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


Montevideo, Uruguay
June 27, 2003

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

Dear Mr. Köhler

1. Following the successful completion of Uruguay's comprehensive and voluntary debt exchange, the government of Uruguay intends to continue implementing policies aimed at fostering the resumption of growth. To that effect, the government is committed to achieving a primary fiscal surplus of 3.2 percent of GDP in 2003, excluding the one-off expenses paid on account of the debt exchange. The fiscal effort is supported by expenditure restraint and the continued implementation of structural reforms. These measures are described in the attached Supplement to the Memorandum of Economic and Financial Policies.

2. In support of these efforts, the Government of Uruguay requests: (i) completion of the third review under the Stand-by Arrangement, allowing a purchase of SDR 145.7 million upon approval by the Fund's Executive Board; (ii) waivers of applicability for the end-June performance criteria on the cumulative primary balance of the combined public sector and the overall nonfinancial public sector debt ceiling, given that the data to monitor these performance criteria will not yet be available at the time of Board consideration of this review; and (iii) modifications of the performance criteria for end-June on the cumulative primary balance of the combined public sector and the overall nonfinancial public sector debt ceiling.

3. We are confident that the policies set out in the attached supplement to the Memorandum of Economic and Financial Policies and the continued support of the international financial institutions will provide the needed stability for the resumption of economic growth. The government stands ready, in consultation with the Fund, to take any additional measures necessary to ensure the success of the program.

Sincerely yours,

SUPPLEMENT TO THE MEMORANDUM OF ECONOMIC AND FINANCIAL POLICIES FOR 2003

I. BACKGROUND AND MACROECONOMIC FRAMEWORK

1. Uruguay's economic and political situation has improved significantly in recent months. Following the completion of the second review under the Stand-By Arrangement in March, market sentiment has improved, and private sector deposits continued to increase in April and May. Reflecting these reflows, as well as sizeable IFI disbursements, gross international reserves have nearly doubled since mid-March, to about US$1 billion at mid?June (5 months of imports of goods and services).

2. There are signs that the economy has bottomed out. While real GDP contracted by 10.8 percent in 2002, indicators show an increase in activity during the first quarter of 2003, supported by an incipient recovery in export performance. The unemployment rate has fallen somewhat in March, and inflation has been under control, averaging 1.2 percent a month during the first five months of the year, somewhat below program projections. Against this background, we have revised slightly our macroeconomic framework. Consistent with developments in recent months, we expect that the economy will continue to gradually recover, and that real GDP will only contract by 1 percent for the year as a whole, while inflation should be somewhat lower than initially envisaged, at about 20 percent by year-end.

II. DEBT EXCHANGE

3. In 2002, the debt-to-GDP ratio of the consolidated public sector doubled, to 94 percent. This increase reflected a sharp depreciation of the peso against the U.S. dollar, the cost of government assistance to stabilize the banking system, and the fiscal deficit. While Uruguay faced tight liquidity conditions associated with a large concentration of debt amortization in 2003-07, the deterioration in debt dynamics also raised uncertainty about fiscal sustainability. To address these problems, the government launched a comprehensive and voluntary debt exchange in April 2003. The exchange aimed at extending the average maturity of virtually all international and domestic market debt by about five years, while broadly maintaining the low average interest rates on the debt contracted in previous years, under investment grade rating conditions.

4. In May, the government successfully completed the debt exchange, based on strong support from bondholders. The debt exchange received 93 percent participation by investors, well above the minimum 80 percent acceptance rate. Participation was particularly strong for domestically-issued bonds, at nearly 100 percent, while participation in the internationally-issued bonds was close to 90 percent. This debt exchange was a crucial step to ensure sufficient financing to meet immediate needs and address medium-term debt sustainability through a cooperative approach with creditors. The strong support expressed by private sector investors is a key component of Uruguay's efforts to restore the economy to sustained growth and financial stability.

