

Turning to domestic risks, excessive wage growth in the coming years could present concerns: it would boost private consumption, fuel inflation and further real appreciation, and the ensuing loss of competitiveness would eventually hurt exports and growth, raising the risk of a hard landing.

“The immediate macroeconomic challenge is to tackle the above-target inflation rate in a context of high capital inflows and elevated risks to the outlook. High inflation reflects robust domestic demand, extensive wage indexation, food price shocks, an insufficiently tight monetary stance, and an inflation target that is not anchoring expectations within the range. The spike in global food prices has also added to inflation recently. At the same time, there has been a surge in capital inflows to Uruguay this year, reflecting ample global liquidity, the investment grade rating, and rate cuts in Brazil. The peso has strengthened against the currencies of Argentina and Brazil since spring 2012, causing competitiveness concerns in some sectors. However, staff’s assessment, based on a broad set of indicators is that external stability risks are contained.

“The BCU’s recent policy rate increase was a welcome step, and it would be important to maintain a tightening bias to put expected inflation on a path toward the target. The pace of tightening should be cautious, and take account of the evolution of the economy. But given surging capital inflows and attendant currency appreciation pressures, tight monetary policy cannot fight inflation alone. Concerted efforts on other fronts are also needed, especially prudent wage growth and further fiscal restraint in order to contain cost pressures and real exchange rate appreciation. Foreign exchange intervention could be used to contain overshooting.

“The mission is more sceptical about the recent agreement to cut/freeze some consumer prices as it creates distortions without addressing the root causes of inflation. In the view of the mission, extensive and hard wired wage indexation is a key factor in the pass-through of price shocks into higher wages and core inflation.

“The mission supports the recently introduced capital flow management measure, given the sharp rise in portfolio capital inflows. It would be important to use the breathing space afforded by this measure to tackle inflation.

“For the coming years, the mission welcomes the authorities’ plan to reduce public debt to about 45 percent of gross domestic product (GDP) by 2015. To achieve this, the state-owned electricity company’s (UTE) recurring drought-related deficits need to be tackled. In the meantime, the budget should rely on a greater contribution from the central government and less on public enterprises to achieve the debt target. This objective also calls for a tight grip on government spending.

“The floating exchange rate is a crucial shock absorber and a cornerstone of the policy framework. Given the very comfortable reserves position, there is clearly no need for further reserve accumulation for prudential reasons. However, occasional intervention may be needed to avoid excessive swings in the exchange rate. Sector-specific competitiveness problems are best handled through structural policies.

“The medium term outlook for Uruguay is favourable but will need efforts to enhance resilience to shocks and boost long-term growth. On the fiscal front, Uruguay’s already strong framework could be enhanced by casting the budget on a rolling five-year horizon and to include even longer horizons for certain items (e.g., social spending), and addressing contingent liabilities. Promoting deeper and sound financial markets can also support growth prospects. A comprehensive strategy is needed to help develop a capital market to promote efficient allocation of financial resources. To promote a more dynamic, sound, banking system, the authorities could consider measures to level the playing field among banks and increase support for financial inclusion by expanding small and medium-sized enterprises’ access to credit and households’ access to saving products.

“More broadly, there is scope to enhance further the competitiveness and dynamism of the business environment and this will require attention in a few key areas. Staff welcomes the investment plans in the energy sector, raising the share of renewable sources to half of electricity supply. It will also be important to tackle the improvements needed in the road network and the deep-sea port. A dynamic labour market with a well-educated labour force is important for fostering productivity growth, supporting the evolving structure of the economy, and facilitating adjustment to shocks. The authorities could undertake an evaluation of the experience with recent labour market regulations and consider changes to ensure a labour market commensurate with the needs of a dynamic economy while ensuring appropriate protection for workers.