Uruguay—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding


Montevideo, Uruguay
February 24, 2003

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler

Since the augmentation of the Stand-By Arrangement last August, financial indicators have stabilized. The Government of Uruguay has formulated an economic program to create the conditions for a resumption of economic growth, as described in the attached Memorandum of Economic and Financial Policies for 2003.

In support of these efforts, the Government of Uruguay requests: (i) completion of the delayed second review under the Stand-By Arrangement, and availability of a purchase equivalent to SDR 218.5 million upon completion of the review; (ii) a one-year extension of the current arrangement, through March 31, 2005; and (iii) the rephasing of all remaining purchases under the arrangement, in an amount equivalent to SDR 798.1 million (Table A). We also request that the repurchase expectations arising during the arrangement period be moved to an obligations basis.

Data are not yet available to assess observance of the end-December 2002 performance criteria on the cumulative balance of the combined public sector and the nonfinancial public sector debt. The government accordingly requests waivers of applicability with respect to these two performance criteria. We also request a waiver for the nonobservance of the standard performance criterion on exchange restrictions in connection with the reprogramming of time deposits at BROU and BHU. All other continuous and end-December 2002 performance criteria under the Stand-By Arrangement were observed, as well as all structural performance criteria.

We are confident that the policies set out in the attached Memorandum of Economic and Financial Policies and the continued support of the international financial organizations will provide the needed stability for the sustained resumption of economic growth. Nonetheless, the government stands ready, in consultation with the Fund, to take any additional measures necessary to ensure the success of the program. Reviews under the arrangement in 2003 will be completed by May 31, 2003, August 31, 2003, and November 30, 2003. These reviews will be held in conjunction with financing assurances reviews, and will assess overall performance under the program and observance of the performance criteria for end-March 2003, end-June 2003 and end-September 2003, respectively.

Sincerely yours,

Memorandum of Economic and Financial Policies for 2003

I. Main program objectives

1. Building on the 2002 program, the government has elaborated policies for 2003 aimed at creating the conditions for a resumption of economic growth while keeping inflation under control. The economy is projected to gradually recover during this year, although real GDP is nevertheless projected to fall by 2 percent on a full year basis. The recovery will be led by exports, and the external current account surplus is projected to widen from 1.2 percent of GDP in 2002 to 2.4 percent.

2. The key objectives of the program are to ensure fiscal, monetary, and banking soundness. Its main components are: (a) the 2003 budget, which seeks to achieve a primary surplus of the combined public sector of 3.2 percent of GDP; (b) a monetary program aimed at limiting inflation to about 27 percent by year-end; (c) the deepening of structural measures needed to strengthen the fiscal position over the medium term; (d) to ensure sufficient financing assurances to meet the financing need for 2003; and (e) a comprehensive resolution of the suspended domestic banks.

3. The performance criteria under the program are set out in Table 1 and defined in the attached Technical Memorandum of Understanding. Table 2 presents the prior actions and structural benchmarks under the program. The government will also observe the standard performance criteria against imposing exchange restrictions, multiple currency practices, and import restrictions for balance of payments reasons. There will be three program reviews in 2003, including for financing assurances.

II. Fiscal policies

4. In 2003, the primary surplus of the combined public sector will rise significantly, setting the basis for a sustainable fiscal position over the medium term. Under the current set of policies, the primary surplus will be 3.2 percent of GDP in 2003, to be achieved mainly through expenditure restraint. The primary surplus of the combined public sector is projected to average 3.3 percent of GDP in 2004-05, and to progressively rise to about 4 percent of GDP over the medium term. Over time, improvements in the revenue base will help underpin the primary surplus target.

5. Regarding expenditure policy, the nominal growth of non-interest expenditure will be limited to 14 percent in 2003. The nominal increase in discretionary spending, including wages and pensions, will be restrained to ensure achievement of the program's objectives. If, however, tax revenue were to be higher than envisaged under the program, consideration will be given to higher increases in discretionary spending, provided there is compliance with the program objectives. In addition, any cash or in-kind salary advances will be avoided. The main elements of the fiscal framework for 2003 are as follows:

Consolidated Public Sector Summary Accounts 1/ (in Ur$ billion)
	2002		Q1	Q2	Q3	Q4	2003
Revenue	72.8		21.7	21.3	24.1	26.6	93.8
Non-Interest Expenditure	72.3		19.6	19.8	20.9	23.1	83.3
Of which: Wages	14.7		3.8	4.2	3.7	4.4	16.1
Social security benefits 2/	42.1		10.9	10.9	11.4	12.2	45.4
Primary Balance	0.5		2.1	1.6	3.2	3.6	10.5
1/ As defined in the Technical Memorandum of Understanding, excluding local governments. 2/ Includes pensions and other social security benefits from the BPS and the police and military pension funds.

