We visited Uruguay and met with economic analysts and officials from the central bank and ministry of finance. Below are our main takeaways:
Economic growth has moderated. GDP grew 2.5% YoY in 2Q18 (0.2% sa) down from 2.7% in 2017, driven by Manufacturing, Transportation, Storage & Communication. The CPA Ferrere consulting firm expects GDP to grow 2.2% this year and 1.9% in 2019, as public and private investments remain weak and consumer confidence is subdued (Itaú forecasts 1.5% growth for 2018 and 1% for 2019). A positive one-time effect related to the return of operations of the Ancap refinery will likely be offset by the impact of a severe draught on the agricultural output at the beginning of this year.
A less dynamic economy was accompanied by a drop in employment. The investment ratio has fallen 6 points since 2012, to 16.4% of GDP in 2017, reflecting less public-sector capital spending and less private investment in clean energy (windmills) and in the pulp and paper industry. The employment rate fell to 57.0% in mid-2018, from 60.2% in 2014. A simultaneous decline in labor participation (due to discouraged workers) moderated the increase in the unemployment rate, which stands at an average of 8.4% in 2018 (up from 7.9% in 2017). The government changed the investment promotion regime to encourage employment, construction and key strategic sectors (pharmaceutical and biotechnology).
Weaker economic activity in Argentina and Brazil pose downside risks to economic growth in the short term. According to CPA Ferrere, GDP growth may drop to 1% if the financial stress in Argentina intensifies. While the trade dependence on Argentina and Brazil has diminished (and trade ties with China have increased), a stronger bilateral real exchange rate is another risk factor to hinder economic activity and employment in Uruguay. On the positive side, the expected new investment by the Finnish company Botnia in pulp mills (in 2020) and other associated investments (a new railway in 2019) have the potential to boost growth.
The Uruguayan peso (UYU) strengthened in real terms. Despite some nominal depreciation accompanying the trend in emerging markets, the bilateral exchange rate against the ARS is now 23% stronger than the average for 1980-2017, 35% for the BRL. The central bank has halted its interventions in the exchange market after purchasing USD 1.6 billion in the first four months of 2018, but authorities noted that it has excess reserves that could be applied to moderate the UYU volatility. Actually, the central bank sold UYU 260 million after May. Gross international reserves stand at USD 17 billion (28% of GDP), while the net of USD reserve requirement is 19% of GDP. CPA Ferrere forecasts an exchange rate of 32.5 UYU/USD by year-end (Itaú forecast: 33.5 UYU/USD), but acknowledges that there are upside risks (up to 34 UYU/USD).
Inflation is rising after an initial disinflation in non-tradable goods. The economic deceleration and weaker labor market helped reduce core and headline inflation in 2017, bringing it within the target range set by the central bank (5%+-2%) for the first time in seven years. However, inflation rose in May due to the pass-through of the depreciation of the UYU to tradable goods prices as well as to the increase in food and vegetable prices.
Higher inflation poses risks to the new round of wage bargaining negotiations. The adjustment guidelines for 2018 were set by the wage negotiation council. The guidelines establish increases of 6.5%, 7.5%, and 8.5% per industry depending on its degree of competitiveness (a higher adjustment for more dynamic industries). Negotiations started in July but have not advanced due to the rebound in inflation. So far, only the beverage sector has signed an agreement for an 8.9% wage adjustment. We note that while the indexation system was abandoned in 2015, there are still compensations if inflation crosses the 12% threshold.
The central bank sets the expansion of the broad monetary base on quarterly basis. As a result, the yield of the central bank bills ranges from 7.5% for the 30-day instrument to 9.5% for the one-year tenor. Given the expected deceleration and inflation at 7.5% (according to the latest central bank survey), authorities define the stance as “moderate contractive” (an ex-ante real interest rate of 2%).
External accounts are sound. The current account balances run a surplus of 1.6% of GDP in 2017 (flat if the trading of grains in free-zone areas is excluded). A deterioration in the travel account is expected due to reduced inflows of tourism (particularly from Argentina) during the upcoming summer season as a result of the weakening ARS. We estimate a current account balance of 0% of GDP in 2018.
Rising pensions maintains high fiscal deficit. We expect the consolidated fiscal deficit (including the central bank) to increase to 3.9% of GDP in 2018, from 3.5% in 2017. Despite several rounds of tax hikes (on individuals and corporates) in 2017, the government has postponed the planned fiscal consolidation to 2.5% of GDP to 2020 from 2019. The deficit of the pension system (including specific schemes for security forces) represents approximately 3% of GDP. The easing of regulations to access pensions in 2008 and increase social benefits (particularly health) resulted in an increase in primary expenditures, to 28% of GDP in 2017 from 24% in 2010. On top of that, pension adjustments are based on a wage index. The deterioration of fiscal accounts widened the net public-sector debt ratio (central government) to 42% of GDP in 2017, from 34% in 2013.
High liquidity buffers still support investment grade ratings. S&P and Moody’s rate the sovereign two notches above junk bond category, while Fitch’s is just one notch higher. The ministry of finance notes that hard-currency treasury deposits and access to contingent credit lines cover maturities for the next 12 months. Another positive is the adequate maturity profile and low foreign currency debt, 50% of which is denominated in domestic currency. However, private analysts estimate that a primary surplus of 1%-1.5% of GDP is needed to stabilize the debt ratio, assuming 3% GDP growth and a stable real exchange rate. Given the presidential election in October 2019, analysts do not expect changes in the fiscal stance. However, there is a consensus that a debate, and eventual reform, of the pension system seems unavoidable.