Macroeconomic resilience and sound policies amid a once-in-a-century drought and a difficult external environment
In 2023, Uruguay confronted the impact of a once-in-a-century severe drought and external headwinds. From October 2022 to April 2023, rainfall was about 47 percent below historical averages, affecting key agricultural areas, and causing significant direct losses to the primary sector, especially for soybean production and cattle farming. Agricultural output was mostly affected between the last quarter of 2022 and the second quarter of 2023 when it declined by 25 percent on a year-on-year basis, although it quickly recovered in the second half of the year as rainfall normalized. Amid a strong Uruguayan peso, the substantial depreciation of Argentina's currency, particularly in the parallel market, motivated important cross-border consumption flows taking advantage of relatively cheaper Argentinian goods and services, doubling the number of Uruguayans visiting Argentina in 2023. This situation depressed commercial activity in Uruguay, particularly in border cities, and weighed on domestic consumption and tax collection.
Against this backdrop, the economy remained resilient, owing to the authorities' sound macroeconomic policies, the country's political stability, and strong institutions. Despite the challenging environment, Uruguay maintained favorable market access with improved sovereign debt ratings and sovereign spreads at historically low levels, including the lowest spreads in the region. The current administration, in office since 2020, has implemented a significant upgrade of the fiscal and monetary policy frameworks and has advanced decisive structural reforms. In 2023, the authorities approved a key pension reform, placing medium-term public finances on a more sustainable path, and started implementing an education reform. Consolidating these gains should be the most important priority, as they provide the necessary macroeconomic policy space to confront domestic and external risks and support long-term growth.
While economic growth decelerated in 2023, inflation fell within the target range, reaching its lowest level in the last eighteen years. Real GDP growth was 0.4 percent in 2023. IMF staff estimates that the impact of the drought on growth was about 1 percent in 2023. Employment rose to 1.7 million in 2023 (up 37,000), while the unemployment rate continued to hover around 8 percent, and the share of labor informality increased moderately relative to 2022 while remaining amongst the lowest in the region. Net FDI inflows reached USD 4.2 billion (5.5 percent of GDP), providing more resilient sources of external financing. CPI inflation fell from 8.3 percent in December 2022 to 5.1 percent in December 2023, the lowest end-of-year value since 2005, owing to a strong contractionary monetary policy response in 2022, the appreciation of the Uruguayan peso, and falling import prices. Inflation expectations have recently converged to the central bank target range, reflecting gains in policy credibility, enhanced Central Bank communication and the continued easing of price pressures in the first quarter of 2024, with CPI inflation at 3.7 percent.
Monetary and fiscal policies supported the economy while preserving credibility gains
As inflationary pressures cooled off, the Banco Central del Uruguay (BCU) started its easing cycle in April 2023. The Monetary Policy Committee of the BCU gradually lowered the monetary policy rate from 11.5 percent at the start of 2023 to 8.5 percent in April 2024 as headline inflation reverted within the target range and inflation expectations gradually declined. While cutting nominal interest rates, the BCU kept a contractionary stance by keeping ex-ante real rates above the neutral rate throughout 2023. At the end of 2023, the authorities reaffirmed that the BCU inflation target is the center of the target band (4.5 percent) in a Macroeconomic Coordination Committee meeting. The authorities have continued to not intervene in the foreign exchange market, providing clarity and consistency on the main objectives of monetary policy. The peso appreciated by 2.6 percent against the US dollar in nominal terms during 2023, and by 7 percent on average in real effective terms, driven by domestic and global factors.
Amid external headwinds and the severe drought, the fiscal deficit increased during 2023. The deficit for the non-financial public sector (NFPS), excluding cincuentones[1], widened to 3.2 percent of GDP in 2023, driven by the smaller balance of the rest of the NFPS (state-owned enterprises and local governments). The deficit of the Central Government (including the Banco de Previsión Social) was unchanged, despite the increased transfers to support drought-affected sectors and the impact on tax collection caused by the situation in Argentina. The faster-than-expected disinflation in 2023, which is a welcome development, had adverse implications for the fiscal accounts, because real spending in wages and social security benefits increased while weighing on revenues as a share of GDP, driven by a lower-than-expected GDP deflator. Extreme dry conditions particularly affected the power company (UTE), forcing lower hydropower generation and larger energy purchases from neighboring countries. Gross NFPS debt increased to 64.5 percent of GDP but remains below pandemic levels. The deficit and debt outcomes are consistent with the targets of the fiscal rule in 2023, which are defined at the Central Government (including the Banco de Previsión Social) level.
Uruguay's fiscal rule played a notable role in strengthening fiscal discipline, while the pension reform approval improved longer-term debt dynamics. Adherence to the rule for four consecutive years has bolstered fiscal credibility, helping stabilize the debt-to-GDP ratio under a sequence of negative shocks. The pension system reform, that was approved in May 2023, will stabilize spending over the medium term, by including a gradual increase in the retirement age, a restructuring of pension contributions, and a revision of the pension calculation basis towards OECD norms. The improved fiscal outlook is being reflected in historically high sovereign debt ratings and low sovereign spreads, including the lowest EMBI spread in Latin America.
Outlook and risks
The economy is expected to strongly rebound in 2024, while macroeconomic risks are broadly balanced. The recovery of agricultural exports, increased cellulose production, easing of financial conditions and robust private consumption as real wages recover and the price differential with Argentina normalizes are expected to support a growth rate of 3.7 percent in 2024 and 2.9 percent in 2025. Inflation is projected to pick up in the second half of 2024, but stay within the target range, following a gradual easing of monetary policy and robust wage growth. Downside risks are derived from a worsening of external financial conditions, deterioration of international geopolitical tensions and the potential for further extreme climate events. Upside risks draw from events that could bring higher-than-expected agricultural export prices or lower fuel import prices.
