Regardless of who wins the presidential election, no material changes to the current policy framework are likely.

BY FRANCO UCCELLI

Presidential election is too close to call. The latest polls show a high probability that a runoff will be required to determine the next president of Uruguay, and that it will be a very close race to the finish. Indeed, with voter support for former-President Tabaré Vázquez of the ruling Broad Front averaging 42 percent and backing for Luis Lacalle of the opposition National Party averaging 32 percent, it is unlikely that either candidate will secure the 50 percent-plus-one majority required in the October 26 election to prevent a November 30 runoff. With most backers of the third-place Colorado Party (around 15 percent of the electorate) likely to side with Lacalle, accurately predicting the outcome of the probable runoff has become largely academic. This is indeed confirmed by the latest polls, which show the two leading candidates in a statistical dead heat in a second-round simulation. By most accounts, the ruling Broad Front is unlikely to retain its current congressional majority, an outcome that most local observers would seemingly welcome, as it would set limits on its legislative agenda.

No material changes to the prevailing policy framework are likely. Regardless of who wins the presidential election, there is broad consensus that no material changes to the current policy framework are likely. Indeed, the leading party platforms are viewed as very similar to each another, and only subtle changes are generally envisaged, with neither policy direction nor economic performance expected to vary all that much. Moreover, should the Broad Front win the election, the existing economic team is likely to only marginally change, with former and current government officials either assuming old roles or maintaining present ones. Alternatively, should the National Party win the presidential election, some senior ranking officials of the Broad Front administration are poised to assume new responsibilities within the new government. The bottom line is that no major changes are likely in terms of both the composition of the economic team and the current policy thrust.

FISCAL DEFICIT

Elevated fiscal deficit is lifting the debt burden. For years, healthy economic growth, a relatively low fiscal deficit, and rapidly expanding foreign reserves progressively lowered Uruguay’s net public debt as a percentage of GDP. However, given the ongoing economic slowdown, the positive (i.e., declining) trend would only be sustainable if the fiscal deficit were kept below 2 percent of GDP, which is clearly not the case. Accordingly, critics of the recent increase in the fiscal shortfall are quick to note that the net debt of the public sector is liable to start trending up again in the near term, calling for at least a 1.5 percent-of-GDP reduction in the deficit from current levels of around 3.3 percent of GDP (2.3 percent of which is contributed by the central government) to restore proper debt sustainability.

Lowering inflation and the fiscal deficit will remain key policy challenges. With annual inflation consistently printing above the 3-7 percent target range and the fiscal deficit widening to more than 3 percent of GDP, most locals believe that curbing inflationary and fiscal pressures will be the new administration’s fundamental and most pressing challenges. However, most pundits believe that very limited progress is likely to be achieved on either front, at least in the near term, with recent surveys putting inflation north of 8 percent and the fiscal deficit north of 3 percent of GDP at least through the end of 2015. Despite inflation exceeding the explicit target, the recent move to monetary aggregates as the nominal anchor of monetary policy is viewed by the authorities as working effectively and there is therefore no indication that they are considering deploying alternative policy tools to contain elevated price pressures.

RESERVE REQUIREMENTS

Views on recent changes to reserve requirements are mixed. The timing of recent changes to marginal reserve requirements on investments made by foreigners in both central bank and government paper appears to have taken everyone by surprise, but that is where the consensus ends, as theories differ widely as to the real aim of the measures. Whereas before the changes a 50 percent marginal reserve requirement applied to purchases by foreign investors of central bank or government securities, now only central bank instruments are subject to the requirement and at a reduced 30 percent rate. While some locals believe the aim of the measures is to facilitate and enhance government access to financing in anticipation of higher interest rates triggered by monetary policy normalization in the US, others believe it is part of an effort to contain inflationary pressures though the appreciation of the currency, which presumably increased hard-currency inflows would foster. As in most cases, the real aim of the recent changes in reserve requirements probably lays somewhere in the middle, with the new measures likely to improve government access to financing while helping to sustain peso strength and hence contain price pressures.

Negative carry cost of maintaining high level of reserves is quite hefty. According to official estimates, the fiscal cost of maintaining $18bn worth of foreign reserves—equivalent to 32 percent of GDP or 18 months of imports—is approximately 0.6 percent of GDP, which, some vehemently argue, means that the fiscal deficit is significantly higher than it needs to be. This situation has led some critics to claim that the country is unnecessarily over-reserved and that a better way to utilize the perceived surplus in financial assets is to pay down the country’s external debt. The trouble here is that while just about everyone acknowledges that reserves are indeed excessive, there is no consensus as to what the optimum level should be, delaying any decision to adjust the reserve stock to match that level. Accordingly, there is little indication that the pace of reserve accumulation (they are up more than 10 percent so far this year) will be altered anytime soon.

Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on a recent trip report. Republished with permission.