MercoPress. South Atlantic News Agency

Record purchase of US dollars to keep Uruguayan Peso from further appreciation

Last week the Central bank increased the basic interest rate 25 points to 9.25%

Uruguay’s Central bank on Wednesday made its largest purchase of US dollars on record totalling 120 million dollars following on the bank’s monetary committee decision in the last week of 2012 to increase the basic rate to 9.25% as the country struggles to contain inflation.

Although Uruguay’s macroeconomics are far more serious than neighbouring Argentina, domestic demand and a budget deficit have seen inflation soar to almost two digits in the eleven months of last year, despite the government’s annual target of 4 to 6% and the IMF estimate of 7.9%.

Twelve month inflation in November was 9.03%, down from 9.11% in October but still far higher than expected following an agreement with supermarkets on a basic basket of 200 items and the freezing of public utilities rates.

In its positive report on Uruguay the IMF forecasted that the economy would expand 3.5% in 2012 and 4% this year. However the Fund also made a stern warning regarding inflation.

The latest IMF report on Uruguay said the government must appeal to other tools than interest rates to fight inflation, including cutting back on government spending and moderating wage growth.

“Monetary policy cannot fight inflation alone, given capital inflow concerns; concerted efforts on other fronts are also necessary. In particular, fiscal policy could better support monetary policy”.

The IMF also pointed out that “recent initiatives to cut/freeze some consumer prices create distortions without addressing the root causes of inflation. In the view of the mission, extensive wage indexation is a key reason why price shocks feed into wages and core inflation”.

Slower spending would help moderate domestic demand, alleviate real appreciation pressures, and support disinflation. It would also help secure the authorities’ target of reducing public debt to 45% of GDP by 2015. Likewise prudent wage growth is also essential.

The central bank’s last decision of 2012 increasing the basic interest rate triggered a run by US dollar holders to invest in Pesos. To impede an over appreciation of the Uruguayan currency (and collapse of the greenback), the bank had to intervene purchasing 120.3 of the 120.8 million dollars in the first trading day of 2013.

The massive purchase just managed to keep the exchange rate at 19.40 Uruguayan pesos to the US dollar, which is 0.01% higher than trading last Friday. It was the largest volume traded on record by the central bank on a single day.

With rates in the leading world markets virtually zero or negative (taking into account inflation) investors look for profit even in riskier markets causing a massive inflow of capital, a strong appreciation of the local currency which threatens the country’s exports.