Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
700 19th Street NW
Washington DC

Dear Mr. de Rato:

Since the completion of the fourth review under the Stand-By Arrangement last February, the Uruguayan economy has staged an impressive recovery, and is expected to grow by at least 7 percent in 2004. Financial indicators have also continued to strengthen. Available data indicate that the quantitative performance criteria (PCs) under the program for end-June on NIR, NDA, and general government noninterest expenditure have been observed, as were the end-March PCs on the public sector primary surplus and the nonfinancial public sector gross debt. This performance reflects the macroeconomic and structural policies that the Uruguayan government has implemented since the onset of the financial crisis. The government remains firmly committed to consolidating the gains achieved so far and to completing the objectives of the program, through continued sound fiscal and monetary policies and the implementation of measures to strengthen further the financial system.

The attached Supplement to the Memorandum of Economic and Financial Policies updates the economic program of the government of Uruguay through the end of the Stand-By Arrangement in March 2005, and establishes end-September and end-December quantitative performance criteria and structural performance criteria within that period. The last purchase under the arrangement is subject to a program review to be completed by mid-February 2005.

In support of its program, the government requests: (i) completion of the fifth review under the Stand-By Arrangement, with availability of a purchase equivalent to SDR 139.8 million; (ii) waivers of applicability of the end-June performance criteria on the combined public sector primary balance and the nonfinancial public sector gross debt, for which data would not be available by the time of the Board meeting; (iii) waivers of nonobservance of the end-March 2004 structural performance criteria on the outsourcing of assets of liquidated banks and the contracting of specialized asset recovery services for the fiduciary trust of the public bank BROU. The waivers of nonobservance of the two structural performance criteria are requested on the basis of the remedial measures that have been implemented and our commitment to maintain the policy framework established under the program. In particular, the structural performance criterion on BROU's contracting of specialized services was observed with only a slight delay.

We also request a rephasing of the remaining purchases under the arrangement (Table A), including a final review of the program to be held in February 2005. With the improvement of Uruguay's economic outlook and external position, we have decided to forgo the purchase originally envisaged for August and reduce the total remaining access by SDR 139.8 million.

The Government of Uruguay is confident that the policies set out in the attached Supplement will ensure the success of the program and justify the requested waivers and completion of the review. The continued support of the international financial institutions will be fundamental in sustaining the economic recovery and maintaining financial stability. The Government stands ready, in consultation with the Fund, to take additional measures necessary to ensure the success of the program.

Sincerely yours,

Supplement to the Memorandum of Economic and Financial Policies

I. Background

1. The economic recovery in 2003 has turned out stronger than previously envisaged, and leading indicators point to a further acceleration of growth in 2004: Real GDP grew 12 percent during the second half of 2003 and 14 percent in the first quarter of 2004. Financial indicators have also continued to improve. Inflation has declined to near single digits and bank deposits have increased. Gross international reserves have held firm in 2004, at US$2 billion by end-July, which has helped to raise to about 60 percent the coverage of dollar liabilities in the banking system by official reserves and banks' foreign assets. All 2004 quantitative PCs under the program for which data are available have been observed.

2. Consistent with these developments, we have raised our projection for economic growth in 2004. The government expects that real GDP will grow by at least 7 percent, with inflation in the 7-9 percent range by year-end. The stronger-than-envisaged balance of payments position will allow us to raise the program target on net international reserve accumulation for 2004 from US$100 million to US$180 million. Over the medium term, we expect growth to average 3-4 percent, supported by sound macroeconomic policies and sustained implementation of structural reforms.

II. Fiscal and Monetary Policies

3. The government remains firmly committed to achieving the primary surplus targets under the program, to put Uruguay on a path of debt sustainability while providing room for supporting private sector growth. The fiscal program is well on track, allowing us room to roll back temporary tax surcharges on wages and corporate income and taxes on commissions and public utilities that were implemented during the economic crisis. Expenditure restraint will be maintained, keeping the growth in central government noninterest expenditure to 9 percent and the wage bill of the central government to Ur$15½ billion, as envisaged under the program; and tariffs charged by public enterprises will continue to be adjusted in line with operating costs. Revenue higher than envisaged under the program will not be used to increase expenditure, and no further tax reductions will be implemented. In light of the strong fiscal performance in the first half of the year, we have raised our end-year primary surplus target to 3.4 percent of GDP (up from the original target of 3.2 percent of GDP). We will also closely monitor the floating debt of the nonfinancial public sector, to ensure that it does not rise during the program period.

