Uruguay - Current economic position and prospects

RESTRICTED Report No. WH-198a This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION CURRENT ECONOMIC POSITION AND PROSPECTS OF URUGUAY March 24, 1970 South America Department  CURRENCY EQUIVALENTS US$1.00 = 250.00 pesos 1 peso (Ur$) - US$o.0o4 1 million pesos = US$4,000.00  CURRENT ECONOMIC POSITION AUD PROSPECTS OF URUGUAY TABLE OF CONTENTS Page No. BASIC DATA ....................... i-ii SUMMARY AND CONCLUSIONS ......................... i-ix I. POSTWAR TRENDS ...... ............., ...... 1 A. Institutional Background . . 1 B. Fiscal Policy and Administration . . 2 C. Development Trends to 1965 . .3 II. THE ECONOMY IN CRISIS; 1965-1968. 7 A. Introduction ...... 7 B. Financial and M4onetary Situation ............. 8 Fiscal Policies - Central Government. 8 Fiscal Policies - Public Sector .......... ... 11 Monetary Management ........................ 14 C. Prices and Wages .19 D. Sectoral Developments .21 E. Balance of Payments Developments ........ 24 III. CURRENT ISSUES AiD OUTLOOK ............................ 30 A. Developments in 1969.. . . . . 30 B. Development Potentials and Issues, 1970-1973.. 38 Overall Strategy . .38 Opportunities in the Private Sector . .39 The Financing of Public Sector Investment, 1970-1973. 45 Balance of Payments Policies and the Out- look for Economic Growth ......... ........ ,49 STATISTICAL ANNEX This report is the result of visits to Uruguay in May-June and October 1969 by Messrs. Maurice Perkins (Chief of Mission), Roger Hipskind and Carlos Quijano. The mission was also assisted by a livestock sector appraisal mission headed by Mr. August Schumacher.  BASIC DATA Area: 187,000 square kilometers (72,000 square miles) Population (1968) 2.8 million Rates of Growth: 1.2 per annum Gross National Product (1968): 1.7 billion of U.S. dollars GNP per capita: US$590 Gross Fixed Investment as % of GDP, 1968: 10.9 National Savings as % of GNP (1968): 11.7 Annual Rate of Growth in GDP: 1946/50-1951/55: 4.3 1956/60-1961/65: 0.3 1966: 2.5 1967: -6.3 1968: 0.3 Output by Sectors, 1968: Livestock 9.7% Crops 2.5% Manufacturing 26.5% Construction 5.2% Transport and Communications, Electricity, Gas 6.8% Water and Sanitary Services 1.4% Other Services 47.9% Total 100.0% Consolidated Cash Operations of the Central Government (in millions of Pesos) 1968: Revenues 48,337 Current Expenditures -47,160 Surplus 727 Capital Expenditures -2,461 Overall Deficit -1,734 Financing (Net) 1,734 (a) Monetary Authorities -1,642 (b) Treasury Bills 2,401 (c) Treasury Bonds 975 (d) Other -  Money, Prices and Exchange Rate: Money Supply Cost of Living Index Exchange Rate In millions of current Percent (Percent Change, Pesos/US$ Percent pesos Change Dec.-Dec.) End of Year Change 1966 21,098 23.3 49.3 75.88 26.7 1967 41,080 98.1 135.9 200.00 163.5 1968 65,400 56.5 66.3 250.00 25.0 Balance of Payments in Millions of U.S. Dollars (1968): Exports of Goods and Services 236.1 Imports of Goods and Services -199.8 Resource GAP (- = inflow) 36.3 Interest Payments -18.1 Other Factor Income -8.0 Donations and Transfer Payments 9.8 Current Account Balance 20.0 Official Donations 2.2 Foreign Direct Investments - Loan Disbrusements 39.7 Loan Amortizations 47.0 Short-Term (Net) -2.4 Other Transactions -28.4 Net Short-Term Reserves -15.9 Net IMF Position, July 1969: (- = debt) $20.8 maillion Comnmodity Concentration: 1960 1965 1968 Wool 51.6% 47.3% 43.5% Meat 23.8% 31.8% 31.8% Hides 12.2% 8.3% 9.2% Foreign Exchange Reserves, Nov. 1969 Central Bank and Banco de la Re-nublica (in mi.lions of U.S. dollars) Gross: 204.2 Net: 22.0 External Public Debt: December 31, 1968: 309.0 million External Public Debt Service Ratio, 1968: 21.2%  SUNmLARY AND CONCLUSIONS 1. From 1955 until 1968, Uruguayan GDP remained almost constant in real terms. As a result of virtual stagnation in output and of the 1.4 percent average annual rate of population increase which prevailed during the period - one of the lowest in the Americas - Uruguay's per capita GDP declined by about 16.5 percent between 1955 and 1968. This decline, from the equivalent of about US$720 to about Us$600, has severely strained the social stability of the country and has led, moreover, to a dangerous pattern of emigration among the younger and more highly trained Uruguayans. Despite its long-term stagnation, however, Uruguay's favorable resource endowment, high level of literacy and generally homogeneous population offer strong assurance that with proper economic policies the satisfactory rates of growth enjoyed prior to 1956 could be regained. 2. Perhaps the most important cause of the stagnation of Uruguay's economy has been neglect of its clear comparative advantage in livestock production and processing for export. Despite the importance of the ex- ternal sector - a function of the country's diminutive internal market as well as of its natural advantages in pastoral production - Uruguay, after World War II, pursued a policy of stimulating the installation of light manufacturing industry while largely ignoring the needs of live- stock producers and processors. Consequently, resources accumulated during and immediately after the War as a result of the suppliers' market for wool and meat prevailing during this period, were inefficiently allocated and soon dissipated. Imports and exports of goods and services declined from an average of 19 and 15 percent of GDP, respectively, in the 1946-55 period to 13.2 and 12.9 percent over the 1956-68 period. Fixed investment declined from an annual average of 19.2 percent of GDP over the 1946-55 period to 12.3 percent over the l956-68 period. 3. The neglect of its livestock sector, however counter-productive. is understandable in terms of Uruguayts social structure. About 50 per- cent of the population is concentrated in Montevideo and an additional 20 percent in a few other urban areas. The resulting urban orientation of economic policies led to such distortions as excessive taxation of agricultural exports, undue restraint of internal agricultural and other commodity prices and accumulation of an enormous personnel surplus in the public sector. With declines in traditional export earnings, suc- cessive governments were confronted with the dilemma of a very inelastic revenue structure and rigid current expenditure requirements. The result was a rapidly accelerating inflation, which peaked at an annual rate of 183 percent in June 1968.  - ii - 4. At this point the Government which took office in 1967 moved courageously - and in sharp variance with traditional orientations - to interrupt the inflationary process by instituting direct controls over wages and prices. During the next twelve months, the price level increased by only 10.1 percent. However, to transform this temporary interdiction of the inflationary process into a program designed to promote development within a framework of reasonable price stability, the Government would have to take measures to correct the underlying distortions afflicting the economy. Perhaps the most urgent of these measures are those required to restore to the price mechanism its resource allocating functions, with particular emphasis on channelling investments into Uruguay's natural export industries. Of almost equal importance is the modification of the tax structure to make it less dependent on exports and more elastic to changes in nominal income, so as to enable the Government in the future to manage the balance of payments with fewer constraints imposed by fiscal revenue requirements. While otlher measures of structural reform may also be required, these will become feasible only once economic growth has been resumed in a framework of financial viability. 5. Uruguay's cattle and sheep population has remained almost constant at 8 and 23 million head, respectively, since the mid-1950's. Variations which have occurred are primarily attributable to climatic factors. Mean annual cattle slaughter has been 272,000 tons, deviations from this mean averaging only 10.6 percent; 70.3 percent of Uruguay's beef production has been locally consumed, its per capita beef consumption - currently at 65 kilos annually -being among the worldts highest. Wool production has also remained relatively constant, averaging 83,000 tons annually since 1956, of which no more than 10 percent was utilized inter- nally. The decline in the value of livestock sector output as a percent- age of GDP has been primarily a function of price rather than volume. In 1968, for example, producers' prices for beef and wool were 8.9 and 9.4 times their respective 1962 levels. During the same period the Montevideo consumer price index rose by about 20 times. The deterioration in the producers position was partly caused by a 20 percent decline in world wool prices. Mlore important, however, was the combined effect of changes in export taxes and in the slaughterhouse fee. 6. Throughout most of 1969 the effective rates of beef and wool export taxes were approximately 15 and 28 percent, respectively. At these rates, retention taxes yielded about 9 percent of Central Gov- ernment revenues. The wide variation in export tax rates experienced over the last several years is demonstrated by the fact that, applied against a relatively constant volume of exports, their yield has ranged from 6.5 to 19.4 percent of Central Government revenues since 1961. This variation is associated with several massive exchange rate devaluations effected during the period. The Government has tended to absorb the increment in the local currency equivalent of world beef and wool prices resulting from these devaluations through simultaneous increases in export tax rates in order to alleviate its chronic fiscal problem. In  - iii - the case of beef, such applications of the export tax have served another purpose as well. Together with retail price controls they have operated to hold consumers' prices substantially below the world price equivalent. Viewed in this light, the differential in internal and external beef prices brought about by application of the export tax is revealed as a levy against al1 Uruguayan beef production, the bulk of the yield from which is allocated as a subsidy to consumers. 7. The desire to protect the urban consumers, and the long- standing reliance on export taxes as a significant source of revenues, combined with the effects of the gross inefficiency of the state-owned slaughterhouse to depress cattle prices paid to producers to levels at which investment was no longer attractive. The state-owned slaughter- house, which until recently had the monopoly for supplying meat to the Montevideo market, determined the prices which the other slaughterhouses could pay; the latter being more efficient thus enjoyed markups which in May 1969 were as high as 23 percent of the world price, or about 3.5 times that prevailing in Argentina. 