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.
According to the latest IMF report on the Uruguayan economy, 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% 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 un-hedged 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.