4. The government remains committed to improving the efficiency of the tax system. Steady progress is being made in modernizing the Tax Administration Department (DGI). The DGI is upgrading its physical facilities and is improving its computer system and taxpayer-audit procedures. The DGI has also initiated the establishment of an internal audit unit, and is coordinating with the real estate registry to improve taxpayer compliance. However, we now expect the establishment of the Large Taxpayers Unit (an end-September structural benchmark) to be completed by December (structural benchmark). Also, prospects for legislative approval of the tax reform package submitted in June 2003 are unlikely; nevertheless, we will continue to foster dialogue and seek consensus toward adoption of this reform. In this context, the government will not grant any new tax exemptions and will work to phase out existing ones.

5. Over the medium term, Uruguay needs to attain primary surpluses rising to about 4 percent of GDP to put the country on a path toward debt sustainability and to avoid crowding out credit to the private sector. Under this path, the debt-to-GDP ratio is projected to decline to between 60-70 percent by 2012, consistent with the objectives of the May 2003 debt exchange. For 2005, we are committed to an expenditure plan that, under the current tax structure, is consistent with a primary surplus of 3½ percent of GDP as envisaged in the medium-term framework under the program.

6. The Central Bank of Uruguay (BCU) will continue the policy of a floating exchange rate, with base money as the intermediate target of monetary policy. To impart greater flexibility into monetary policy operations, the BCU has established a repurchase (repo) mechanism to address intramonthly variability in the demand for pesos. In March, to improve the transparency of exchange market operations, the BCU began announcing foreign exchange purchase plans for one month ahead. For 2004, base money is targeted to grow by 9 percent, consistent with the revised macroeconomic framework. To the extent that market conditions permit, we intend to (i) reduce the stock of costly BCU debt to improve the quasi-fiscal position of the central bank, (ii) promote the use of peso instruments, and (iii) attain a modest buildup of net international reserves.

III. Restructuring of the Banking System

7. The government will continue to strengthen further the banking system and will accelerate the disposal of assets in the liquidated banks, in close consultation with the Fund. Progress is being made in implementing our comprehensive restructuring of the public financial institutions BROU and BHU, and we are moving ahead on soliciting equity investment in the new commercial bank NBC, in which the government holds 100 percent of the shares.

8. Accelerating the disposal of the remaining assets of the liquidation funds will be a key priority during the remainder of the program. Following the delays that have hampered the process over the past year, we have taken measures to ensure that the strategy will be in full operation before the end of the year. We have put in place the following steps:

• An inventory of the assets held by the funds is being completed and their balance sheets as of end-May have been prepared. To promote creditor discipline, information on nonperforming loans obtained from the inventory has been transferred to the Bank Superintendency for inclusion in the credit registry.
  
  
• Audit firms have been contracted to prepare: (i) financial statements for the funds' operations since inception; and (ii) financial audits of the funds.
  
  
• A full-time supervisor has been appointed to oversee the implementation of the strategy.
  
  
• A contract will be signed with the firm selected through competitive bidding to manage all available assets of the liquidation funds, on the basis of a first tranche of at least US$300 million.
  
  
• The liquidation funds will transmit to the Ministry of Economy and Finance (MEF) and BCU their July financial statements.

9. Consistent with our fiduciary responsibility, we will closely oversee the activity and performance of the asset manager and the bank liquidation funds, including through establishing structural benchmarks under the program for future reviews on the performance of the asset manager, in line with its business plan. We will take the following additional measures:

• The financial statements since the inception of the liquidation funds will be completed by end-September; and the financial audits, by end-October (structural performance criteria).
  
  
• All the remaining available assets will be transferred to the asset manager by end-October (structural performance criterion).
  
  
• The liquidation funds will continue transmitting monthly financial statements (by the 20th of the following month) to the Ministry of Economy and Finance (MEF) and BCU (monthly structural performance criterion beginning in September).
  
  
• The funds will also publish quarterly financial reports within 30 days of the close of the quarter (end-January 2005 structural performance criterion).

10. BROU is making progress toward achieving its financial targets for end-2004. BROU's business plan is proceeding on schedule and progress will continue to be monitored under program reviews.

• The end-March and end-June structural performance criteria on transferring to the fiduciary trust the second and third tranches of BROU's nonperforming loans have been observed. BROU's Executive Board will take the legal steps to ensure the smooth transfer of all new and remaining nonperforming loans by end-December (structural performance criterion). An audit firm is about to complete the audit to reassess the value of all assets in the fiduciary trust (an end-June structural benchmark).
  
