Mission Concluding Statement 

Uruguay: Staff Concluding Statement of the 2021 Article IV Mission

October 6, 2021

Washington, DC:

An economy facing pre-existing challenges, impacted by the pandemic

Uruguay entered the pandemic with solid institutions but pre-existing macroeconomic imbalances. The country stands out in the region for its well-functioning democracy, strong institutions and high degree of social cohesion. Its solid financial sector, ample reserve buffers and investment grade status are key pillars of its stable economy. However, the economy had been on a stagnant path since 2015—after the end of the last commodity price boom—amid low investment and a weak manufacturing sector, which contributed to a secular fall in employment. Poor education outcomes contributed to an erosion of human capital and high and persistent youth unemployment. Public finances had also weakened markedly in the years preceding the pandemic—leading to a 10 percent of GDP increase in non-financial public sector debt between 2013 and 2019. The new administration took over in early 2020—only weeks before the pandemic—and launched an ambitious program of reforms to boost growth and strengthen public finances, notwithstanding the challenging circumstances.

The economy contracted markedly in 2020, albeit less than other countries in the region. As the pandemic struck, like in the rest of the world, activity fell sharply in the second quarter of 2020—reflecting social distancing measures and the sudden drop in mobility—before rebounding in subsequent quarters to end the year with a 5.9 decline in output. Contact-intensive sectors bore the brunt of the fall as demand dropped sharply. Employment followed the contraction and rebound in economic activity, with higher impact on young and low-earning workers, contributing to an increase in poverty, although from a relatively low base. The contraction in employment and economic activity, as well as the widening of the fiscal deficit, were less pronounced than in other countries in the region.

A well-targeted policy response

A very effective policy response mitigated the impact of the pandemic while prudently balancing fiscal sustainability objectives. The strong existing health care and social protection systems, along with low poverty rates limited the need for additional fiscal resources to directly address the health crisis. A fiscal package of about 2.7 percent of GDP for 2020-21—commensurate with available policy space—provided well-targeted support to firms, employment and the most vulnerable. The introduction of the partial unemployment benefit was instrumental to containing employment losses and supporting the jobs recovery—by maintaining employer-employee relationships—while increased transfers through the strengthening of existing social programs and the creation of new ones provided needed support to the most vulnerable groups. A prudent wage policy—balancing workers’ purchasing power and the need to support employment—was also key to support the labor market. At the same time, it is worth noting the creation of the Covid-19 Solidarity Fund to separately record temporary measures to contain the impact of the pandemic. A new fiscal framework—aimed at strengthening fiscal discipline and ensuring medium-term sustainability—served to strongly signal the authorities’ commitment with fiscal sustainability.

Monetary loosening, along regulatory forbearance and credit guarantee lines helped sustain companies and prevent financial stress. The BCU loosened monetary policy in response to the pandemic to provide liquidity and avoid disruptions in the money market. At the same time, the BCU clearly signaled a renewed commitment to bringing down inflation, including through changes to its monetary policy framework and the return to the interest rate as operational instrument. Regulatory forbearance—especially the extension of bank loan repayments—and credit guarantee lines at favorable terms for small and medium-size enterprises through the National System of Guarantees (SIGA) were also key to maintaining companies afloat and avoid financial stress.

The ongoing recovery

The recovery in early 2021 was uneven, reflecting a late but strong COVID wave. Supported by policy measures, the increase in mobility, and robust external demand and export prices, primary activities and construction recovered strongly, and activity in those sectors reached pre-pandemic levels. Contact-intensive sectors, on the other hand, remained subdued, reflecting the strong COVID wave in early 2021. After rebounding in 2020, about 50 percent of the losses in employment have already been recovered.

The economy is expected to continue strengthening in late 2021 and 2022. Thanks to the rapid vaccination campaign—about 77 percent of people are fully vaccinated—the spread of the virus has come to a near halt, the economy is reopening and there are signs of recovery in lagging sectors. Driven by normalizing contact-intensive sectors, the recovery in economic activity and employment are expected to gain strength in the coming quarters. The economy is projected to grow by 3.4 percent in 2021 and 3.2 in 2022. A reopening of borders and the associated resumption of tourism may provide further support to growth in 2022, although prospects remain uncertain. Inflation is projected to end 2021 around 7.2 percent, to continue on its downward path to reach 5.8 by end-2022.

Economic challenges

The crisis has exacerbated some of Uruguay’s pre-pandemic structural imbalances. The contraction of the economy and the needed stimulus measures have further weakened public finances and exacerbated medium-term sustainability risks, although there was an effort to contain non-pandemic related spending. The pandemic is also likely to have a visible impact on human capital, especially at the lowest income deciles—due to lost schooling—compounding pre-existing problems in education. It is likely that the higher impact on young workers has also exacerbated pre-existing high youth unemployment, and the leap in digitalization and teleworking is having transformational effect on jobs, speeding the obsolescence of low-skilled jobs and the existing skill mismatch between the labor force and new jobs.