Expenditure savings equivalent to 0.2 percent of GDP will be achieved under the newly established program for centralization of public sector procurement of medical supplies and food. Social expenditure will be protected and, following significant reductions in recent years, capital expenditure is programmed to recover somewhat in 2003.

6. Revenue of the consolidated public sector is projected to remain at about 30 percent of GDP in 2003. This performance will be supported by: (i) the full-year effect of the tax measures adopted in May 2002; (ii) an increase of the current surplus of public enterprises by 0.7 percent of GDP led by expenditure restraint and adjustments in public tariffs to reflect operating costs; and (iii) a reform of the tax refund scheme for exporters. The government also intends to significantly strengthen tax administration and combat evasion through improved data exchange between collection agencies, the designation of agents of retention for the VAT in activities prone to evasion, and renewed efforts to combat informal commerce and smuggling. The government will not grant new ad hoc tax exemptions to specific sectors of the economy and will develop a framework for reviewing and streamlining existing ones.

7. The government will advance tax reform, designed to increase efficiency, facilitate tax administration, and enhance revenue collections over the medium term. The main objectives of the reform are to: (i) broaden the VAT base; (ii) eliminate several low-yielding taxes by incorporating them under the umbrella of the main excise-type tax; (iii) unify and consolidate existing income tax schedules, which will ensure comparable treatment for all sectors, and expand the taxpayer base; and (iv) rationalize and simplify the tax system. During the first half of the year, the government will seek to build the political consensus needed for reforms that will support the improvement in the primary surplus projected over the medium term. To that effect, the government will, with the support of technical assistance from the Fund's Fiscal Affairs Department, work on a revised draft law that will be submitted to congress by end-June for approval by end-December 2003. The government will also seek congressional approval of the reforms of the pension funds for the police and the military by end-July and end-September 2003, respectively.

III. The Banking System

8. The government is committed to taking all steps needed to enhance confidence in the domestic banking system. In December 2002, congress approved a banking law aimed at facilitating the restructuring of the four banks suspended last August, broadening the powers of the central bank in the area of bank resolution, and extending the coverage of prudential regulations to include state-owned banks. The government will work in close consultation with the Fund's staff to ensure that any new steps taken toward the resolution of suspended banks are consistent with a further strengthening of the banking system (Table 3).

9. In the coming months, emphasis will be placed on the resolution of the four banks suspended in August 2002 and the reform of the mortgage bank BHU.

· A working plan for the resolution of the four banks is being prepared in close collaboration with Fund staff, to be finalized by end-February 2003. Under this plan, any restructured bank will have to be viable, possess a sound business plan, meet all prudential norms, and demonstrate that it does not pose potential risks to the rest of the banking system or to public finances. This is a structural performance criterion under the program.

· The reform of the BHU, which is part of the World Bank SAL I operation, will be accelerated. Following congressional approval of its new charter in December 2002, BHU has been transformed into a non-bank institution. Foreign currency deposits have been transferred to the public bank BROU and the government will ensure that sufficient resources are made available to cover the liabilities transferred. The government is working on the business plan of the BHU with a view to reducing its operating costs, improving asset recovery, and completing a comprehensive audit of the bank's portfolio.

10. The government will continue to use the resources of the Fund for the Stabilization of the Banking System (FSBS) for the purpose of providing backing for the sight and savings deposits of domestic banks, as originally envisaged. The government will continue to invest the funds not yet disbursed in highly liquid and secure international assets. The recommendations of the on-site Safeguards Assessment completed by the Fund in 2002 are being implemented. In particular, the government is committed to conducting an external audit of the FSBS before September 30, 2003.

IV. Exchange rate and monetary policies

11. The government is committed to a floating exchange rate policy with only minimum intervention in the foreign exchange market. Consistent with this approach, in late 2002, the central bank introduced a new framework for the conduct of monetary policy, under which monetary base developments are used to anchor inflation expectations. The monetary program for 2003 seeks to limit inflation to about 27 percent, consistent with a 19 percent

expansion in base money during the year. Pre-announced monthly targets are being set to keep base money growth in line with the desired medium-term path, while short-term monetary instruments are being used to minimize intra-month volatility. The NDA and NIR performance criteria of the program are presented in Table 1.

12. The central bank will introduce new instruments of monetary management. It recently initiated weekly auctions of inflation-indexed six-month Treasury bills, in addition to the daily auctions of short-term peso bills with maturities ranging from one week to two months. The Central Bank is committed to broadening further the range of instruments of liquidity management, including the possible issuance of its own certificates of deposit.

13. The government is committed to avoid introducing schemes aimed at providing debt relief to specific sectors of the economy. In January, a facility was launched to ease debt repayments for small debtors in the agricultural sector, through partial debt relief by the public bank BROU. The scope of this facility is limited and it will be implemented with strict control to avoid quasi-fiscal implications and moral hazard problems.