III. FISCAL POLICIES

5. The government is firmly committed to achieving the primary surplus objectives of the program. These objectives remain broadly unchanged, at 3.2 percent of GDP in 2003¹, 3.3 percent on average in 2004-05, and about 4 percent over the medium term. Attaining these surpluses will help address Uruguay's immediate and medium-term financing needs, provide a realistic path toward fiscal sustainability, and avoid crowding out credit to the private sector. Under this path, the debt-to-GDP ratio is projected to decline to about 60 percent by 2010, consistent with the objectives of the debt exchange.

6. In 2003, steps are being taken to adjust expenditure in order to offset revenue shortfalls associated with lower projected inflation. Although the fiscal program is on-track for the year as a whole, the end-March performance criterion on the cumulative primary balance of the combined public sector was not observed due to the reclassification of an operation involving the state oil company ANCAP². So far this year, the government has maintained a tight grip on discretionary spending, and the nominal growth of general government non-interest expenditure was contained to 4 percent during the first four months of 2003. In May, the government issued two decrees aimed at placing lower limits on central government spending during 2003, with a view to bringing them in line with revised program projections. Full-year projections for social security outlays, including pensions, have been revised downward owing to moderate increases in private sector wages. During the remainder of this year, tariffs charged by public enterprises will continue to be adjusted in line with the program, to fully reflect operating costs.

7. Tax reform is important in achieving the medium-term primary surplus objectives of the program and promoting high sustainable rates of growth. With technical assistance from the Fund, the government is preparing a revised tax reform to be submitted to congress by end-June and expected to become effective in 2004. The revised tax reform is aimed at enhancing revenue collections through rationalization and simplification of the tax system, which include broadening the VAT base; elimination of low-yielding taxes and their incorporation into the main excise tax; and a broadening of the coverage of corporate income tax. The improved tax structure will facilitate the strengthening of tax administration, for which the government has also requested technical assistance from the Fund.

IV. THE BANKING SYSTEM

8. The government is committed to taking all necessary steps to further strengthen the banking system. Significant progress has been made in enhancing confidence. On March 24, 2003, a new bank (Nuevo Banco Comercial—NBC) was opened with assets of three liquidated banks, after the Superintendency of Banks had declared it to be viable and in full compliance with prudential norms.

9. In the coming months, the government's restructuring agenda includes a swift resolution of the fourth liquidated bank, the disposal of the remaining assets of all liquidated banks, and the ongoing reform of public banks.

• A trust fund has been created to facilitate the disposal of the assets of the fourth liquidated bank (Banco de Crédito). As part of the resolution process, the government will contribute a maximum of US$40 million (face value) in government bonds if the proceeds from the auctioned assets of this bank are insufficient to cover depositors.



• As a prior action to Board consideration of the third review under the Stand-By Arrangement, the Central Bank will complete a strategy document for disposal of the remaining assets of the liquidated banks and establish a central liquidation steering committee to facilitate implementation of the strategy. To promote timely recovery of resources, it will outsource to third parties the disposal of assets in at least two asset groups by end-July (structural performance criterion). In addition, the Superintendency of Banks will issue regulations requiring that all foreclosed bank debtors, including remaining debtors in the liquidated banks, be registered in the credit bureau (Central de Riesgo). This will include the requirement that the loan classification in any bank reflect the distressed conditions of these debtors.



• The ongoing reform of the BHU will be accelerated. The government is currently working in close collaboration with the World Bank on a comprehensive plan to restructure the BHU and reduce its operational costs, to be finalized by end-September.

10. Reestablishing stability and confidence in the banking system is key to restoring credit flows. As the banking system remains in the early stages of recovery, the 100 percent reserve requirement on new sight and savings deposits of the public bank BROU and NBC will be maintained until confidence is solidified. In this respect, the liquidity position of BROU is being closely monitored to ensure the smooth repayment of reprogrammed deposits scheduled to begin in August. Also, BROU will continue with its efforts to improve efficiency and bring its operations in line with modern practices. In this connection, it will adopt a reform plan, in agreement with the central bank and the government, aimed at: (i) overhauling corporate governance to ensure operational independence; (ii) rationalizing operating costs; (iii) strengthening credit risk administration and control; and (iv) improving the bank's capital adequacy ratio.

