Uruguay: Nowhere to Hide

Despite sound macro indicators, Uruguay will be hit by problems in neighboring Argentina and Brazil.

BY WALTER T. MOLANO

Autumn can be splendid. The Parisian leaden sky contrasts nicely against its mansard slated roofs. The orange leaves of Central Park become a plush carpet. However, fall is anything but glorious in Montevideo. A stiff wind blows down the Rambla, bringing in a mix of rain and the salty mist of the South Atlantic. The dark overcast could be an omen of what lies ahead. Uruguay's two colossal neighbors are hurtling towards uncertainty. Brazilian President Dilma Rousseff is losing control of her economy. A dozen years of leftist policies have taken their toll on the country. The pace of economic activity has stalled. Inflation is high and the currency is grossly overvalued. More importantly, the electorate is fed up with the rampant corruption. Billions of the reais that were spent on the new stadiums for the World Cup were siphoned off by politicians and political allies. At the same time, the country's infrastructure is collapsing. Medical services are non-existent, and Brazil has one of the highest illiteracy rates in Latin America. Rumors abound that various social groups are preparing major demonstrations that could interfere with the games. Ironically, the market is taking the rumors in stride. Many hope that a disastrous World Cup will mean no re-election for President Rousseff, and that would very good.

Argentina also finds itself a critical juncture. Many people believe that important economic changes are on the horizon. A positive outcome in Brazil and Argentina would be brilliant for Uruguay, but that could be wishful thinking. Chances are that there won't be any major changes in Argentina, and President Rousseff pulls a rabbit out of the hat on the eve of the elections. If that is the case, the situation in Uruguay could become tenuous. Fortunately, the country's macroeconomic indicators remain sound. GDP growth at the end of the fourth quarter was 4.6 percent y/y. The economy has a bulwark of external and fiscal buffers that will help shield it from external shocks. Net Foreign Direct Investment was $2.7 billion in 2013, with strong capital inflows in paper plants and mining projects. Even though its current account deficit is more than 6 percent of GDP, the central bank continued to accumulate international reserves, with levels reaching a third of GDP by the end of last year. The fiscal accounts are also better. However, the economy is starting to slow. The level of economic activity was only 2 percent y/y during the first quarter of this year. Industrial production dropped 6.8 percent y/y in March. Even though most Uruguayan economists expect the level of economic activity to expand 4 percent y/y this year, there is a better chance that the growth rate will be close to zero. One of Uruguay´s persistent problems has been its high rate of inflation, which still remains above 9 percent. Moreover, the renewed appreciation of the currency is forcing the export sector to lose competitiveness. Uruguay rivals Brazil, Colombia and Chile as being one of the most expensive countries in Latin America. An explosion in domestic credit is only making matters worse. Uruguayan banks are brimming with cash, and they are lavishing the funds on consumers in the form of mortgages, car loans and credit cards. This is generating a latent vulnerability, which will eventually become a banking sector crisis if there is a reversal in international capital flows or general concerns about regional stability.

Uruguay was created in the early days of the 19th century as a buffer state, along with Paraguay, Bolivia and Ecuador. They were established to separate the largest bastions of the colonial viceroyalty system—principally Colombia/Venezuela, Peru, Argentina and Brazil. Squeezed in by the two largest regional superpowers, Uruguay was always heavily influenced by its neighbors due to its permeable borders. Argentine culture prevails along the southern littoral, while a patois of Portuñol dominates the grassy north. There is no way that Uruguay can escape what happens next door. Its macroeconomic buffers can help soften the blow of a regional downturn, but it has no place to hide.

Walter Molano is head of research at BCP Securities.