V. Policies for fostering growth and protecting vulnerable groups

14. In recent months, the government took further steps to establish an improved regulatory framework and to open competition in activities previously reserved exclusively to the state. In this context, a multisectoral regulatory unit for energy and water services was created; regulations for the transmission, distribution, and wholesale of electricity issued; and the maintenance of the public railroad separated from the public rail transport company. In addition, authorization was obtained from Congress to divest the remaining stake in the national airline PLUNA; sell the public holding company of a large road infrastructure concession; issue concessions in the mining sector; and auction the concession for the operations at the international airport of Montevideo in the first half of 2003. These reforms are being supported under a new World Bank adjustment loan of US$250 million that was negotiated in December 2002 and is scheduled to be presented to the Board shortly. The government will continue to promote the IDB-supported credit facility that has been helping to restore bank credit to the export sector.

15. The government has taken concrete steps to mitigate the adverse impact of the recession on vulnerable groups. Priority social programs in education, health and social protection have been shielded from expenditure cuts in 2002 and in the 2003 budget under both World Bank and IDB Adjustment Programs. Protected programs include: (i) family support; (ii) the school feeding program; (iii) the national supplementary food program; and (iv) the primary education quality improvement program. Targeting of social programs is being improved, by integrating databases of beneficiaries of different agencies, cross-checking benefit duplications, and reducing cross-subsidies through the public health system.

VI. Financing Assurances

16. The government is working on the financing assurances for the 2003 program. It is confident that steadfast implementation of its structural reform program will enable disbursements from the World Bank and the Inter-American Development Bank in a total amount of US$655 million in 2003, including US$575 million under program loans (US$250 million from the World Bank and US$325 million from the IDB). Disbursements from bilateral creditors are projected to amount to US$50 million. The government will finalize and provide adequate financing assurances prior to Board discussion of the program.

Uruguay - Technical Memorandum of Understanding

This memorandum presents the definitions of the variables included in the quantitative performance criteria and indicative targets annexed to the Memorandum of Economic and Financial Policies.

17. Cumulative Primary Balance of the Combined Public Sector. The Combined Public Sector comprises the Central Administration (including as defined in "Article 220" of the Constitution, Salto Grande, and the funds managed directly in the ministries (Fondos de Libre Disponibilidad), the social security system (Banco de Prevision Social), the local governments (Intendencias), the public enterprises (ANCAP, ANTEL, UTE, OSE, AFE, ANP, INC, and ANCO), and the quasi-fiscal balance of the Central Bank (BCU).

· The public sector primary balance, excluding valuation adjustments, will be calculated as the overall balance measured from below the line minus interest payments measured from above the line.

· The below the line overall balance will be measured on the basis of information provided by the BCU on: (a) the change in the nonfinancial public sector debt (defined below), including all short term debt, in foreign currency and pesos; (b) change in net bank credit to the nonfinancial public sector in foreign currency and pesos; (c) other nonbank financing including privatization; and (d) the quasi-fiscal balance of the BCU (defined below).

· The limit on the primary balance of the combined public sector will be adjusted downward (upward), i.e., the limit on the surplus would narrow (widen), by the amount that the actual social security contributions to the private pension system exceeds (falls short of) the projected amounts in the program, specified in Schedule A.

18. Cumulative Balance of the Combined Public Sector (indicative target). The combined public sector balance is calculated as the sum of the primary balance of the combined public sector described in 1 and interest payments. The limit on the balance of the combined public sector will be adjusted downward (upward), i.e., the limit on the deficit would widen (narrow), by the amount that the interest payments exceed (fall short of) the projected amounts in the program, specified in Schedule B for end-March, end-June, and end-September. The limit on the balance of the combined public sector will be adjusted upward, i.e., the limit on the deficit would be narrowed, by the amount that the interest payments fall short of the projected amounts in the program at end-December.

19. The quasi-fiscal balance of the BCU is defined as interest earnings on gross international reserves, as defined below, and other earnings including those on other foreign and domestic assets minus operating expenses, commissions paid, and interest paid on domestic and foreign debt administered by the BCU.

20. Cumulative changes in net domestic assets (NDA) of the BCU is defined as the difference between end-of-period monetary base and net international reserves (NIR) of the BCU as defined in 5 and 6 below. The flow of NIR will be valued at the accounting exchange rate of Ur$ 29 pesos per US$. The limit on the change in the NDA will be adjusted by the difference between actual program loan disbursements by the World Bank and IDB and scheduled loan disbursements as reflected in Schedule C:

· The NDA ceiling at end-June will be adjusted upward in the event of shortfalls compared with projected program loan disbursements, up to a limit of US$75 million.