8. The margin of value-added by Uruguay to its livestock products is low. Since 1960, exports of tops and scoured wool have averaged only 45 percent of total wool exports while exports of processed beef have averaged only 31 percent of total beef exports, with neither processed wool nor beef showing any tendency to increase as a percentage of the total. l4anufactured products of livestock origin such as wool cloth, woolen clothing or shoes, do not contribute significantly to export earnings. While industries of this nature do exist they are generally limited to supplying the internal market. Failure to develop export- oriented industries based on livestock production is attributable to the priority accorded import substitution industries in the allocation of investment resources and to the disincentive impact of Government tax and pricing policies on the livestock sector. Although the Government now offers tax rebates and other incentives to export industries, the fragmented organization and relatively obsolete equipment of meat proc- essing, leather goods and textile industries have prevented them from increasing their exploitation of the external market. A particular problem has emerged in connection with meat; the U.K. has imposed a temporary ban on meat imports of Uruguayan origin pending improvement of sanitary conditions in Uruguayan slaughterhouses. Even with improve- ment in sanitary conditions, Uruguayan slaughterhouses may well be required to expand their capacity to debone carcass beef, if traditional markets are to be retained, owing to the existence of foot-and-mouth disease. 9. Field crop output - grains and oilseeds - accounts for a minor portion of Uruguayts primary production. It now provides a small ex- portable surplus in climatically normal years. Field crop production was about 50 percent larger in the early 1950's. The high world prices prevailing during that period together with restrictions on Uruguayts  - iv - access to Argentine wheat imposed by the Peron regime moved the Gov- ernment of Uruguay to provide the special credit facilities and price supports which crop production intermittently continues to enjoy. Subsequent declines in world prices and the absence of clear compara- tive advantage for Uruguay in crop production for export now suggest, however, that it might be better to modify the distribution of resources allocated to the agricultural sector in favor of livestock. 10. Consumption in Uruguay as a percentage of GDP increased from an average level of 85 percent during the 1946-55 period to 87.8 percent during subsequent years. During the earlier period, capital formation averaged 19.1 percent of GDP annually as the economy grew in real terms at an average rate of 4.3 percent. With concentration of investment in light manufactures for internal consumption rather than in export pro- duction capacity, the resources gap yielded by this rate of capital formation averaged 3.9 percent annually. This was financed by the depletion of the liquid foreign exchange reserves Uruguay had accumulated during and immediately after World War II and the accumulation of substan- tial external indebtedness despite the favorable terms of trade prevailing at the time. 11. Having left unexploited its natural potential for an expanded volume of livestock production and export and depleted its reserves, Uru- guay was poorly prepared to confront the deterioration in the terms of trade occurring after 1955. As indicated by the above-mentioned con- sumption ratios, domestic savings declined sharply to an average level of 12.2 percent of GDP annually. Added to the depressive effect of declining savings on investments was capital flight which became especially massive during the mid-l96O0s. Thus, despite additional accumulation of short and medium-term external debt, which brought the ratio of service on public external debt to exports of goods and serv- ices to 21 percent in 1968, fixed capital formation averaged only 12.3 percent of GD? throughout the 1956-68 period, declining to 10.3 per- cent of GDP in 1968. 12. Constitutional modifications in 1966 abolished the nine-member collegiate executive which had governed Uruguay for 14 years and replaced it with a single chief executive. Realizing that firm and coordinated leadership was required if the country were to overcome the price in- stability and stagnation afflicting it, the new Administration undertook a series of significant measures including the creation of a Central Bank late in 1967 and the imposition of restraints on bank credit expansion; the 100 and 25 percent exchange rate devaluations of November 1967 and April 1968, respectively; and the imposition of direct wage and price con- trols in June 1968. The latter measure was accompanied by the installatiori of Central Government interventors in several key autonomous agencies such as the Bank of the Republic of Uruguay, the state energy and tele- phone administration, and the state railway administration, which had not been adhering to Central Government economic policy. In taking these  measures, the Executive Branch of the Government managed to secure the support of a broad coalition of forces in the national legislature. This support has been difficult to maintain in view of the adverse and some- times violent reaction of various groups - such as organized labor and students - to stabilization and reform efforts. Ultimately the fate of the economy will depend on whether sufficient social consensus can be mobilized in support of a positive economic program. 13. In 1968, the fiscal operations of the Central Government yielded a deficit equal to only 3.5 percent of expenditures (as compared to 19.6 percent in 1967), the money supply decreased by 10 percent in real terms, and the balance of payments yielded a US$20.8 million surplus. This was accomplished with high levels of export taxation (19.4 percent of total Central Government revenues), a 17 percent real decline in civil service wage scales, restraint of direct Central Government investment to 0.6 percent of GDP; and the imposition of absolute ceilings on credit expansion by individual banks. Imports - other than PL-480 purchases - amounted to only 75 percent of the average level prevailing during the 1960-67 period. The cost of living, which had increased by 63.7 percent during the first six months - prior to the imposition of wage and price controls - was held to a 66.3 percent increase for the year as a whole. 14. For 1969 the primary economic policy goal of the Government was to restrain cost of living increase to 20 percent. A 5 percent real in- crease in GDP was forecast on the basis of the anticipated recovery of agri- cultural and related production from the bad weather prevailing in 1967 and 1968. The Government's program was designed to minimize cost pressures by limiting the frequency and amount of private sector wage adjustments; by requiring private entrepreneurs to absorb nominal increases in wage costs without increasing prices; by generally limiting public enterprise rate adjustments to amounts proportionate to targeted price level changes; and by structuring such adjustments in ways that would minimize secondary price effects. Monetary expansion was to be limited to 28 percent by holding the fiscal deficit to 6.3 percent of expenditures and by continuing the imposition of absolute ceilings on bank credit. 15. Implementation of this program confronted the Government with a number of dilemmas, particularly in the fiscal sector. Following the sharp decline in real civil servantst wages in 1968 the Government au- thorized an increase of about 15 percent in real terms in its wage bill. At the same time, it was forced to reduce export tax rates substantially below the average levels prevailing in 1968 in order to offset real de- clines in producers' prices in the absence of further exchange rate de- valuation. To compensate for these factors, the Government would have needed a real increase of at least 17 percent in regular tax revenues and to reduce transfer payments to decentralized agencies and municipalities by about one-third in real terms. The Government hoped to accomplish both of these objectives, but as of end September 1969, revenues were about 8 percent short of projected levels and transfer payments were already in excess of the total projected for the entire year. The implications of  - vi - this situation for the growth of the economy are clear; with no corrective adjustment of public enterprise rates and in the absence of substantial modification of the regular tax structure to offset declining export revenues, public sector savings would tend to become negative, as against 0.6 percent of GDP which they are estimated to have averaged in 1964-68. 16. Real declines in bank credit have stimulated an increase in the activity of a parallel market in which entrepreneurs obtain working capital credit through non-bank financial intermediaries. The range of interest rates prevailing in this market is very wide, but even at the low end of the range these rates are now substantially in excess of the pace of inflation. Given the openness of the Uruguayan exchange system, the supply of funds to this market depends on the expectations of investors as to exchange rate devaluation. W4ith the relative financial and price stability prevailing in Uruguay over the past several months and the real rates of return offered by the parallel market, the supply of funds has been ample. Although no data on the volume of parallel market operations are available, indications are that the debt portfolios of many private Uruguayan enterprises are now heavily dependent on the parallel market. As long as this system prevails, the situation is thus inherently volatile, since resumption by the fiscal authorities of heavy borrowing from the Central Bank or any other signal of financial instability could well trigger a massive shift into foreign exchange on the part of suppliers of funds. 