OREANDA-NEWS. February 18, 2016. Uruguay has achieved more than a decade of high and inclusive economic growth, supported by social stability and reduced regional linkages. International financial markets have recognized Uruguays stability and strong financial buffers. Yet, economic activity in Uruguay markedly slowed in 2015, triggered by a regional downturn and weakening prices of its export commodities. Real GDP growth is estimated to have fallen to 1.5 percent in 2015, as investment and consumption growth have declined from recent highs. Meanwhile, inflation remains entrenched above the central banks 37 percent target range. Defying the closing output gap, a relatively tight monetary stance over the past two years, and low international food and energy prices, headline inflation has edged up to more than 9 percent since July.

Depreciation pressures intensified during 2015, broadly in line with the regional and global trend among emerging markets. Domestic deposit dollarization picked up, although more than half of the increase was driven by valuation effects rather than a portfolio shift. Gross international reserves have dropped by US\\$2.6 billion since June, as the central bank has extensively intervened in the foreign exchange market to contain the depreciation of the peso.

The medium-term budget for the new governments 5-year term foresees an improvement of the primary fiscal balance by 1.5 percent of GDP over 20152019. The 2015 primary balance is estimated at close to zero, in line with the budget, as lower tax revenues were offset by a sharper

reduction in public investment. The overall fiscal deficit in 2015 is estimated at 3.6 percent of GDP, 0.3 higher than in the budget, because of higher interest payments.

GDP growth is projected to remain tepid in 2016 as external conditions remain weak and consumer confidence has dropped. The further slowdown in fiscal spending and consumption is likely to temper domestic demand. In the medium term, growth is expected to rise back to a potential rate of 3.1 percent.

Risks to the outlook are mostly external. Although Uruguays regional economic linkages have lessened, a worse-than-expected slowdown in Argentina and Brazil could significantly weigh on Uruguays economy. A global slowdown would affect Uruguays commodity exports, and increased volatility in oil prices would impact on import costs. A tightening in global financial conditions could raise financing costs.

Near-term financial risks seem limited. There is no evidence of a credit bubble or excessive private sector leverage. The 2015 uptick in non-performing loans, from low levels, does not, at this stage, seem a cause for significant concern. Uruguays strong liquidity buffers should facilitate an orderly adjustment to shocks.

Executive Board Assessment2

Executive Directors commended the Uruguayan authorities for their sound macroeconomic policies, institutions, and reforms, which have supported strong and inclusive growth over the last decade and have helped achieve one of the lowest poverty and income inequality rates in Latin America. While the economys strong fundamentals position the country well to weather the recent slowdown, Directors encouraged the authorities to continue implementing prudent macroeconomic policies and structural reforms to further strengthen the economys resilience, lower persistently high inflation, and boost potential growth.

Directors emphasized that continued exchange rate flexibility is essential to absorb external shocks. They welcomed the authorities intention to limit foreign exchange interventions to smooth excessive volatility, which should also help avoid premature erosion of the countrys reserve buffers.

Directors stressed the importance of continued efforts to put inflation on a downward path. They supported the authorities tight monetary policy, and noted that a prudent fiscal stance should help the monetary policy effort. They welcomed the new wage setting guidelines aimed at curbing inflation inertia, but encouraged further steps to fully remove backward indexation. Directors also called on the authorities to closely monitor the performance of the new monetary policy framework.

Directors welcomed the governments five year budget, which appropriately combines budgetary consolidation with efforts to support infrastructure development and key social objectives. The authorities commitment to fiscal consolidation and continued improvements in the public sectors primary balance will be essential to stabilize net debt over the medium term. Directors also stressed the importance of restoring the financial soundness of the public oil distribution company expeditiously and of improving the financial performance of state owned enterprises more generally. They agreed that well designed private public partnerships, with strong control of liabilities, could help finance needed infrastructure investment and improve project management.

Directors welcomed the recent initiatives to promote financial inclusion and deepening, such as the financial inclusion law. They noted that these initiatives may require upgrades to the countrys solid regulatory framework, including the full implementation of the Basel III standards. Directors observed that foreign currency credit to unhedged borrowers in the non tradable sector has moderated from its 2013 high, but underscored that close monitoring of this ratio remains warranted, particularly given the recent peso depreciation.

Directors agreed that further diversification of export markets and expansion of higher value added commodity production could help reduce the countrys exposure to adverse external shocks. They welcomed the authorities efforts to upgrade transport and logistics infrastructure, and encouraged initiatives to reform secondary education in order to boost growth potential.