V. EXCHANGE RATE AND MONETARY POLICIES

11. The government remains committed to a floating exchange rate policy. The new framework for the conduct of monetary policy adopted in late 2002, using monetary base targets, has served Uruguay well. So far in 2003, the monetary base has moved in line with the program, though inflation has been lower due to higher real money demand. Accordingly, for the remainder of the year, to accommodate the ongoing remonetization of the economy, we have retained the original monetary program, which targets a 25 percent increase in the monetary base by year-end. The government intends to maintain this framework as a means of anchoring inflationary expectations, building a track record for monetary policy credibility, and laying the groundwork for future adoption of inflation targeting. The Central Bank is committed to creating a deeper and more liquid market for peso instruments by expanding further the available range of peso instruments for liquidity management and by promoting market acceptance of inflation-indexed instruments.

VI. STRUCTURAL REFORMS

12. In addition to banking system restructuring, the government is implementing comprehensive reforms in other areas of the economy. In this context, it is committed to advancing the structural reforms envisaged in the Fund-supported program, and recognizes the need to expedite implementation in some areas to prevent delays in IFI disbursements. In this regard, two laws on utility regulations (natural gas and water), tied to the World Bank SAL II, are currently being considered by Congress, for which the government intends to seek approval by end-September. In addition, the government is committed to pursuing the reform of the specialized pension funds originally envisaged under the program, particularly for the police, military, and bank employees. The government will give continued priority to social spending toward programs that are targeted at the most vulnerable groups. The Fund for the Stability of the Banking System will continue to operate as originally envisaged, and an external audit will be conducted by end-September.

VII. FINANCING ASSURANCES AND OTHER ISSUES

13. The successful completion of the debt exchange has served to eliminate any residual financing needs in the near term, and projected disbursements from the IFIs will help to ensure that the program is adequately financed through the end of 2004.

14. Significant progress has been made in improving data reporting and transparency in Uruguay. To further improve information disclosure, the government is working toward early subscription to the SDDS, with assistance from the Fund's Statistics Department, to be finalized by end-September (structural benchmark). In addition, the government is committed to promptly resolving the long reporting delays in BROU's banking data to the central bank, so as to publish, without further delay, monthly bank balance sheet data with a two-month lag, consistent with the program.

 

Table 1. Uruguay: Performance Criteria and Indicative Targets Under the 2003 Economic Program 1/
	Dec. 2002		March 31, 2003					June 30	Sept 30	Dec 31
	Base		Target	Adj. Target	Actual	Margin (+)		Targets
A. Quantitative performance criteria
	(in millions of Uruguayan dollars)
1. Combined public sector primary balance (cumulative floor ) 2/ 3/			2,170	2,123	1,880	-243		2,176	5,727	9,631
2. Combined public sector overall balance (cumulative floor) 2/ 3/ 4/ 5/			-3,385	-3,467	-3,710	-243		-7,864	-9,982	-10,720
3. General government non-interest expenditure (cumulative ceiling) 2/			...	...	...	...		...	25,821	35,125
4. Change in the net domestic assets of the Central Bank of Uruguay (ceiling) 2/			14,000	14,000	10,738	3,262		9,000	7,600	6,600
5. Change in the monetary base (ceiling) 4/ 6/			165	165	393	-228		790	1,175	2,325
	(in millions of U.S. dollars)
6. Net international reserves of the Central Bank of Uruguay (- decrease) (cumulative floor) 2/ 7/			-490	-490	-380	110		-290	-245	-130
	(Stock of debt at the end of the period; in millions of U.S. dollars)
7. Nonfinancial public sector gross debt (ceiling) 3/ 8/	8,788		8,915	8,786	8,381	405		9,010	9,088	9,100
	Date
B. Structural performance criteria
1. Presentation to Congress of revised tax reform legislation	End-June
2. No banks to be opened or reopened unless they are viable and meet all prudential norms	Continuous
3. Outsource to third parties the disposal of the assets of the liquidated banks in at least two asset groups	End-July
1/ As defined in the Technical Memorandum of Understanding. 2/ Cumulative changes from end-December 2002. 3/ Adjusted upwards/downwards for changes in social security contributions, as defined in the TMU. 4/ Indicative target. 5/ Adjusted upwards/downwards for changes in interest payments, as defined in the TMU. 6/ Cumulative change from December 2002 average. 7/ Adjusted upwards/downwards for changes in program disbursements from the World Bank and IDB, as defined in the TMU. 8/ All maturities. The 2002 base includes US$294 million of unsecuritized debt arising from an agreement between the Ministry of Finance and BROU. For September and December, the debt ceiling will be adjusted upward to reflect the transfer of Brady bonds from the central bank to the government (at end-May 2003, these transfers amounted to US$237 million).