17. Adequate financial incentives to livestock producers are clearly of paramount importance for the future growth of Uruguay. A pasture im- provement program undertaken in 1961 with IBRD assistance, which now incorporates about 6 percent of total pastures in Uruguay, has proved that, given credit and reasonable prices, Uruguayan livestock producers will exploit the sizeable opportunities open to them to expand the carrying capacity of their ranches. Midway in 1969 the financial rate of return on new investment in improved pastures by participating live- stock producers was less than half of the level estimated as necessary if producers are to be induced to make such investments. This situation was markedly improved late in 1969 when the Government terminated the monopoly of the National Slaughterhouse on the supply of beef to Monte- video so that competing private slaughterhouses were left free to bid up producers'beef prices. With the 30 percent increase in producers, beef prices which ensued at the expense of the slaughterhouse#, the Gov- errment was compelled to reduce the rate of the beef export tax to about 8 percent at current international prices and to adjust consumers' beef prices upwards by about 15 percent. The Government has also moved to in- crease wool producers' prices by reducing the respective export tax from about 28 to about 22 percent at current prices. Thus producers' beef and wool prices by the end of 1969 seemed to provide an adequate rate of return on new investment.  - vii - 18. This analysis of the Uruguayan economy suggests that the two most important intermediate goals of an effective Uruguayan stabilization and development program would be: (a) an increase in the exportable surplus of livestock products; and (b) an increase in the savings capacity of the public sector. Longer term goals would have to do principally with diversification of exports to include livestock-related manufactures and other goods and services, including tourism. Considerations of effi- ciency suggest that the public sector - which comprehends such diverse activities as energy production and distribution, petroleum refining, cement manufacture, etc. - should for now become the residual claimant in the allocation of incremental investment resources except as required for the maintenance of public facilities and services at the levels required to permit the economy to operate and grow with reasonable efficiency. The results of letting the private sector bear the brwnt of the chronic excess of demand over supply of resources have been prejudicial to efficient and productive investment and growth in Uruguay for a considerable time. 19. In the short run, procedural limitations inhibit the Government from making profound changes in its tax and rate structure and from drasti- cally increasing the efficiency of slaughterhouse cperaticns; this could leave the exchange rate as the major short-term variable through which Livestock producers' prices can be maintained at appropriate levels which the public sector deficit is held to tolerable proportions. Of course, the importance of adiustments in taxes and rates which the Government has succeeded in obtaining Congressional authorization to make should not be underestimated; a large increase in gasoline taxes and marginal adjustments in other tax rates, modification of personal income tax exemptions and improvements in tax administration which became effective as of January 1, 1970, can be expected to yield much of the incremental revenue required by the 1970 Central Government budget; in addition, an initial installment in the gradual adjustment of certain public enterprise rates - energy in particular - leading to the establishment of adequate rates of return for these agencies can be made in 1970 without violating overall price targets.. 20. Subsequently, the most useful policy objective would seem to be to make effective a more substantial modification of the tax structure which would permit the Government to undertake an appropriate investment program. without resort to undue taxation of any export commodity. A tax on the imputed productivity of agricultural land which - according to law - comes fully into effect in October 1970, might provide a significant revenue increment in 1971 but the difficulties inherent in the administration of this tax are such as to make it of doubtful effectiveness. The fact that regular tax revenues have declined drastically as a percentage of GD? over the past several years (from 17 percent in 1961 to 9.2 percent in 1968) together with the structure and low yield of income, excise and sales taxes, suggest that the GoverLanent could well increase these levies.  - viii - 21. Moving toward a target of public sector savings of 4 percent should be consistent with annual growth rates of 2 to 3 percent over the 1970-73 period. While these targets are modest, they would represent a substantial turn-around from the experience of the past several years. Implicit in this projection is an increase in total investment levels to 15.9 percent of GDP by 1973 compared to the 12.3 percent average level of the 1956-68 period and to 11.1 percent in 1968. To support this level of investment, domestic savings would have to increase to 15.3 percent of GDP compared to the 12.2 percent 1956-68 average and to 13.2 percent in 1968. The average annual increases in investment and savings required to reach these targets are 11 and 6 percent, respectively. In judging the likelihood of this performance it should be noted that the required marginal savings rate would permit total consumption to increase at the rate of 1.6 percent annually -about proportional with population growth -compared to the decline in per capita consumption over the 1956-68 period. 22. Also implicit in this projection is a net inflow of external capital equal to about 1.6 percent of GDP by 1973. Net factor payments would remain at about one percent of GDP over the 1970-73 period owing to the large burden of interest on foreign debt incurred by the Gov- errment of Uruguay, particularly because of the rescheduling of conmer- cial and financial arrears accumulated during the various balance of payments crises of the recent past. In addition to this net factor payments outflow,an average resources gap equal to 0.6 percent of GDP is projected by virtue of the fact that the projected growth rates require imports to increase more rapidly than exports can be expected to increase in the near term. Hlerchandise imports are expected to grow at the rate of about 11 percent annually during the next few years to the equivalent of about 16 percent of GDP by 1973 as compared to about 11 percent of GDP in 1968. Capital goods imports are expected to increase more than proportionately; the sharp decline of such im- ports after 1955 and consequent obsolescence in Uruguayts stock of capital equipment makes it probable that a large backlog of requirements existE,even though its quantitative aspects can only be guessed at. In contrast to the anticipated 11 percent annual increment in merchandise imports, exports are expected to increase at the rate of 5 percent per year. Beef is expected to account for the bulk of this growth, in- creasing in value by 60 percent over the 1969-73 period as the incre- mental output resulting from the pasture improvement program is added to Uruguay's exportable beef surplus. (This projection takes into account the climatic factors which have caused exportable beef pro- duction to vary between 163,000 and 66,000 tons over the last five years and assumes that world beef prices will remain at the average levels prevailing over the last three years. The 60 percent increase is vis a vis 1968 beef export earnings of US$56 million.)Other com- modity exports are expected either to increase slowly or remain constant. Growing tourist earnings are also anticipated, however; a 30 percent increase in such earnings is projected over the 1969-73 period on the basis of Uruguayan investment plans and the markets for its tourist services in Brazil and Argentina.  - ix - 23. Taking account of the resources gap indicated by import requirements and the export forecast, of heavy factor payment obli- gaions (including both interest and profit remittance), of the amortization schedule confronting the Government and of disbursements from existing official credits, and assuming that net outstanding suppliers' credits remain constant at current levels, about US$37 mil- lion annually in disbursements from new official foreign credits would be required to cover Uruguayts total external gap over the 1970-73 period. By generally adhering to the stabilization and development program outlined here, the Government of Uruguay would greatly enhance its prospects for obtaining loans of this magnitude on acceptable terms.  I. POSTWAR TRENDS A. Institutional Background 1. Uruguay has enjoyed a long history of democratic government, which has functioned, at times, in a somewhat turbulent manner. The arts of political compromise have created a tenuous modus vivendi between a normally dominant (Colorado) party, largely representing urban groups, and a minority, rural and wealthy urban oriented (Blanco) party within a governmental system combining parliamentary and presi- dential elements. 2. The system of proportional representation and the long dominance of the Colorado party at the polls have resulted in the fractionalization of congressional representation of the two tradi- tional parties. Each is divided into a complex series of "lists" and even "sub-lists." Thus political atomization, with its reflection of particular interests and shades of opinion, plus a general consensus on the curbing of executive power, has effectively prevented any one faction from controlling the executive branch of the Government. More- over, during a 14 year period ending in 1967 executive responsibility was exercized by a nine-member National Council of Government with a short-term revolving chairmanship and representation for the minority party. 3. In addition, the popular orientation of the majority party with its preoccupation with public welfare, has led to the incorporation, within the public sector, of a wide variety of economic and social ac- tivities. There has emerged a large group of social welfare institutes, special agencies and autonomous entities both within and alongside the ministries. The autonomous agencies perform commercial and industrial functions, as well as some traditional to government, through largely autonomous boards of directors. The resulting complexity of the Uru- guayan public sector has greatly exacerbated the lack of effective leadership and efficient administration. 4. Partisan influence and pressures to provide and share public jobs has led to considerable over-staffing by a part-time and poorly paid public service. Control of autonomous public agencies was dispersed amongst various political sub-groups in such a manner that they were operated not only inefficiently but also independently of any coordinated control. A by-product of the system has been misallocation of public resources. Moreover, a complex and uncoordinated system of controls over private sector activity has further interfered with investment incentives and efficient resource allocation.  - 2 - 5. A final characteristic of the Uruguayan institutional scene has been the role of the urban sector. About 50 percent of the popu- lation lives in Montevideo and another 20 percent in other cities of over 10,000; this distribution, together with the system of represen- tation described above, was an important factor in shaping economic policies. 6. The reason why markedly inefficient resources allocation could be borne for such a long time is Uruguay's exceptionally favorable resource endowment in relation to its population, which has resulted in one of the highest living standards in Latin America. However, for more than a decade this living standard has been in decline; the economy has in many respects drawn down its capital accumulated in the past and there is emerging a growing recognition that only a drastic reorientation of social goals and economic and political behavior can reverse the trend of a deteriorating social and economic environment. B. Fiscal Policy and Administration 7. The institutional framewrork outlined above has had a considerable influence in the past in rendering fiscal controls and administration re- latively ineffective. The Ministry of Finance did net have the necessary authority to control the financial operations of a large and important proportion of the public sector located in the autonomous agencies. These, in effect, were to a considerable extent independent in terms of their rate policies and/or their programming of annual expenditure, investment and borrowing. Inadequate pricing policies and overstaffing in the public utilities have resulted in an inadequate return on capital and, in several cases, deficits on current operations. This situation, to varying degrees, has been characteristic of UTE, the electricity and telephone administrat or. ANCAP, the petroleum,cement and alcohol administration, AFE, the railroad, ANP, the Port of Montevideo authority, OSE, the state water and sewerage administration as well as other agencies. In the case of the railway, the situation has been compounded by a stagnation in traffic. The financing of the investments of these agencies and, in some cases, the subsidization of their current expenditures, has saddled the Mlinistry of Finance with a substantial and growing level of transfer payments. 8. The tax system has been seriously deficient. Despite their welfare orientation, past governments have been urnable to levy direct and progressive imposts to an appropriate extent. Among the reasons were the concentration on public expenditure rather than taxation as a means of income redistribution, inefficient tax administration and the widespread use of export taxes on animal products which are borne directly by the landowning group. The resulting system has been very inelastic to changes in money income. In addition, the tendency to obtain revenue increments through the enactment of new taxes, rather than through increases in existing taxes and/or improvements in tax administration has resulted in a plethora of taxes. The present system registers yields from  36 individually identified tax categories and includes a far greater number Of individual taxes many of which fail to produce sufficient revenue to cover the cost of their administration. M4oreover, one tax is often super- imposed on others. For instance, wool bears 23 different taxes. The result is that a consensus was created as to the permissibility of tax evasion. Finally, efficiency in the utilization of tax revenues has been substantially curtailed by the partial or total earmarking of many taxes. Recently, earmarked taxes have averaged more than 20 percent of regular tax revenues. 9. The above mentioned export taxes ("tdetraccionesIr or export retentions) have been levied on the main export commodities: wool, meat and hides. These taxes are easily administered and relatively adjustable to expancing revenue needs. They have been used as the main fiscal device to meet short-term fiscal crises in recent years. One significant re- striction on the flexibility of these taxes is their interrelationship with the exchange rate. With internal inflation forcing input costs upwards even maintenance of export tax rates at constant levels would have required periodic exchange rate adjustment. In fact, export tax rates have varied widely with several massive but irregularly timed devaluations. 10. As a percentage of GDP, public sector consumption remained relatively constant at approximately 12 percent since World War II. The propensity to maintain public consumption despite declining revenue levels has brought public savings to very low levels, currently averaging less than one percent of GDP. Thus the magnitude of public investment has been severely constrained. Moreover, the distribution of investment resources in the public sector has been without systematic regard to economic prior- ities. In the absence of a proper programming mechanism, through which the Government's as well as the autonomous agencies' activities could be made consistent with overall policy objectives, investment decisions were made chiefly on short-term political bases, often with a predominantly urban orientation. C. Development Trends to 1965 11. The Uruguayan economy enjoyed satisfactory rates of overall growth averaging about 4.3 percent during the decade 1946-55. This was made possible by the heavy build-up of foreign exchange reserves during the war plus favorable terms of trade in the early postwar years. During the 1946-55 period there was a heavy dependence on net capital inflows which averaged about 23 percent of gross fixed capital formation. These inflows were largely the result of facilities offered foreigners - particularly Argentinians - for holding dollar claims against Uruguayan Banks. 12. Post World War II investment was focused on a domestically oriented expansion in manufacturing, fostered by a very high level of protective tariffs, import surcharges and a generous tax exemption policy. By the mid-fifties, therefore, there existed a high cost  - 4 - manufacturing sector characterized by a large number of small firms, inefficient management and a considerable degree of over-capacity. Although imports of final goods were reduced in volume by this policy, they were replaced to a considerable extent by a heavy dependence on imports of intermediate goods and capital replacements. 13. In contrast there was neglect of the country's livestock sector, which traditionally has been the main source of exports and in which Uruguay clearly enjoys a comparative advantage. Those rural development policies which were adopted, concentrated on crops rather than on pasture improvement and livestock development. Here, the emphasis on wheat production for self-sufficiency and export may have been misplaced, given the nature of Uruguayan soils and climate, the prewar history of international surpluses and the government organized and supported foreign trading programs in all the major wheat exporting countries. It should be noted, however, that temporary restrictions on Uruguayan access to its wheat surpluses imposed by Argentina plus the high international prices prevailing during the period did provide a short-term justification for special measures to stimulate Uruguayan crop production. 14. Although Uruguay sought technical assistance in appraising its livestock development capabilities, through a joint FAO/IBRD survey followed up by an IBRD project mission in the early 1950's, no effective action was taken until the early 1960's, when the Plan Agropecuario - an entity for financing and providing technical assistance for pasture improvement - was established. 15. Rather than stimulating the livestock industry, Government policies tended to constitute disincentives tocattle and sheep producers. The practice of levying relatively heavy export taxes (detracciones) on traditional livestock products held down profit margins and effectively maintained the livestock sector as an extractive industry utilizing the natural pastures extensively. The situation was compounded by the oper- ation of a large but obsolete packing plant as an autonomous public entity. This Frigorifico Nacional was given the monopoly of supplying the Montevideo market. The official buying price for live cattle was fixed so as to cover its high cost of operation. These margins were subsequently widened by the overstaffing of the Frigorifico. Thus the combination of export taxes plus officially determined Frigorifico margins effectively reduced live cattle prices to low levels as compared with the external price of beef. The export taxes also had the effect of reducing the internal price of beef and thereby stimulating internal consumption which, in the mid-fifties, reached an annual per capita level of about 80 kilograms per annum, close to the highest in the world. 16. The development policy in the first postwar decade did not prepare the country for a continuation of output expansion in the second decade, 1956-65, when the advantages of a strong external market had disappeared. By 1955, the expansion in manufacturing capacity exceeded domestic market requirements in most lines. High manufacturing costs and inadequate marketing structures largely inhibited expansion into export markets an6 growth in primary industrieE wias insuffLicient to take up the slack.  Table A: GROWTH IN GDP AT FACTOR COST (percent per annum) -1946-50 1956-60 Sector to to 1951-55 1961-65 Primary industry 3.7 1.1 Secondary industry 7.0 -1.0 Services 3.3 0.7 GDP 4.3 0.2 Source: Central Bank of Uruguay. 17. During the 1956-65 decade output grew by only 0.3 percent and in per capita terms declined by over one percent per annum. Fixed capital formation declined to 12.9 percent of GDP as compared with about 19.2 per- cent on the average in the previous decade, as capital flight and inadequate fiscal policies reduced the availability of domestic savings and net foreign capital inflows declined sharply. (See Table 2.6 in the Statistical Annex.) 18. Capital flight became especially large at the end of the period, averaging approximately US$50 rillion annually during 1962-65. (See errors and omissions item in Table 3.1 Statistical Annex.) External resource gaps averaging 3.9 percent of GDP during 1946-55 which were financed by drawing down exchange reserves and substantial inflows of private capital gave way to negative resource transfers by the end of the 1956-65 decade as imports were reduced from an average level of 19.0 percent of GDP to 13.7 percent of GDP. In the process the net foreign exchange reserves of the banking system declined from a peak level of more than US$300 million as of the end of 1953 to a negative US$92.3 million as of the end of 1965 (see Table 3.6 in the Statistical Annex). 