Policies to support the recovery and boost medium-term growth

Policies should gradually shift to addressing fiscal imbalances and tackling structural impediments to growth.

In the near term, efforts should shift towards rebuilding policy space while providing targeted support to still-affected sectors. The authorities’ consolidation plan for 2022, in line with the expected recovery, is welcome. A targeted extension of the partial unemployment benefit should provide further support to workers in affected lagging sectors, while a gradual phasing out would incentivize a full return to work and facilitate labor reallocation where needed. This shift towards policies to foster job creation is welcome.

Over the medium term, additional fiscal consolidation would help put public debt on a firm downward path. Near term fiscal risks are contained—as financing needs are manageable and market financing remains at favorable terms—and the envisaged consolidation plan is expected to stabilize the debt-to-GDP ratio over the medium term. However, the debt trajectory derives from assumptions of stable macroeconomic conditions and leaves limited space to respond to future shocks. Thus, additional fiscal efforts would be needed to put debt on a firm downward path and rebuild policy space.

Refinements to the fiscal framework and pension reform would further bolster confidence on public finances’ sustainability . The new fiscal framework and the recent creation of the Committee of Experts and Advisory Fiscal Council are very important steps towards ensuring fiscal discipline. Moreover, compliance with the rule during the pandemic has shown the authorities’ strong commitment to fiscal sustainability. Further refinements to the framework—for example, moving to 5-year rolling limits, introducing an explicit debt target, and formalizing an escape clause with correction mechanisms—would help ensure that the new rule delivers fiscal discipline over time and across administrations. Advancing with pension reform is also key to secure fiscal sustainability, even if the associated fiscal savings may take time to materialize.

Monetary policy may need a tightening bias to bring inflation within the target range as the economy recovers. Amid challenging circumstances, monetary policy adequately supported the economy through the pandemic while gradually steering inflation and inflation expectations towards the target range. Building further credibility and durably steering inflation into the target range may require acting promptly as the recovery takes hold. In the meantime, a well communicated policy strategy—that signals the expected path of monetary policy—should help sustain recent gains in re-anchoring inflation expectations. Durably lowering inflation remains a necessary condition to reduce dollarization and help boost credit and investment.

Timely phasing out credit support measures would prevent misallocation and fiscal costs. The extension of SIGA guarantee lines will adequately support companies in still-affected sectors. As uncertainty about the recovery dissipates, however, tightening eligibility criteria and conditions will be key to prevent misallocation of capital and to limit potential fiscal costs. Stress-tests—which the BCU has been conducting since the start of the pandemic, together with assessments of the possible impact of adopted measures—do not point to significant risks. It is important to continue monitoring closely possible financial stability risks—especially stemming from exposure to sectors highly affected by the pandemic— as support measures are unwound.

Policies to foster employment and address skill mismatches in the labor force are welcome. The employment subsidy for vulnerable groups and the differentiated wage-setting guidelines for affected sectors strike the right balance between employment recovery and protection of workers’ purchasing power. Further decentralizing wage negotiations could further support employment and limit long-lasting effects of the pandemic. In addition, a multi-dimensional strategy is needed to address the structural problems in human capital exacerbated by the pandemic. The leap in digitalization during the pandemic has accentuated the skill mismatch, highlighting the urgency of effective (re)training programs—especially for low skilled workers—to facilitate a rapid re-insertion into the labor market. Education reform should also proceed speedily to tackle high dropout rates and ensure that formal education is adapted to the needs of an increasingly IT-based economy.

Moving forward with the authorities’ broader reform agenda will be key to boost medium-term growth. The new domestic fuel price formula is a welcome development. There is scope for deepening the reforms of state-owned enterprises (SOEs), reining in inefficient activities and unprofitable investments (that lead to unbudgeted cross subsidies and raise the cost of doing business), separating commercial and social objectives, and improving SOE independence and governance. The development of domestic capital markets is a recent initiative that could contribute to boosting investment. At the same time, new trade agreements under study could lead to important advances in trade integration, Finally, Uruguay’s commitment to environmental objectives—as well as the advances to incorporate environmental aspects in the design of economic policy in general and fiscal policy in particular—are also commendable.

The mission praises the authorities for their prudent macroeconomic management of the crisis and encourages them to press ahead with their reform agenda as the pandemic is overcome . The team also thanks Uruguay’s authorities and stakeholders for their hospitality, constructive policy dialogue, and productive collaboration.

***Note: These estimates and projections are based on statistical information and analysis available through October 5, 2021. The estimates published in the October 2021 World Economic Outlook (and the associated database) are based on information available through September 27 2021 (i.e., predate the ones presented in this table).