· The NDA ceiling will be adjusted downward in the event of excesses over projected program loan disbursements by their full amount.

21. Monetary base is defined as the sum of (1) currency issue; (2) nonremunerated and remunerated peso sight deposits of BROU, BHU, private banks, and other institutions defined below at the BCU; and (3) call deposits of BROU, BHU, private banks and other institutions at the BCU. Other institutions include pension funds (AFAPs), local governments, public enterprises, trust funds of the liquidated banks (FRPB), investment funds, off-shore institutions (IFEs), insurance companies, exchange houses, stock brokers, and the nonfinancial private sector. The monetary base excludes central government deposits held at BROU subject to a 100 percent reserve requirement. The indicative target is defined as the cumulative change calculated using the monthly averages relative to the base month average.

22. Cumulative changes in net international reserves (NIR) of the BCU. NIR is defined as the difference between the gross international reserves and BCU reserve liabilities. Gross international reserves include all foreign exchange assets that are in the direct effective control of the BCU and are readily available for such purposes of the BCU as intervention or direct financing of payment imbalances. Such assets may be in any of the following forms, provided that they meet the test of effective control and ready availability for use: currency, bank deposits in nonresident institutions and government securities and other bonds and notes issued by nonresidents (with a rating not below "A" in the classification of Fitch and IBCA and Standard and Poor's or "A2" in the classification of Moody's). In addition, holdings of SDRs or of monetary gold would be included under gross international reserves (provided they meet the test of effective control and ready availability of use) as would the reserve position in the IMF.

· Excluded from gross international reserves are all foreign currency claims arising from off-balance sheet transactions (such as derivatives instruments), claims on residents, capital subscriptions to international financial institutions, any assets in nonconvertible currencies, claims on any nonresident Uruguay-owned institutions, or any amounts (in all components of assets, including gold) that have been pledged in a direct or contingent way.

· Also excluded from gross international reserves are foreign exchange assets in the escrow account at the BCU created to provide backing to sight and savings deposits at the public banks and the closed domestic banks (the escrow account at the BCU). Funds not used to support banks will be invested in highly liquid and secure international assets to be reported daily to the International Monetary Fund and will be subject to periodic special audits.

· BCU reserve liabilities include all foreign currency-denominated liabilities of the BCU with original maturity of one year or less to residents and nonresidents, the use of Fund resources, any net position on foreign exchange derivatives with either residents or nonresidents undertaken directly by the BCU or by other financial institutions on behalf of the BCU.

· For the purpose of the NIR calculation, (a) the gold holdings of the BCU will be valued at the accounting rate of US$42 per troy ounce; (b) liabilities to the IMF will be valued at US$/SDR rate of December 31, 2002; (c) gains or losses from gold swaps and other operations will be excluded; and (d) non-U.S. dollar denominated foreign assets and liabilities will be converted into U.S. dollars at the market exchange rates of the respective currencies as of December 31, 2002.

23. The NIR floor will be adjusted by the difference between actual program loan disbursements by the World Bank and IDB, and scheduled loan disbursements by the World Bank and IDB as reflected in Schedule C, in the following manner:

· The NIR floor at end-June will be adjusted downward in the event of shortfalls compared with projected program loan disbursements, up to a limit of US$75 million.

· The NIR floor will be adjusted upward in the event of excesses over projected program loan disbursements by their full amount.

24. The nonfinancial public sector gross debt refers to (a) the outstanding stock of gross debt in domestic and foreign currency owed or guaranteed by the public sector as defined in (1) above excluding the BCU¹. Debt in the form of leases will be calculated as the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.²

25. The overall nonfinancial public sector debt ceiling will be adjusted upward (downward) by (1) the upward (downward) revisions made to the actual nonfinancial public sector gross debt stock at end-2002;³ (2) the difference between the actual and projected amount of social security contributions that are transferred to private pension funds according to schedule A; (3) the difference between the actual and projected interest payments, specified in Schedule B for end-March, end-June, and end-September; the ceiling will be adjusted downwards by the amount that the interest payments fall short of the projected amounts at end-December; (4) the difference between actual and scheduled program disbursements by the World Bank and IDB as reflected in schedule C below; and (5) the overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million.

26. The data for assessing compliance with the quantitative performance criterion on net international reserves will be provided by the BCU no later than one week after each test date. The data for the assessment of all other quantitative performance criteria and indicative targets will be provided by the BCU no later than two months after each test date.

² The suppliers' contracts of ANTEL with equipment providers Ericsson and NEC, which predate the Fund's consideration of lease contracts for programming purposes, are expensed under goods and services as rental outlays and, therefore, excluded from the definition of nonfinancial public sector gross debt for program purposes.

³ The debt stock at end-2002 includes US$294 million of unsecuritized debt from an agreement between the Ministry of Finance and BROU.