19. Price level increase began to accelerate in the second half of the 'fifties. Consumer prices, which increased at an annual rate of about 7.8 percent during 1951-55, accelerated to an annual rate of 18.6 percent during 1956-60 and to 27.5 percent during 1961-65. The exchange rate remained more or less stable until 1962 and rose spasmodically thereafter. Lags in exchange rate adjustment with accelerating inflation contributed to the deteriorating balance of payments situation, especiaUy by stimulating capital flight.  - 6 - 20. With accelerating inflation, the inelasticity of regular tax revenues to changes in nominal income, and the rigidity of real public sector consumption, the Government tended to become increasingly dependent on export taxes. This has generally resulted in a severe deterioration in the internal terms of trade of the main export commodities Table B: EFFECTIVE EXCHANGE RATE OF SELBCTED YiAJOR EXPORTS AS A PERCEST OF THE FREE MARKET RATE (Percent) August September September 1963 1964 1965 Greasy Wool 66 58 27 Beef 90 66 27 Dry Cattle Hides 72 49 21 Dry Sheepskins 78 58 31 Source: Central Bank of Uruguay. 21. The outcome was a great djxiinu-tion of investment and cash inputs in the livestock sector, except for participants in the Plan Agropecuario. Even here, however, sufficient profitability was only ensured as long as working capital loans were available at negative real interest rates; when in 1969 such loans began to be indexed, the financial returns on investment in ranching dropped sharply. 22. The instability of the Uruguayan economy reached acute proportions in 1965 when the cash deficit of the Central Government amounted to 2.3 per- cent of GDP, the money supply increased by 62.3 and the cost of living rose by 88 percent. There was a temporary respite in 1966 when the Government was able to avoid a civil service wage increase owing to a constitutional prohibition of such increases in election years but in 1967 the cash deficit soared to 2.9 percent of GDP and the pace of internal price level increase rose to 135 percent.  II. THE ECONOMY IN CRISIS, 1965-1968 A. Introduction 23. By the end of 1967 the inflationary process may be said to have developed to the point where it was no longer susceptible to control by purely fiscal and monetary restraints. This forced the current Government to take unprecedented action in the form of direct controls on wages and prices which were imposed as of mid-1968. Until 1968, economic policies had been designed essentially to maintain the level of consumption. This had been achieved, but only at the expense of increasing price instability and declining investment. The adoption of severe stabilization measures in 1968 interrupted the price spiral but has not, as yet, revived investment and growth prospects. 24. In 1968, gross domestic product was 0.6 percent less than in 1964 in real terms. Per capita GDP was about 7.5 below the 1964 level. The two years, 1965 and 1966, were in retrospect, relatively good years with growth rates of 1 and 2.6 percent respectively in GDP. This was offset in 1967 by a sharp drop in primary production (which also affected other sectors) caused by a series of adverse weather factors beginning in the latter half of 1967 and continuing into 1968. 25. The present Government has been beset by short-term fiscal and balance of payment crises from the onset of its assuming office in March 1967. The granting of a 90 percent increase in public sector wages by the outgoing administration, retroactive to the beginning of 1967, was not accompanied by adequate new sources of regular tax revenue or by an exchange rate devaluation which would have permitted an increase in export retentions taxation. This led to substantial recourse to Central Bank financing of the deficit. The rate of inflation accelerated and substantial capital flight, aggravated by heavy debt service in a time of normal sea- sonal downturn in foreign exchange earnings prior to the opening of the new wool season, exhausted the Central Bank's sparse foreign exchange reserves. The exchange market was closed in July 1967 and stringent import controls were introduced, including complete prohibitions for some major categories of goods. Finally, in November, the peso was de- valued by 100 percent from Ur$100 to Ur$200 to the U.S. dollar. With this devaluation there was a substantial inflow of flight capital into the country. 26. Late in 1967, the Government imposed tight fiscal and monetary restrictions on the economy. Absolute ceilings were placed on commercial bank loans and, assisted by a very substantial increase in export taxes made possible by the November 1967 devaluation, a contractionary 1968 fiscal program was put into effect. Nevertheless, the rate of inflation in the first six months of 1968 was as high as in the last six months of 1967 (yielding price level increase over these 12 months of 183 percent).  Ry April 1968, the Government was forced to devalue the peso by another 25 percent. As of June 23, 1968, the Government instituted direct con- trols on wages and prices. With this interdiction of the cost push elements in the inflationary process, the increase in prices over the last six months of 1968 was limited to a modest 1.5 percent. 27. These measures created a short-term but tenuous equilibrium which might permit measures lending to a more solid and lasting stability, although they did not, by themselves, attack the underlying problems responsible for the prevailing inflation and stagnation. Consumption was maintained both in the public and the private sectors at 87 percent of GDP for the 1966-1968 period. This, coupled with an increasing burden of service on external debt (amounting to 21 percent of goods and services exports in 1968) led to a decline in gross fixed investment to an average level of 10 percent of GDP over the 1966-68 period. The level of public investment wias about 3 percent of GDP; private investment was 7 percent. Net of depreciation, public investment was probably nil or negligible. 28. Although a National Development and Social Plan was formulated in 1965 and the 1966 Constitution created an Office of Planning and Budgeting to implement such plans, sufficient resources have not been made available to permit an adequate level of investment. Moreover, what public investment programming has occurred has largely been under- taken unilaterally within the ministries and independent agencies. The Office of Planning has been non-operational, partly because of a lack of authority and staffing and partly because the Ministry of Finance was un- able to generate sufficient resources for investment purposes. B. Financial and Monetary Situation Fiscal Policies - Central Government2/ 29. Betwieen 1964 and 1967, tax revenues declined from 17.6 to 11.8 percent of GDP while expenditures fell only from 17.4 to 14.7 percent of GDP. This divergence would have been even more accentuated, had there not been increasing resort to export retention taxes - up from 6.6 percent of total revenues in 1964 to 11.0 percent in 1967 - made necessary by the low elasticity of other tax revenues estimated at about 0.55 percent for thJ period. This inelasticity is the result of a number of factors: the low level of income taxation (about 7 percent of 1967 total revenues), the levying of many excise taxes on a specific rather than an ad valorem basis, and above all, the deterioration of the administrative efficiency of the tax system. (See Table C). g/ Excludes the 19 departmental governments, the social security systemL and autonomous agencies. These are included with the Central Gov- ernment as the "public sector" discussed below.  Table C: CENTRAL GOVEI?NMENT FISCAL OPERATIONSIv (percent of GDP) 1964 1965 1966 1967 1968 Revenues 17.6 13.1 13.8 11.8 12.2 Expenditures 17.4 15.7 14.4 14.7 12.6 Personnel 9.1 9.7 8.0 9.5 8.0 M4aterials and Services 2.0 2.4 2.4 1.9 1.3 Debt Service 1.0 0.9 0.8 0.7 0.8 Subsidies and other Transfers 4.7 2.2 2.4 2.0 1.9 Direct Investment 0.6 0.5 0.8 0.6 0.6 Deficit (-) or Surplus before Transfers and Direct Investment 5.4 0.1 2.6 -0.3 2.1 Total Deficit (-) or Surplus -0.2 -2.6 -0.6 -2.9 o0.4 Financing -0.2 2.6 0.6 2.9 0.4 Net Treasury Bills and Bonds -1.0 -0.9 - 0.5 0.9 Monetary Authorities 0.8 3.5 o.6 2.4 -0.5 j Since data on the distribution of cash outlays are not available prior to 1968, estimates have been made on the basis of expenditure obligations and on total cash flows. Source: Contaduria General de la Naci6n and Staff Estimates. 30. By and large the inability of the Central Government to reduce its personnel surplus, or to resist pressure to adjust salary levels more than proportionately with the increase in living costs, has been almost as important a factor as the inelasticity of the tax structure in con- tributing to the deterioration of the Government's finances between 1964 and 1967. Personnel expenditures averaged approximately 9 percent of GDP; the deviations from this average that did occur were largely due to special circumstances rather than design, as for instance the constitutional provision prohibiting public service salary adjustments in an election year, which held personnel expenditure to 8 percent of GDP in 1966.  - 10 - 31. The Central Government did manage to reduce its subsidy and transfer payments from a level of about 5 percent of GDP in 1964 to about 2 percent in 1967. An important element in this reduction was the Treasury's limiting the automatic transfer of certain earmarked revenues to other government agencies, which had accounted for more than half of total Central Government subsidy payments. By retaining certain revenues formerly transferred automatically, the Central Government succeeded in reducing the ratio of earmarked to total regular revenues from 25.5 per- cent in 1967 to 13.9 percent in 1968. Through this device, and by resisting pressures for discretionary subsidization, the Treasury was able to offset, to a certain extent, the inelasticity of its revenue structure and the rigidity of its personnel costs. 