  
• The general manager of the fiduciary trust has contracted specialized asset recovery services (an end-March structural performance criterion), including collection agencies and legal services, albeit with some delays. The trust started operating in April.
  
  
• BROU's operational restructuring is proceeding as planned, and the bank's operating costs will be reduced by 15 percent during 2004-05. In line with the business plan, operations are being rationalized, credit risk management is being improved, and activity is being redirected toward business segments where BROU has a competitive advantage.
  
  
• The release of the second tranche of reprogrammed deposits has been completed, and results have been positive, with about 95 percent of deposits remaining in BROU. BROU is continuing to build up liquidity in order to meet the repayment of the third tranche of reprogrammed deposits, which is scheduled for next year.

11. The restructuring of BHU is moving forward. BHU has observed World Bank conditionality on its operational restructuring, enabling the disbursement of US$50 million under the World Bank's SAL-I operation in the third quarter. BHU's government-guaranteed obligation to BROU is being serviced, and its operations are being closely monitored to ensure the timely service of the note (a continuous structural performance criterion).

12. As part of strengthening NBC, improvements to NBC's governance are envisaged, in line with the recommendations of the Banking Superintendency, including increasing the size of its Executive Board and appointing to the Board individuals experienced in commercial banking. We will continue to pursue negotiations with the IFC for a strategic equity stake in NBC.

13. Some progress has been made in winding down the liquidation of Banco de Crédito. An attempt to auction its liquidation fund's remaining nonperforming loans did not prosper because of a lack of acceptable offers. In light of this situation, we have begun the process of extinguishing all remaining depositor claims through the purchase of some of the liquidation fund's assets with government bonds (face value) that have been held in the government's portfolio. We intend to dispose of these assets as well as all remaining assets in the liquidation fund of Banco de Crédito by end-December, including through the securitization of performing loans and the appointment of a manager to work out nonperforming loans. The recoveries from these operations will fully accrue to the government, which holds all remaining claims against Banco de Crédito's liquidation fund.

14. The government will not increase its compensation plan for depositors and other creditors of the other three liquidated banks beyond the recent exchange offer (on market terms) to bondholders and depositors with claims in excess of US$100,000 for a swap of these claims and shorter-term government bonds for longer-term government bonds that does not involve any net resource transfer from the government. The Fund for the Stability of the Banking System (FSBS), having fulfilled its original purpose of providing backing for sight and savings deposits at qualifying banks, has been closed, and the remaining balance was used for an early repurchase to the Fund.

15. The government is pursuing measures to improve bank supervision. Most important, banks are being required to improve their risk management procedures. With assistance from the IDB under the Financial Sector Loan, the capacity of the Banking Superintendency is being bolstered, including through the hiring of additional staff and strengthening of on-site supervision.

IV. Structural Reforms, Data Provision, and Safeguards Measures

16. In addition to maintaining sound financial policies, structural reforms will be critical in promoting medium-term growth prospects. These reforms include reducing the involvement of the public sector in the economy and improving its efficiency, gradually opening the areas where public enterprises operate to private sector competition, and further improving the institutional framework and investment climate.

17. The government will continue efforts to encourage investment and private sector activity and deepen Uruguay's integration into the global economy. Toward these ends, we are pursuing the following measures:

• International trade and investment are being promoted. The free trade agreement with Mexico is being implemented, and the auction of the cellular phone concession in May was successful. A bilateral investment treaty with Finland was ratified in May, and we hope to conclude the negotiations on a similar treaty with the United States by August.
  
  
• A law that regulates the issuance of warrants has been approved and—in conjunction with the trust fund law―will facilitate the development of a broader range of financing instruments for the private sector.
  
  
• Legislation has been approved that clarifies the legal status of the inflation indexation unit to help foster the development of the market for peso-denominated instruments.
  
  
• We will continue to work toward legislative approval of structural reform measures supported by multilateral disbursements, including in the areas of the regulatory frameworks for the gas and water sectors. The government has also received a grant from the World Bank to promote energy efficiency.
  
  
• We will continue to pursue the adoption of reforms of the specialized pension funds for the police, the military, and bank employees (end-December structural benchmarks).

18. To improve the provision of fiscal data for program monitoring purposes, we have established a committee to bolster coordination between the MEF, the BCU, BROU, and BHU, with the objective of providing the necessary fiscal information for monitoring targets under the program within 60 days of the close of the previous quarter and, thus, avoid the need for waivers of applicability for test dates more than two months past. We are allocating more resources for data collection and analysis, and will continue to provide timely data under the SDDS.

