Montevideo, Uruguay
June 16, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

1. The Uruguayan economy has performed well in recent years. Real GDP growth averaged 3¾ percent a year during 1990-98, compared with population growth of ½ percent; inflation declined substantially to a single digit by end-1998; and the external current account deficit remained modest. This favorable performance has been achieved through a gradual but sustained adjustment effort, combining cautious fiscal and monetary policies with economic deregulation and market based reforms in the areas of education, social security, public enterprises, and the public administration. The government is committed to continue with these cautious policies in 1999, which is proving to be a challenging year. In March the Fund approved the request for a 12-month stand-by arrangement equivalent to SDR 70 million in support of our economic program. We do not intend to make drawings under the stand-by arrangement, and are treating it as precautionary. Presidential elections are scheduled for October, and the new administration will take office in March 2000.

2. All quantitative performance criteria under the program through end-March 1999 were met. Nevertheless, developments suggest that the economy has been affected more severely than expected by January's depreciation of the Brazilian real and the slowing of economic activity in Brazil and Argentina. Together with the depreciation of the Euro vis-à-vis the U.S. dollar and continued weakness in most other regions of the world economy, competition for exports has been severe and export prices (particularly for agricultural commodities) have dropped more sharply than was anticipated. In addition, oil import prices have increased more than expected and the terms of trade are now projected to deteriorate by around 4 percent this year, compared with virtually no change in the program. Deseasonalized real GDP growth in the first quarter of 1999 is estimated to have been negative by over 3 percent, compared with the previous quarter. Inflation was slightly lower than expected, while unemployment increased, and the external trade balance was weaker than programmed. Reflecting these circumstances, the government is now projecting real GDP growth around negative 2 percent for the year as a whole, compared with negative 1 percent in the program. Consumer price inflation should fall to 4¾ percent by end-1999, from 5½ percent envisaged earlier.

3. To deal with these challenges, there is agreement in Uruguay that output costs need to be reduced to bolster competitiveness. In the private sector, several leading companies have initiated the renegotiation of labor contracts. In some sectors, and in cooperation with labor representatives, firms are reducing nominal wages (and helping to limit layoffs). Also, trade delegations are tapping nontraditional or under-explored markets outside the Mercosur to foster trade relations, and several Uruguayan companies are considering bids for cooperation agreements or mergers with foreign companies to improve access to capital, technology, and new markets abroad, and to increase their scale and bolster efficiency.

4. For its part, the government continues managing the public sector finances in a cautious manner, consistent with the envisaged decline in inflation and the need to lower costs and recover competitiveness. At the same time, with real GDP growth weaker than expected, the cyclical weakness is putting further strain on the public finances and the government is requesting an increase in the program limit on the public sector deficit from 1.8 to 2.1 percent of GDP, to allow the impact of automatic stabilizers. The government does not anticipate difficulties in financing a slightly higher deficit as the country has an investment grade credit rating and has maintained access to the markets at a modest spread of just over 200 basis points so far this year.

5. Under the revised fiscal plan, revenues are projected to be lower than originally programmed, mainly reflecting weaker output growth. Tax policies are to be kept broadly unchanged except for modest reductions, limited to the agricultural sector, in rates on employer's social security contributions and the tax on net worth. The agricultural sector was hardest hit by the decline in commodity prices and slowing foreign demand. Moreover, to help reduce overall costs in the economy, the tariffs of some public sector enterprises are being lowered slightly in real terms. Apart from the reduction in employers' contributions in agriculture, overall social security receipts are benefiting more than expected from improvements in administration. Enhanced cross-checking of (now computerized) labor histories and strengthened efforts in compliance and enforcement are boosting employment registration in the formal sector, which is helping to raise receipts.

6. In the expenditure area, and as described in the program presented to the Fund in March, in February 1999 the government reduced outlays on goods and services and investments by 0.4 percent of GDP for the year. These measures are being implemented on schedule. Since then, further cuts have been decided: the suspension of inflation correction to budgetary spending ceilings through May 1999 has been extended through August 1999, and will likely be extended further through year-end. In addition, with inflation projected to be lower than envisaged in the original program, public sector wage adjustments planned for July 1999, based largely on forward looking six-month inflation, will also be lower than originally programmed. In the social security system, the reform of 1996 is beginning to have an impact on the public pay-as-you-go system as the number of old-age pensioners receiving benefits from the public system has peaked recently, but the savings from this turnaround in volume are still small. At the same time, there are some additional health care costs for those now registered formally in the labor markets, together with an uptick in unemployment insurance costs owing to the cyclical downturn.

7. Receipts from real property and automobile taxes permitted local governments to build up deposits in the first quarter of the year, and helped to meet the program fiscal target for end-March. However, the local governments are expected to draw down these deposits in the rest of the year and end the year with their accounts in balance, as originally programmed. The public sector enterprises also are expected to perform about as originally programmed, even though the increase in oil import costs is causing additional outlays in the petroleum and electricity companies. This impact is offset by reduced capital spending.