32. It is impossible to identify specifically the current account surplus generated by the Central Government, since subsidy payments are not identified as between those utilized for current outlays and investment expenditures of recipient entities. However, savings, estimated as the difference betvween current revenues and current expenditures exclusive of all subsidy payments, fluctuated widely in 1964-1967 from a high of 5.6 per- cent of GDP in 1964 to a low in 1967 of minus 0.3 percent. This illustrates the residual nature of the public savings process and its dependence on variations in export retentions, taxes and personnel expenditures. For instance, the severe devaluation of October 1965, and the accompanying increase in export taxes, plus the decline in personnel expenditure in 1966, produced an increase in savings whereas, in 1967, the opposite was the case due to the 90 percent increase in wages and salaries granted from the beginning of the year and the postponement until November 1967, of needed exchange rate devaluation. 33. Total Central Government cash operations registered a small surplus in 1964 but thereafter yielded large deficits through 1967. These rose in the latter year to a level equal to 3.5 percent of GDP. Net sales of treasury bills provided some resources to the Government during this period. The main burden of financing the deficits, however, fell on the monetary authorities. In 1967, a year in which Uruguayan means of payment increased by 98 percent, the financing of the Central Government cash deficit accounted for 55 percent of the expansion in the net domestic assets of the monetary authorities. 34. In 1968 the Government succeeded in reversing the trend of increasing fiscal deficits through a series of more stringent stabilizatior. measures than had been undertaken in prior attempts. On the revenue side, advantage was taken of the exchange rate devaluations of November 1967 and April 1968 to increase returns from export retention taxes by more than 300 percent in nominal terms. These taxes constituted 19.4 percent of total tax revenues in 1968 as compared with 11.0 percent in 1967. In addition, the elasticity of other taxes to changes in the value of national product improved substantially.  - 11 - 35. On the expenditure side, the wage and salary increase granted to civil servants at the beginning of 1968 was held to 60 percent, or less than half the cost of living rise of approximately 135 percent since the previous adjustment. This was followed by a further 30 per- cent increase]/ effective July 1 which again was much below the inter- vening 63 percent rise in the cost of living. Both subsidy payments and direct Central Government investment were held relatively constant in 1968, vis a vis 1967 at approximately 2.0 and 0.6 percent of GDP respec- tively. Purchases of materials and services were restricted to a level equal to 1.3 percent of GDP as compared with the average level of 2.2 per- cent which prevailed in the previous four years. 36. The resulting 1968 increase in overall revenues by 0.4 percent and the decline in expenditures by 2.0 percent of GDP was sufficient to reduce the cash deficit to Ur$1.7 billion or 0.5 percent of GDP as com- pared with 2.9 percent in the previous year. Moreover, net sales of Treasury bills and bonds yielded Ur$3.4 billion, so that the account of the Central Government with the monetary authorities contracted by Ur$1.7 billion. This contraction permitted some expansion in the credit of the monetary authorities to the private sector despite the substantial accumulation by the banking system of net foreign reserves during the year and of the containment of the expansion of the money supply to 56.5 percent compared to an increase in the price level of 66.3 percent. Fiscal Policies - Public Sector 37. Overall public sector revenues (exclusive of local governments other than Montevideo) declined steadily over the 1964-1968 period, al- though those of the decentralized agencies fell much less precipitously than those of the Central Government and the social security bank. This revenue shrinkage has largely been offset by reduction of current expendi- tures, principally of annuities paid to social security beneficiaries and of the personnel expenditures of other government agencies. These latter are estimated to have declined from 8.5 percent of GDP in 1964 to 5.9 per- cent in 1968. 38. In 1964 and 1966 transfers from the Central Government to the decentralized government agencies and Montevideo were sufficiently larger than the current account deficits of these agencies to have financed a substantial portion of their investments. In 1965 and 1967, the combined savings of the public sector were negative. In 1968, they were positive 1/ Pending incorporation of appropriations in the 1969 budget to cover this 30 percent increase in base wage scales, the pay increment was to be disbursed to civil servants by the National Savings and Discount Bank in the form of non-reimbursable loans. Only four of the six monthly installments of these "loans" due in 1968 were paid, however, resulting in the carry over of Ur$1.4 billion in delayed wage payments into 1969.  - 12 - but only sufficiently so to finance 14 percent of total public sector investment made during that year. The railway administration is pre- dominant among decentralized agency dissavers; it covered only about 40 percent of its operating costs with its own revenues in 1968. Other dissavers of significance include the state waterworks, airline and slaughterhouEe (Frigorifico Nacional) and the Montevideo transport authority. In 1967 and 1968, the state cement, petroleum and alcohol company (AiCAP) also registered substantial current deficits. 39. Total public sector investment averaged 3.2 percent of GDP during the 1964-1968 period. Approximately 45 percent was financed by disbursements of foreign loans. The level of investment was more directly related to the availability of external financing than to the level of public sector savings. 40. One effect of the increasing pressure of fiscal problems on the economy has been a substantial reduction in the burden of the social security system on the national economy. This has been accomplished by gradually reducing the real value of annuity payments and by tolerating evasion of social security taxes, including those paid by the Government itself. Annual adjustments in nominal annuity values have been kept less than proportionate to the corresponding increases in the cost of living and, in 1968, the annual adjustment was suspended entirely. 41. Throughout 1964-1968, the social security bank, to which the bulk of the workers covered by social security are affiliated, has generated significant current account savings as a result of the re- duction in its annuity payments, despite the sharp decline in its revenues. In fact, in 1968 the declining trend of these savings was temporarily reversed with the suspension of annual upward adjustment in annuity payments. The bank maintains no investment portfolio; it merely deposits its receipts with the monetary authorities.  - 13 - Table D: CASH OPERATIONS OF THE PUBLIC SECTOR (Expressed as Percentages of GDP) 1964 1965 1966 1967 1968 A. Central Government Revenues/ 17.3 13.0 13.7 11.7 12.1 Current ExpendLtures-? -12.0 -13.1 -11.3 -12.1 -10.1 Current Account Surplus (-) or Deficit 5.3 -0.1 2.4 -0.4 2.0 Direct Investments -O.9 -0.8 -1.0 -1.2 -1.6 Transfers to other Government Agencies!/ -4.5 -2.0 -2.2 -1.9 -1.8 Total Deficit (-) or Surplus -0.1 -2.9 -0.8 -3.5 -1.4 B. Decentralized Agencies /and Montevideo Revenues 11.1 11.6 9.5 10.6 9.2 Current Expendituresa -14.2 -13.6 -10.7 -12.1 -10.7 Current Account Deficit (-) or Surplus -3.1 -2.0 -1.2 -1.5 -1.5 Direct Investment -1.6 -2.2 -1.3 -3.4 -1.9 Transfers from Central Government 4.5 2.0 2.2 1.9 1.8 Total Deficit (-) or Surplus -0.2 -2.2 -0.3 -3.0 -1.6 C. Social Security Bank Revenues 9.2 6.3 4.9 5.2 4.9 Transfers from other Government Entities 2.4 1.8 2.0 1.8 1.3 Current Payments -9.4 -7.6 -6.6 -6.5 -5.4 Current Account Surplus (-) or Deficit 2.2 0.5 0.3 0.5 0.8 Direct Investment - - - - - Total Deficit (-) or Surplus 2.2 0.5 0.3 0.5 o.8 D. Public Sector Revenues 37.6 30.9 28.1 27.5 26.2 Current Expenditure -33.2 -32.5 -26.6 -28.9 -24.9 Current Account Deficit (-) or Surplus 4.4 -1.6 1.5 -1.4 1.3 Investment -2.5 -3.0 -2.3 -4.6 -3.5 Total Deficit (-) or Surplus 1.9 -4.6 -0.8 -6.0 -2.2 E. Financing -1.9 4.6 0.8 6.0 2.2 Utilization Foreign LoansW (Gross) 0.5 1.5 0.9 2.4 1.8 Treasury Bills and Bonds (Net) -1.0 -0.9 - 0.4 0.9 Monetary Authorities and other Internal -1.4 4.0 -0.1 3.2 -0.5 lJ Excludes earmarked revenues repassed to "Intendencias" other than Montevideo. y/ Including funds transferred to social security bank and amortizations. j Before transfers of funds to government agencies other than social security bank. / Estimated on basis of average exchange rate prevailing during year in which loans disbursed. / Includes AFE (Railway Administration), ANCAP (the National Cement, Petroleum and Alcohol Administration), UTE (the state electric and, telephone company), OSE (state water works), SOYP (the state fishery agency), PLUNA (state air- line), BHU (state mortgage bank), INC (the colonization institute), INITE (the state low cost housing agency), FRLCU.fALL (the state slaught.erhouse), and AMDET (Montevideo murlicipal transr3ort auThot'y.) Source: Questionlaires sutmitted by the missiun tu autor,omous agencies and the Dep&rtment of Montevideo.  - 14 - Monetary Management 42. Since 1964, the expansion of the means of payment in Uruguay has tended to be substantially less than proportionate to the increase in the money value of gross domestic product. From December 31, 1963 to December 31, 1968 the cost of living increased by a factor of 14.9 but the money supply increased by a factor of only 8.6. Another method of expressing this demonetization of the economy is to note that the liquidity coefficient (the ratio of money and quasi money to gross domestic product) declined from 27.8 percent at end-1963 to 16.6 percent at end-1968. Table E: PERCENTAGE CHANGES IN ASSETS AND LIABILITIES OF BANIING SYSTEM AND IN GDP (percentage change December to December) 1964 1965 1966 1967 1968 Net Foreign Reserves 3.5 -59.0 -65.0 37.2 13.4 Net Domestic Credit 34.9 121.6 88.3 60.9 43.0 Public Sector 2.8 16.?7 4- 27.9 Private Sector 52.9 52.8 21.9 40.6 34.4 Miscellaneous -20.8 52.1 62.0 -7.6 10.0 lfoney Supply (minusiincrease) -38.4 -62.6 -23.3 -98.1 -56.4 Currency with Public -11.1 -28.7 -77T7 -41.3 -32.0 Deposits with Authorities -5.5 -17.3 1.8 -5.7 -2.9 Deposits with Central Bank -21.8 -16.6 -6.4 -51.1 -21.5 GDP 28.5 61.1 96.6 68.5 125.7 P/ Changes in the elements of the monetary accounts are expressed as percentages of total monetary liabilities outstanding as of the out- set of each annual period. Source: Central Bank of Uruguay. 