Policies to rebuild buffers, consolidate credibility gains, and boost medium-term growth
Fiscal Policy
The 2024 revised budget is aligned with the fiscal rule targets and social protection objectives. The projected NFPS deficit, excluding cincuentones, of 3.1 percent of GDP balances deficit reduction with safeguarding social spending, a sizeable share of total expenditures. The ongoing disinflation could continue weighing on the fiscal accounts in 2024. The post-drought growth momentum creates opportunities for reinvigorating consolidation efforts. However, capitalizing on these opportunities requires navigating inherent spending rigidities that constrain policy options.
The crafting of the next five-year budget law provides an opportunity to recalibrate the fiscal rule targets to place debt on a downward path. Under current policies, the NFPS debt-to-GDP ratio remains largely stable over the projection period with limited near-term risks—as financing needs are manageable and market access remains at favorable terms. While the current fiscal rule has been successful at stabilizing the debt-to-GDP ratio under challenging circumstances, further efforts are needed to ensure a sustained downward path for the debt-to-GDP ratio and rebuild fiscal buffers over the medium term, requiring lower targets for the structural balance and net indebtedness pillars of the fiscal rule.
Refinements to the fiscal framework would help consolidate recent credibility gains. The successful implementation of the new fiscal framework under challenging circumstances has strengthened policy credibility. Within the current framework, the following refinements could be considered: (i) adopting five-year binding targets, consistent with lowering the debt-to-GDP ratio to a reference level over the forecasting period, when the new budget law is approved, (ii) establishing corrective mechanisms if escape clauses need to be triggered or should slippages occur, (iii) increasing the operational autonomy of the Advisory Fiscal Council, including through adequate resources, in line with best international practices, and (iv) exploring alternative methodologies to estimate potential output, the output gap, and desirable medium-term debt-to-GDP ratios.
Monetary and Exchange Rate Policy
Monetary policy should remain contractionary to ensure that inflation and inflation expectations stay within the target range in a sustained manner. Sustained monetary policy vigilance is crucial for continuing to build credibility and supporting de-dollarization efforts. The authorities should continue emphasizing that the inflation target is the mid-point of the target band (4.5 percent) in their public communications, to help anchor expectations. Enhancing de jure central bank independence would further improve credibility and support policy continuity. The exchange rate should continue to be allowed to act as a shock absorber and foreign exchange intervention should only be used to address disorderly market conditions.
Financial Sector
The financial sector has remained resilient. The banking system is well capitalized, highly liquid, and profitable. With capital requirements for credit, market, operational and market risks, the Uruguayan banking sector maintains almost twice the minimum regulatory requirement. Amid higher international interest rates and a more stable exchange rate, profitability increased. Despite last year's economic slowdown and losses in the agricultural sector, non-performing loans remained low with adequate loan loss provisions. Financial intermediation remains low with the private credit-to-GDP ratio at 30 percent while dollarization remains high at 69 percent for deposits and around 49 percent for loans, compared to other countries in the region.
The authorities have reaffirmed their commitment to enhancing their supervision framework and creating an enabling environment for the financial system to contribute to growth and development. The Superintendency of Financial Services (SSF) should continue pursuing efforts to upgrade its risk-based supervision framework, by enhancing its stress-testing framework. Closing data gaps will also be key in building more comprehensive measures for credit risk analysis (i.e., probability of default, loss given default) and for assessing system-wide FX liquidity and concentration risks. Operationalizing the Pillar II capital add-ons will create an opportunity to address the adverse effect on capital buffers from the bank wealth tax. The BCU aims at creating an efficient, integrated, and accessible payment system, promoting competition, preserving financial stability, and fostering compliance with AML/CFT regulations. Promoting the development of the peso capital market and fostering greater competition in the retail banking sector could provide more attractive investment opportunities and alternative sources of funding, as well as lower lending-deposit spreads.
Structural Policies
Efforts to continue implementing structural reforms are key to unlock potential growth, create policy space to preserve the country's safety net and social cohesion, and support favorable sovereign debt ratings. The implementation of the education reform is critical to provide the human capital Uruguay needs in the medium-term to foster the adoption of innovative technologies and increase productivity. Closing the labor force participation gender gap could help improve long-run growth prospects. Strengthening state-owned enterprises' corporate governance could further enhance their management and efficiency. The deepening of Uruguay's global integration should focus on pursuing efforts for trade facilitation, addressing non-tariff barriers and red tape, and reducing logistics costs. Reducing backward-looking indexation and introducing more sectoral differentiation in wage negotiations would support the disinflation process and competitiveness. The increase in crime over the last decade, albeit from a low base and amongst the lowest in the region, needs to be addressed before it starts weighing on growth.
Uruguay has been a trailblazer in climate mitigation and finance, but climate adaptation efforts need to be intensified. Uruguay has been at the forefront of climate finance innovation, with the issuance of its pioneering sustainability-linked bond and securing access from multilateral banks to global-first loans with financing conditions linked with the achievement of environmental targets. Climate hazards have become more intense and frequent. Droughts are becoming particularly relevant considering the output losses to the agricultural sector, requiring recurrent fiscal interventions. Against this backdrop, it is critical to enhance water resource management, promote sustainability, and increase resilience.
The team would like to thank the Uruguay's authorities and stakeholders for their hospitality, constructive policy dialogue, and productive collaboration during the Article IV mission to Montevideo between April 23-May 3, 2024.
[1] Temporary proceeds from the pension reform that allowed certain workers to voluntarily move back to the public pension system.