8. Financial markets have responded calmly to the events in January and to the more subdued growth outlook for the year, and the government does not anticipate a need for changes in the monetary objectives of the program at this time. Interbank interest rates have dropped to below their level just prior to the Russia crisis in August 1998 and, adjusted for the pace of depreciation in the exchange rate band, have remained in recent weeks close to the equivalent short-term U.S. dollar rate. There are no evident pressures in the foreign exchange market and the peso has remained in the most appreciated half of the exchange rate band, notwithstanding lower peso interest rates in the interbank market. In April 1999, the BCU cut the benchmark call interest rate by half a percentage point to 12.5 per-cent. The end-March levels of NIR and NDA were well within program limits, with gross reserves in excess of six months of imports of goods and services, equivalent to two-and-a-half times the narrow money base, and providing cover for about two years of scheduled external debt service, respectively.

9. Growth in credit to the private sector is projected to be modest in 1999. Private sector credit had grown sharply in 1998 and, to slow it, in September 1998 the BCU announced tighter lending regulations including increased use of collateral and higher risk weighting attached to consumer loans. Also, the BCU eliminated a credit facility from the IDB directed at selected investment projects (FOFIDE). At the same time, to strengthen the resilience of the banking system, the BCU increased the minimum capital adequacy requirements from 8 to 10 percent of assets (risk weighted), phased in over two years, and in May 1999, issued regulations boosting bank liquidity by limiting the banks' ability to transform short-term deposits into long-term loans with a maturity mismatch in excess of three years. While not all measures were binding for all banks in the system, each measure was binding for some banks, and jointly they contributed to strengthening the health and resilience of the banking system.

10. The external current account deficit is projected to widen to 2½ percent of GDP under the revised program, from 2 percent envisaged earlier. The widening reflects the worsening of the terms of trade. In volume terms, the external trade balance is expected to improve. Receipts from tourism earlier this year were slightly below those of 1998. Notwithstanding an expected recovery in regional economic activity by year-end, projections for the late-1999 summer season have been kept modest. As mentioned, competitiveness was adversely affected by the depreciation of the real (Brazil accounts for a third of merchandise exports), and between end-1998 and April 1999, the real effective exchange rate is estimated to have appreciated by about 10 percent. With the efforts at cost cutting underway, and assuming a moderate depreciation of the U.S. dollar vis-à-vis the Euro, the government expects the real effective exchange value of the peso to return to its end-1998 level in about a year's time. With foreign demand and commodity prices expected to firm up in the future, these efforts should permit Uruguay to reduce its external current account deficit to below 2 percent in the medium term. Uruguay is not experiencing pressures in the external capital account as foreign direct investment in the economy has remained unchanged, deposit inflows slowed but did not turn negative, and as the government has maintained access at good terms to financial markets. Nevertheless, the government will closely monitor trade performance and capital flows.

11. Notwithstanding the difficulties in external merchandise trade, the public recognizes that weak global demand and commodity prices are beyond Uruguay's control, and that domestic costs must reflect these new realities. For its part, the Central Bank of Uruguay (BCU) will not reduce, for now, the pace of adjustment of the exchange rate band. At the current pace, the exchange rate will depreciate by nearly 8 percent in the year through December 1999 which, with the expected drop in inflation, will help to recover some of the competitiveness lost in January.

12. As mentioned in our letter of March 12, 1999, the government is concentrating in 1999 on implementing structural reforms that are already underway and intensifying, where possible, efforts to involve private sector initiatives and expertise in areas and activities previously reserved exclusively for the state. The government is intensifying efforts to transfer infrastructure investment projects to the private sector (e.g., building and operating toll roads); new bids have been issued for the privatization of port facilities; public enterprises continue to expand their capacity and improve efficiency, in joint ventures with private sector firms, inter alia, in the gas sector; the market for cement and lubricants; mobile telephony; and electricity generation. To bolster the development of the domestic capital market, draft laws on factoring and discounting are progressing in Congress, as is the overhaul of the bankruptcy legislation. In April 1999, the BCU approved new regulations permitting private pension funds to trade qualified securities in the Montevideo stock exchange. In the banking sector, bids have been received for the privatization of the intervened bank La Caja Obrera and a decision on these bids is expected in June 1999. The Bank of the Republic (BROU) has renewed its contract with a private sector consultant to improve the information system in the bank, and hired specialists from the National University to improve personnel management and manpower training. The BROU and the National Mortgage Bank (BHU) have called for bids from international accounting firms to conduct an independent external audit of the banks beginning in the second half of 1999. Also, the government is finalizing negotiations with the World Bank for financial and technical assistance with reforms in the financial system and to bolster banking supervision.

13. A multisector statistics mission from the Fund is expected to visit Montevideo around mid-year to help prepare Uruguay's adherence to the SDDS, as planned, and special efforts continue to improve the information on national accounts and the international investment position. In May 1999, the BCU conducted a comprehensive test of the bank clearing system, and efforts are underway in the electricity, telephone, and other important sectors of the economy to guard against the Y2K computer problem. The government of Uruguay supports the initiatives of the international organizations to improve the transparency of country operations and agrees to prepare, in cooperation with Fund staff, a transparency report. The report will be prepared for the 2000 Article IV consultation with the Fund.

14. In support of our request for completion of the review and modification of the targets for the public sector deficit and debt, the attached table presents the proposed revised quantitative performance limits under the program for 1999. We also note that the BCU completed a two-year action plan for Uruguay's subscription to the SDDS, included in the program as a structural measure for end-March 1999. The government believes that the policies described above are adequate to achieve the objectives of the program. Uruguay will maintain close relations with the Fund and consult on the adoption of measures that may be appropriate, in accordance with the Fund's practices on such consultations. The Fund staff team is expected to visit Montevideo by end-1999 or early 2000 to discuss progress under the program.