19. We are continuing to carry out the recommendations of the on-site Safeguards Assessment completed by the Fund in 2002. A supplementary external audit of the FSBS is underway and an external audit of the 2003 accounts of the BCU has been completed.

V. Financing Assurances

20. The successful international bond issue in late July completes our financing needs through March 2005, and residual financing needs for the next few years have been largely addressed by the debt exchange in May 2003. Stronger efforts to implement structural reforms will help ensure the flow of IFI disbursements, projected at about US$300 million through end-2004, broadly in line with amortization payments to these institutions.

Technical Memorandum of Understanding

This memorandum presents the definitions of the variables included in the performance criteria and 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 Previsión Social, Caja Militar, and Caja Policial), the local governments (Intendencias), the public enterprises (ANCAP, ANTEL, UTE, OSE, AFE, ANP, INC, and ANCO), and the quasifiscal 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). All upfront payments relating to future concessions, including the sale of mobile phone licenses, will be treated below the line.
  
  
• The floor on the primary balance of the combined public sector will be adjusted downward (upward) by the amount by which the actual social security contributions transferred 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 floor on the balance of the combined public sector will be adjusted downward (upward) by the amount that the interest payments exceed (fall short of) the projected amounts in the program, specified in Schedule B.

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, automatic transfers to the private pension funds (AFAPs), and earmarked revenue) and the social security system (BPS). The ceiling on general government expenditure will be adjusted downward for any expenses arising from pension adjustments which exceed the increase in the legal minimum adjustment. The ceiling on general government expenditure will be adjusted upward (downward) by the amount by which the actual revenues from the Fondos de Libre Disponibildad (FLD) exceeds (falls short of) the projected amounts in the program, specified in Schedule C.

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 paragraphs 6 and 7 below. The flow of NIR will be valued at the accounting exchange rate of Ur$31 pesos per US$1. 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 D:

• The NDA ceiling at end-March, 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$50 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, offshore 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 are certificates of deposit used to constitute reserve requirements at the BCU.
  
  
• 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 IMF 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, all certificates of deposit used to constitute reserve requirements against bank deposits, 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 the rate of US$1.395 per SDR; (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, 2003.

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 D, in the following manner:

• The NIR floor at end-March, 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$50 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 the outstanding stock of gross debt in domestic and foreign currency owed or guaranteed by the nonfinancial public sector, excluding the BCU.¹ 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 The nonfinancial public sector debt ceiling will exclude the government guaranteed BHU note (estimated at US$610 million at end-December 2003) and the government guarantee covering notes issued by the fiduciary trust associated with the transfer of BROU's NPLs (estimated at US$370 million at end-December 2003). It will include debt issued by the Megaconcesión that has a guarantee of the government.

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-2003; (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 upward (downward) 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 upward (downward) 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 above, i.e. the debt ceiling will be adjusted upward (downward) by the amount that program loan disbursements exceed (fall short of) those in Schedule C, and any downward adjustment will be limited to US$50 million; (v) the amount of the government guarantee on the BHU note that is called in 2004, excluding the clearance of existing arrears of BHU to BROU, i.e., the debt ceiling will be adjusted upward by the amount of new debt issued by the government to cover its guarantee (principal plus interest) on the BHU note; and (vi) the amount of the government guarantee on the transfer of BROU's NPLs to the fiduciary trust that is called in 2004, i.e., the debt ceiling will be adjusted upward by the amount of new debt issued by the government to cover its guarantee on the schedule of principal and interest payments owed by the trust to BROU; and (vii) the debt ceiling will be adjusted upward to reflect overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million.

11. The data for assessing observance of 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.

12. Data, reports, and other relevant information for assessing progress on bank restructuring will be provided to staff in a timely manner; in particular, financial audits and associated management letters will be shared with the Fund.

13. The structural performance criteria for the transfer of BROU's Category 4 and 5 loans (end-June and end-December 2004 performance criteria) are defined to mean the transfer of nonperforming Category 4 and 5 loans.

14. The prior action and structural performance criterion (end-September 2004) on the outsourcing of the management of all available assets of the liquidation funds define available assets to include credits and collateral not in litigation and with which the asset management company does not have a conflict of interest arising from related parties and current and prior business relationships. The value of available assets is defined as outstanding principle and accrued interest for credits and the book value for other assets.