43. A striking feature of the relative decline in the money supply is the extent to which the commercial banking system has been restrained from multiplying the impact of primary money creation by the monetary authorities. The ratio of expansion of the monetary liabilities of the commercial banks to the expansion of the monetary liabilities of the authorities which was 1.23 in 1964 was held to 0.32 in 1965 and 1966 and to 0.55 in 1968.  44. Despite the increasing overall relative contraction of the money supply over the five years ending December 31, 1968, there were periods when monetary expansion did constitute a leading factor in the inflationary process. This was generally true in 1965 and 1967, when expansion of credit to the public sector was particularly large. Con- versely, in 1968, which was notable for the fact that net foreign reserve accumulation injected a substantial volume of money into the economy, the authorities were able to hold overall expansion substantially below the increase in the price level, especially during the early part of the year, by -virtue of the contraction in the Government's financial accounts and the application of absolute ceilings on commercial bank lending activity. 45. The expansion of credit to the private sector has tended to be the residual after the needs of the public and external sectors were sat- isfied. (See Table F). Faced with large fiscal deficits, expansion of credit to cover peso losses on foreign exchange operations - which apar- ently make up the bulk of the large expansions in "miscellaneous" assets registered in 1965 and 1966 - and with chronic foreign exchange speculation, authorities tended to concentrate their efforts to contain the money supply by a strict rationing of primary credit to the private sector and by controlling the lending activities of the commercial banks. Thus the stock of credit outstanding with the private sector declined from 29.5 per- cent of GDP as of December 31, 1963 to 11.1 percent of GDP as of December 31, 1968.  - 16 - Table F: OUTSTANDING ACCOUNTS OF THE ICDNETARY AUTHORITIES AND COMMERCIAL BANKS AS A PERCENT OF GDP (end-December data) 1963 1964 1965 1966 1967 1968 141)NETARY AUTHORITIES Net Foreign Reserves -4.4 -1.0 -8.0 -15.2 -7.1 0.7 Net Domestic Credit 17.6 15.4 27.2 27.7 20.9 9.5 a. To Public Sector (net) T73 7 34 5.5 3-5 T.6 IT b. To Private Banks (net) -0.5 1.0 -0.2 1.4 -1.7 -0.7 c. To Private Sector (gross) 12.2 14.2 11.9 8.0 7.8 4.8 d. Miscellaneous Accounts (net) 2.3 -3.2 10.0 14.8 10.2 3.9 Monetary Liabilities -13.2 -14.4 -19.2 -12.5 -13.8 -10.2 COMZ1ERCIAL BANKS Net Foreign Reserves 0.1 -1.5 -5.3 -2.3 -1.3 -1.9 Position with Monetary Authorities 0.5 -1.0 0.2 -1.4 1.7 0.7 Net Domestic Credit 17.2 21.4 20.1 12.4 10.9 8.5 a. To Public Sector (net) 0.3 0.3 0.1 0.1 0.9 0.7 b. To Private Sector (gross) 17.4 21.0 20.5 12.1 9.0 6.3 c. Miscellaneous Accounts (net)-0.5 0.1 -0.5 0.2 1.0 1.5 Monetary Liabilities -17.8 -18.9 -15.0 -8.7 -11.3 -7.3 CONSOLIDATED BANKING SYSTEM Net Foreign Reserves -4.3 -2.5 -13.3 -17.5 -5.9 -1.2 Net Domestic Credit 34.1 34.6 45.7 37.8 29.8 17.8 a. To Public Sector (net) 3.9 3.7 5. 3. 5-5 2 b. To Private Sector (gross) 29.5 35.2 32.4 20.1 16.8 11.1 c. Miscellaneous Accounts (net) 0.7 -4.3 7.7 14.1 7.5 4.4 Money Supply -29.8 -32.1 -32.4 -20.3 -23.9 -16.6 Source: Central Bank of Uruguay.  - 17 - 46. In addition to the compulsory reserve obligation imposed on the commercial banks, currently amounting to 40 percent on sight deposits, 20 percent on time deposits and 16 percent on all dollar denominated deposits, / the monetary authorities, as indicated above, placed absolute ceilings on the peso lending activities of the banks. The most recent of these ceilings was imposed as of July 1, 1968, when the banks' peso loan portfolios were frozen at existing levels, leaving them free to extend new peso credit only to the extent that old loans are repaid. Certain exceptions were made to this general ceiling to facilitate mergers of banking institutions and to provide working capital credit to specific lines of activity, such as wool, cattle, oilseed, wheat and grape production and slaughterhouse operations. These special exemptions were financed with rediscount facilities, since the surplus reserves, which would otherwise have been generated by ceilings on loan applications, were largely absorbed in 1968 by calling in old rediscount obligations and by sales of Treasury bills to the banks. Thus, there was a sharp decline in free reserves as of the end of 1968. Table G: LEGAL RESERVE OBLIGATIONS AND ACTUAL RESERVE LEVELS OF COMMERCIAL BANKS (end-December Data) 1963 1964 1965 1966 1967 1968 1. Peso Accounts (Ur$ millions) a. Required Reserves 471 54O 1,124 1,073 4,418 8,696 b. Actual Reserves 711 728 1,585 1,397 5,442 8,697 2. Dollar Accounts (US$ thousands) a. Required Reserves 493 1,177 4,540 4,645 3,226 3,526 b. Actual Reserves 550 1,113 5,143 5,036 3,863 4,017 Source: Central Bank of Uruguay. 1/ In Uruguay both the monetaiy authorities and the commercial banks accept dollar deposits. This is a reflection of the openness of the economy; the only major restraints on use of foreign exchange being the following: (a) exporters of "traditional" exports are required to sell the dollar equivalent of the arbitrarily fixed fiscal or "aforo" value of these products to the monetary authorities; (b) the authorities are obliged to sell exchange only to cover the cost of importing prior deposit and surcharge free imports; (c) commercial banks are discouraged from engaging in "cross-currency" operations by legal precedents tending to make them bearers of exchange risk in the event of extending dollar loans to cover internal rather than international (i.e., trade or capital) transactions; and (d) imports are controlled through a system of prior deposits and surcharges and the practice of conferring "quotas" of deposit and sur- charge free imports on various importers.  - 18 - 47. Restraints on commercial bank lending activity and the decline in the real stock of bank credit available to the private sector have stimulated the operation of the parallel financial market in which lenders discount the promissory notes of entrepreneurs on terms of about six months and at annual interest rates now ranging upwards from about 54 percent, annually. Legal parallel financial market instruments - averaging six months term - bear a stamp tax at the rate of 2.5 percent and a 3 to 4 per- cent commission charge. Thus returns to lenders in this market now range upward from an annual rate of about 40 percent. Interest rates to commer- cial bank's depositors, on the other hand, are statutorily limited to 6 and 14 percent on time and fixed term deposits, respectively, and forbidden on sight deposits. Some banks apparently far exceed these limits in an effort to bid funds away from the parallel market. Never- theless, restrictions on depositor's interest operate as another restraint on commercial bank activity in addition to absolute ceilings on loan portfolios. Also, although costs to borrowers from commercial banks are not limited, most banks have great difficulty in covering their operating costs. In addition to depositor's interest the banks pay a 6 percent tax on outstanding loans and employ excessive personnel in terms of the low volume of their operations. This personnel surplus stems from a banking crisis in 1965 when, by arrangement with the Government, surviving insti- tutions were required to absorb personnel from a number of agencies which were forced to close. One-third of Uruguay's banking establishments went into bankruptcy during this period. In sum, not only economic, but a number of institutional factors contribute to the very high real financial charges now prevailing in Uruguay's capital market. 48. The magnitude of parallel market financial operations is unknown. That it is large, relative to commercial bank lending, however, is attested by several entrepreneurs, who over the past year, have transformed the dis- tribution of their debt portfolios from primary reliance on the commercial banks to primary reliance on para.lel market credit. Peso resources are provided to the parallel market by individuals and firms who would other- wise place their liquid resources in savings deposits, dollar denominated assets, etc. The liquidity preference of the public in pesos(that is, the ratio of peso currency and sight deposits to the total supply of money and quasi money denominated in pesos) has increased from a coefficient of 0.55 as of December 31, 1963 to a coefficient of 0.77 as of December 31, 1968. Responding to the various restraints on their own operations, many banks are now contributing to this trend by directing clients to parallel market intermediaries with whom they have established affiliation. 49. The availability of pesos to the parallel financial market and its competitiveness with the banking system are largely a function of expectations as to the stability of the exchange rate. Given the openness of the Uruguayan economy, holders of peso claims always have the option of moving into dollars. Subsequent to the devaluation of April 1968, when there was little deviation between official and free exchange rates, a levelling off of the internal price level, relative equilibrium,in fiscal operations and constancy in Government economic policy, the public's  - 19 - willingness to hold pesos rose to an unusual degree. This situation was reinforced by the failure of nominal parallel market interest rates to decline with increasing price stability. Midway in 1968, after a 183 per- cent price increase over the previous 12 months, nominal parallel market rates were ranging upward from about 70 percent annually. At 54 percent annually, midway in 1969, folloTwing a 10.1 percent price increase over the previous 12 months, parallel market rates have increased enough in real terms to offset any deterioration in expectations. C. Prices and Wages 50. The swift acceleration in the cost of living after 1964 from annual increases of about 27 percent over the first five years of the decade to a peak of 183 percent during the 12 months ending in June 1968 led to the imposition of direct controls on prices and wages as of June 28, 1968. The effectiveness of these measures is indicated by the abrupt halt in the upward rise in the index from 63.7 percent in the first half of 1968 to 1.5 percent in the second half. During the first half of 1969 the cost of living rose by 8.4 percent. Table H: I-DE., A ID P ''T1CGE C.IAJG IT T'iE COST OF LfILG INiDa (1961=100) Percentage Cliange Dec. 1963 159.6 June 1964 180.8 13.2 Dec. 1964 216.2 19.5 June 1965 270.7 25.2 Dec. 1965 406.5 50.1 June 1966 503.8 23.9 Dec. 1966 607.3 20.5 June 1967 829.2 36.5 Dec. 1967 1,432.7 72.7 June 1968 2,345.5 63.7 Dec. 1968 2,383.0 1.5 June 1969 2,584.1 8l4 Source: Direcci6n General de Estadistica y Censos, WIinistry of Finance.  - 20 - 51. Wage adjustments moved from 1961 until the wage price freeze of June 1968 generally with the cost of living index. Except for 1966, when they received no pay increase, civil servants' salaries have fared relatively well in comparison to the pace of private sector wage adjust- ment, despite the chronic fiscal crises with which the Government has been confronted. Between 1961 and 1967 they rose by about 3 percent in real terms; they had, however, been quite low at the outset of this period and in 1969 maximum public sector base salaries amounted to the equivalent of about US$270 per month. Average private sector real wages per man declined by approximately 3 percent over the 1961-67 period. 52. Real wages in both the public and private sectors dropped sharply with the stabilization measures of 1968. Nominal adjustments in average public and private sector wage levels averaged 87 and 92 percent, respec- tively, during the year compared with a 125 percent increase in the cost of living vis-a-vis 1967. Consequently, the 1968 averages of public and private sector real wage indexes declined to 86 and 83 percent of 1961 levels, respectively. For 1969, average controls are expected to have been applied in such a way as to yield increases in average real wage levels vis-a-vis 1968 of 10 to 15 percent. 53. Certain distortions, many of long standing, have continued in the price structure, as a result of public policy. Administered prices in goods and services provided by the autonomous agencies have lagged substantially compared with costs, as is indicated by the growth in operating deficits of these agencies in the 1964-68 period. The rela- tively low level of the agricultural wholesale price index, which in 1968 averaged 17 percent less than the overall wholesale index, is largely a function of the depressive effect on internal producers and consumers beef, hides and wool prices of the export retentions tax. Similarly, the lag of 58 percent of the housing component in the cost of living index against the overall cost of living is due to long- term controls on rentals. This has restrained housing construction in the private sector.  - 21 - Table I: INDXES OF AN'NUAL COST AIID PRICE AVERAGES 1961 = 100 1964 1965 1966 1967 1968 Wholesale Prices 193.2 307.5 591.5 998.7 2,315.3 Manufacturing 192.7 309.6 587.6 1,023.0 2,399.1 Agriculture 190.0 320.6 662.7 952.0 1,928.2 Other 202.7 268.1 494.2 906.7 2,402.2 Cost of Living 191.5 299.7 520.0 984.3 2,217.9 Food 198.3 317.3 512.7 1,008.0 2,328.7 Clothing 173.1 280.7 630.3 972.9 2,337.5 Housing 142.9 201.1 286.8 454.5 936.2 Other 210.6 330.0 647.5 1,325.6 2,904.8 Wages Govermnent 206.6 317.2 470.7 1,016.1 1,903.3 Industrial 184.5 274.1 530.3 943.8 2,022.0 Construction 171.6 243.4 462.0 971.2 1,826.1 Commercial 192.7 282.3 481.1 942.0 1,651.2 Administered Prices Electricity: Domestic 215.0 348.6 556.3 1,316.2 2,185.1 Industrial 170.3 233.1 352.1 785.4 1,274.9 Water: Domestic 200.0 238.5 350.3 953.7 1,736.7 Gasoline, Common 166.3 448.3 589.9 1,122.5 2,510.1 Diesel Oil, Common 219.6 417.4 719.6 1,584.8 2,215.2 Import Exchange Rate 151.1 279.4 585.7 960.7 2,124.4 Source: Central Bank of Uruguay D. Sectoral Developments 54. The low level of capital formation and stagnation in aggregate demand during 1965-1968 is reflected in the overall 0.6 percent decline in GDP at factor cost over the 1965-1968 period. (See Table J).  - 22 - Table J: GROSS D)i0ESTIC PXIDUCT AT FACTOR COST Annual Billions Percent Percentage Change 1968 Pesos Change 1965 1966 1967 1960 1964 19B 1968/19o7 Primary 5.8 9.2 -19.3 1.6 44.3 42.0 -1.1 Crops 52.6 (15.7) (-29.7) (12-7) (9.5) (8.7) (-1.6) Livestock -7.2 (6.5) (-14.2) (-26.1) (34.9) (33.3) (-0.9) Secondary -O.8 2.9 -6.1 5.5 107.2 108.7 0.3 Manufacture (-0.6) (1.8) (-5.7) (1.5) (94.2) (91.0) (-0.7) Construction (-3.1) (12.9) (-7.0) (32.6) (13-1) (17.6) (7.7) Services 1.3 0.7 -2.7 -2.9 199.8 192.4 -0.8 GDP 1.1 2.4 -6.4 0.2 351.4 343.0 -o.6 55. Agriculture and Livestock: The wide swings of agricultural crop output were in the main the result of quite unusually bad weather in two consecutive years. The effects of drought and excessive rains not only on yields but also on planted acreage in 1967 and 1968 far outweighed that of price variations. Major field crops now seem to have become established on an area averaging slightly more than one million hectares largely devoted to the supply of the domestic market. There has been very little variation in the percentage distribution of crop output by conmodity over the past several years to 1968. The only exception has been rice, a minor crop, where the significant expansion has taken place with the extension of irrigated land on the east coast. The area planted wiith wheat declined by about 44 percent from the latter half of the 19501s due to the deterio- ration of the international market. It now provides a small exportable surplus in normal years, with the assistance of subsidized credit and price supports. Little significant improvement in methods of wheat production or varietal change has been undertaken in recent years. Under these con- ditions the almost exclusive factor determining output has been climatic conditions. This was favorable in the 1964-1966 period. Production, therefore, rose to above-average levels. The years 1967 and 1968, however, were abnormally unfavorable so that wheat and feed grains were imported in order to bolster a deficient domestic supply. Weaknesses also appeared in the oilseeds in the latter part of the period stemming from competition from synthetics. This may have been a contributing factor in linseed acreage reduction since 1965-1966. Modest increases in vegetable production occurred, apparently in response to secular increases in internal demand.  - 23 - 56. Livestock output has remained stagnant over the past four years, 1965-1968, in line with the trend of the previous five years. The only major exception to this was the sharp reduction in output in 1967, con- sequent upon drought and flood conditions, and the liquidation of animals in the previous year. This trend reflects continuance of the disincentive effects of high export taxes on beef, hides and wool and of inefficiencies in the processing and marketing systems for cattle and beef. The pasture improvement project of the Plan Agropecuario, supported by two IBRD loans, has demonstrated the efficacy of intensive production methods. However, improved pastures, at 1,100,000 hectares, represent only 8 percent of total pastures, and even of these only 500,000 hectares may be said to have reached full potential, as it takes four years before a substantial increase in output is achieved. Hence the program has not as yet reached a point where its impact is sufficient to influence total output, given the.zavAiable influence of weather conditions on unimproved pastures. 57. The level of construction activity has generally been lower than in the years prior to 1963, because of a lack of business investment and a scarcity of public sector savings. Substantial annual variations reflect the availability of external credit to the public sector for road construc- tion. The main orientation of public construction investment has been in roads and to a lesser extent in housing, sewage and water supply in the last few years. Private construction has been more stable. It has been largely confined to investment in tourist facilities and private housing in the resort areas. 58. Activity in manufacturing has fluctuated without showing an up- ward trend, so that by 1966 it was at almost the same level as in 1960. Amongst individual manufacturing sub-sectors, the final consumption groups - food-beverage, clothing, leather goods, printing and paper products - have expanded somewhat in 19B5-l968, as compared with 1960-1964, while the out- put of capital goods and of intermediate goods used by the equipment indus- tries fell. These results are broadly consistent with the trends observed above: consumption being maintained while investment fell as overall income stagnated. 59. Services: The slight downtrend in services generally reflects variation in output of crops and livestock and, especially in the case of trade, credit restrictions and declining real wages. Educational services, especially in secondary education, have been restricted as a consequence of the squeeze on public expenditure, particularly in the past two years. Counteracting forces were the increase in utilities, particularly electrical output, supported by a strong demand for household heating due to the relatively low eleetrriaity rE,es, aiid l;he imiodest expailsion in housing services.  - 24 - E Balance of Payments Developments 60. Beginning in 1962, successive balance of payments crises resulted in large accumulations of short- and medium-term debt. From December 1961 until December 1965, the net foreign reserves of the banking system (excluding liabilities to residents) declined by US$200 million. Perhaps the most important element in this decline was the Outflow of flight capital which appears to have averaged about US$50 million annually over this period, peaking at about US$90 million in 1965, the year of the banking crises. 61. The 1962-1965 balance of payments situation was the result of policies which held down exportable production and produced a periodically overvalued exchange rate through a very rapid rise in internal costs and prices. In order to cover even the minimal levels of imports received during the period the authorities were forced to accumulate debt on unfavorable terms. This was particularly true in 1965 when the monetary authorities accumulated a substantial volume of commercial arrears which were subsequently consolidated and refinanced into a repayment program extending over a period of five to seven years. 62. In 1966, the balance of payments registered a US$23.7 million surplus. This improvement reflected the large devaluation of late 1965 and relative stability of internal finance. It was followed by a sharp deterioration early in 1967 as exchange rate adjustment was postponed, the fiscal deficit rose and the money supply expanded rapidly. The 100 percent devaluation of November 1967 stimulated a reflow of flight cap- ital so that the year closed with the balance of payments showing a US$8.9 million surplus. Tight monetary and fiscal policy plus increasingly stringent import restraint and an additional 25 percent exchange rate devaluation in April produced a US$20.4 million balance of payments surplus in 1968. Utilizing about US$30 million in AID and PL-h80 credits and a US$20 million IMF standby credit the GovoriitLe