Despite slowdown, Uruguay's prospects remain sound.

BY FRANCO UCCELLI

Real GDP growth is converging toward potential. While the government has recently affirmed its 4.0 percent real GDP growth forecast for 2013, which would represent a slight improvement over last year’s 3.9 percent expansion, data for 1Q13 already shows growth slowing to 3.7 percent, driven by a moderation in consumption, down from 4.4 percent in 1Q12. The central bank (BCU) estimates growth potential at 3.0 percent, lower than trend growth of 4.0 percent, and forecasts real GDP to expand 3.2 percent in 2013, still a healthy level if one considers that population growth in Uruguay is virtually non-existent, which means that any growth in the economy, even if it is moderate, will yield growth in per capita income. Interestingly, high-ranking officials have recently indicated that Uruguay is not prepared to sacrifice economic growth for the sake of reducing inflation to unrealistically low levels. 

Recent measures should help ease inflationary pressures. The BCU is hoping that the monetary policy measures that went into effect on July 1 will ease inflationary pressures and lower inflation expectations. Those measures include a shift from rates management to monetary aggregates management as the key policy anchor and the widening of the inflation target range to 3-7 percent from 4-6 percent starting in July 2014. Nevertheless, the authorities have made it clear that the imposition of the new measures should not be viewed as tacit recognition that the inflation-containment policy based on rates management did not work, but rather as an attempt to eliminate the perverse disincentive to the development of an overnight interbank loan market that resulted from the “free lunch” situation that local banks were enjoying, in which they opted to lend their excess liquidity to the BCU at attractive rates (9.25 percent at last count), rather than to each other, thus hindering the development of an interbank loan market. Moreover, the monetary authorities believe that no monetary policy alone is enough to contain inflationary pressures if it is not accompanied by prudent fiscal and income (wage) policies. After closing 2012 at 7.5 percent, inflation is officially projected to inch up to 7.9 percent in 2013, before moderating to 6.4 percent in 2014 (falling within the new target range) and 5.3 percent in 2015.  

There is no consensus on the FX path. Following the peso’s sharp 8.5 percent depreciation since late May, there appears to be no consensus among local agents regarding the path the Uruguayan peso (UYU) is likely to follow going forward. Recall that the depreciation occurred when word got out that the BCU was considering measures to curb massive capital inflows (they are estimated to have totaled around US$1 billion in 1H13) that were attracted to public securities paying hefty interest rates and had put undue appreciation pressure on the local currency. While some local pundits believe the UYU is poised to appreciate from current levels of around 20.60 per US$ as capital inflows in the form of foreign direct investment (FDI) continue in full force, others believe the UYU is likely to weaken further, dragged by less-supportive international conditions, such as the strengthening of the US$ and financial outflows from emerging markets. While we believe the recent repricing has resulted in a new floor of 20 per US$ for the UYU and that the exchange rate will probably close 2013 around 20.85 per US$ (lower than the 22 recently projected by the government), we recognize that UYU performance will probably be largely driven by the behavior of the Brazilian real (BRL), as the high correlation between the two currencies, which had diminished of late, has been recently restored. 

Fiscal deficit is likely to stay north of 2 percent of GDP through 2015. The government has raised its fiscal deficit forecast for 2013 to 2.1 percent of GDP from 1.4 percent previously, bringing it more in line with market expectations. While most locals view the revised forecast as more realistic, with virtually no one believing the government could slash the deficit in half this year from 2.8 percent of GDP in 2012, particularly as the country enters a new electoral cycle, many (including us) believe the new 2.1 percent of GDP official deficit forecast is still a bit too optimistic. The government calls for the deficit to widen to 2.4 percent of GDP in 2014, as the presidential race heats up (it is scheduled for October of next year), taking it to the level where we actually see it closing this year. The government expects the shortfall to decline to 2.0 percent of GDP, up from a previous 1.0 percent estimate, in 2015, once the election is over. Most people believe the current Mujica administration will do just enough not to be blamed for boosting inflation by pursuing a lax fiscal policy, but will do little to lower inflationary pressures by pursuing a tight fiscal policy in the middle of the electoral cycle.  

Government’s financial shield remains substantial. The government has built a sizable financial shield to protect its fiscal standing and the local economy at large from unexpected external shocks. To that end, it has negotiated contingent credit lines (CCL) for almost US$2 billion (4 percent of GDP) from four international financial institutions, including the CAF, FLAR, IDB, and World Bank. These CCL, along with cash reserves totaling some US$1.8 billion (enough to cover roughly two years worth of public debt amortizations), have enabled the government not only to protect itself from unexpected financial shocks, but also to set up more cost-efficient funding strategies. In fact, the government is now relying more heavily on CCL than on cash reserves (which used to total around US$3 billion one year ago) as a hedging mechanism, since the negative carry cost of maintaining cash reserves is higher than the maintenance fees (if any) attached to the CCL. The purpose of the CCL, and of the cash reserves for that matter, is to provide a precautionary line of defense for Uruguay, which is not at great risk of an external payments crisis of its own making, but could be vulnerable to contagion effects from capital account crises arising in other countries. 

Composition of public debt continues to improve. Another way in which Uruguay has made great progress reducing its financial vulnerabilities has been by improving the currency composition of its public debt. The government has raised the percentage of public debt denominated in local currency to 59 percent currently (10 percent in nominal UYU and 49 percent UI inflation-linkers) from only 15 percent in 2006. The initial goal of the current administration was to lift the percentage of local currency-denominated debt to 45 percent by 2014. The fact that the target has not only been met, but has been significantly exceeded ahead of schedule, means that the government now has ample scope to take advantage of favorable funding opportunities, regardless of the currency in question. Accordingly, the government has indicated that it is keeping its options open. All this is solid proof that the government’s de-dollarization strategy, which does not seek to eliminate foreign-currency debt altogether but rather to reduce any mismatches between its assets and liabilities, is paying handsome dividends. 

US$ debt looks more appealing than before. Following the imposition of capital controls in the form of marginal reserve requirements on foreign investments in both BCU and government local currency-denominated debt instruments, many observers believe foreign-currency bonds are looking more attractive, particularly now that Uruguay’s US$ global bonds have underperformed the broad EM market in the recent sell-off, rendering them cheaper than before. While risks, principally regional in nature (Brazil, Argentina), still linger, there is broad domestic consensus as to the proper policies that need to be implemented to reduce the country’s external vulnerabilities, not to mention its massive financial shield to confront any potential external headwinds. Against this background, and perhaps bolstering the case to take a closer look at Uruguay’s foreign currency-denominated debt, is some evidence that key local investors are planning to increase their holdings of US$ debt. At a minimum, they argue, it is worth the look, and we agree.

Franco Uccelli is an analyst with JP Morgan Chase. This column is based on a recent trip report. Republished with permission.