URUGUAY - TECHNICAL MEMORANDUM OF UNDERSTANDING

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

1. 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: (i) the change in the nonfinancial public sector debt (defined below), including all short term debt, in foreign currency and pesos; (ii) change in net bank credit to the nonfinancial public sector in foreign currency and pesos; (iii) other nonbank financing including privatization; and (iv) 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 by which the actual social security contributions to the private pension system exceeds (falls short of) the projected amounts in the program, specified in Schedule A.

2. 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. Interest payments are defined to exclude commissions and fees. 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, and end-December.

3. 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.

4. Cumulative ceiling on general government expenditure applies to total (current and capital) noninterest expenditure of the central administration (includes Fondos de Libre Disponibilidad but excludes transfers to the social security system and automatic transfers to the private pension funds (AFAPs), and the social security system (BPS).

5. 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, end-September, and end-December 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.

6. Monetary base (indicative target) is defined as the sum of (i) currency issue; (ii) nonremunerated and remunerated peso sight deposits of BROU, BHU, private banks, and other institutions defined below at the BCU; and (iii) 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.

7. 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, (i) the gold holdings of the BCU will be valued at the accounting rate of US$42 per troy ounce; (ii) liabilities to the IMF will be valued at US$/SDR rate of December 31, 2002; (iii) gains or losses from gold swaps and other operations will be excluded; and (iv) 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.

8. 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, end-September, and end-December 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.

9. The nonfinancial public sector gross debt refers to (i) 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 BCU³. 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 property⁴.

10. The overall nonfinancial public sector debt ceiling will be adjusted upward (downward) by (i) the upward (downward) revisions made to the actual nonfinancial public sector gross debt stock at end-2002⁵; (ii) the difference between the actual and projected amount of social security contributions that are transferred to private pension funds according to schedule A, i.e. the debt ceiling will be adjusted upwards (downwards) by the amount that social security contributions exceed (fall short of) those specified in Schedule A; (iii) the difference between the actual and projected interest payments, specified in Schedule B for end-March, end-June, and end-September, and end-December, i.e. the debt ceiling would be adjusted upwards (downwards) by the amount that interest payments exceed (fall short of) those specified in Schedule B; (iv) the difference between actual and scheduled program disbursements by the World Bank and IDB as reflected in schedule C below, i.e. the debt ceiling will be adjusted upwards (downwards) by the amount that program loan disbursements exceed (fall short of) those in Schedule C; and (v) the debt ceiling will be adjusted upwards to reflect overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million. For September and December 2003, the debt ceiling will be adjusted upwards to reflect the transfer of Brady bonds from the central bank to the government (at end-May 2003, these transfers amounted to US$237 million).

11. 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.

¹This figure excludes one-off expenses of US$24 million, or 0.2 percent of GDP, paid on account of the debt exchange completed in May.

²In March, ANCAP made forward sales of petroleum products amounting to US$40 million. Although this operation was initially recorded as revenue in the fiscal accounts, it has now been reclassified as a financing item, affecting observance of the end-March performance criterion on the cumulative primary balance of the combined public sector. This operation is being offset during the second half of 2003, as similar transactions conducted in 2002 are unwound.

³The term "debt" has the meaning set forth in point No. 9 of the Fund's Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 6230-(79/140, August 3, 1979), as amended).

⁴The 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.

⁵The debt stock at end-2002 includes US$294 million of unsecuritized debt from an agreement between the Ministry of Finance and BROU.