Uruguay - Current economic position and prospects

DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION Not For Public Use RiTEN uLLLA & Co FILE$J Report No. 120a-UR CURRENT ECONOMIC POSITION AND PROSPECTS OF URUGUAY May 10, 1973 Latin America and the Caribbean Region This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  CURRENCY EQUIVALENTS Currercy Unit = Uruguayan Peso Exchange Rates Effective February 21, 1973 Official Rate (Trade ) Selling Rate = US$1 .00 = Ur$623 Buying Rate = US$1.00 = Ur$615 Average Exchange Rates 1971 1972 US$1 .00 = Ur$260 Ur$1.00 = US$0.003546 US$D.001798 Ur$1 million = US$3,646 JS$1,796  This draft report is based on the findings of an economic mission to Uruguay during August-September, 1972, composed of C. N. Quijano (Chief); G. Thiebach (General Economist); Inder K. Sud (Transportation Economist); A. Stapleton (Agricultural Economist); L. Grayson (Industrial Economist, Consultant); F. K. Vita (Investment Program Advisor); Carmen Martinez (External Debt Specialist); G. Rossel (Statistical Assistant); and Teresa Garro (Secretary) and of an updating visit by Mr. Quijano and Miss J. Vial in March 1973. The August-September 1972 mission was assisted in Uruguay by Mr. Francisco Prieto (OAS-CIAP) in the preparation of the section on Public Sector Finances.   URUGUAY TABLE OF CONTENTS Page No. BASIC DATA SUMMARY AND CONCLUSIONS ... .......................... i-v INTRODUCTION ....................................... 1 STABILIZATION AND GROWTH .......................... . 5 A. Structure of the Economy. 5 Population and Manpower . . 5 Output and Productivity . 5 Income Distribution . . 6 Structural Changes: 1960-68 8 B. Recent Evolution of the Economy .11 Production ..11 Major Uses of Resources ............. 12 Prices and Wages ............... ............... 12 DEVELOPMENT PROSPECTS ............... ............... 15 A. Sectoral Problems and Policies .... ............ 15 Agriculture and Livestock ......... .. .......... 15 Recent Performance ................................. 16 Development Issues and Policies ............ ......... 17 Pricing Policy ...................................... 18 Credit Policy ....................................... 20 Land Development Policy ............ ...............0 22 Tax Policy ............. 23 Prospects for 1973 ................................. 24 Medium-Term Prospects ....... ....................... 25 Industry .................... ................... 30 Recent Trends ........................................... 30 Issues and Policy ........ .......................... 34 Future Prospects ................................... 37 Incentives for Export Promotion ................... . 39 Transportation ....... ......................... 40 Power .. ....................................... 44 Tourism. 45 Social Sectors ....... ......................... 47  TABLE OF CONTENTS - Continued Page No. B. Investment Requirements ................... .... 48 Public Investment .... ......................... 51 Private Investment ............ .. .............. 56 IV. FINANCING OF DEVELOPNENT ..... ...................... 58 A. Introduction ................. ................ 58 B. Public Sector Financing .......... .. ........... 59 The Organization of the Public Sector . ........ 59 Recent Central Government Trends . ............. 60 The Fiscal Performance in 1972 .... ............ 62 Public Savings and Financing of Public Investment ................................. 64 Recent Trends ................................. 64 Financing of Public Investments after 1972 .... 65 C. Private Savings and Monetary Management ....... 68 Structure of the Financial System ............. 68 Recent Trends ................................. 70 Monetary Management and the Capital Market .... 72 Conclusions ........ .. ......................... 73 V. BALANCE OF PAYNENTS AND CREDITWORTHINESS .......... . 75 A. Recent Trends ..................................... 75 Exports . ....................................... 77 Wool Exports .... ............................... 78 Beef Exports . ............... 78 Other Exports .... 79 Imports ..... .................................. 79 Trade Balance ...... ............................ 80 Services Account .............. ................ 80 Current Account Balance ........... ... .......... 81 Capital Account ............................... 81 Exchange Rate ................................. 82 B. Prospects for 1973 ............................ 84 C. Future Prospects ............ .................. 84 Export Projections .................... .. ....... 84 Import Projections .... ........................ 87 Current Account Balance .................... ... 89 Capital Account . .............................. 90 Creditworthiness . ....................... . .... 92 STATISTICAL APPENDIX  Page 1 of 2 pages COUNTRY DATA - URUGUAY AREA POPULATION DENSITY 187,000 km2 2.959 million (mid-1972) 16.0 per km2 Rate of Growth: 1.2% p.a. (from 1965 to 1972) 18.3 per km of arable land POPULATION CHARACTERISTICS (1970) HEALTH (1970) Crude Birth Rate (per 1,000) 21.0 Population per physician 1,040 Crude Death Rate (per 1,000) 8.6 Population per hospital bed 210 Infant Mortality (per 1,000 live births) /a INCOME DISTRIBUTION (1960-64) DISTRIBUTION OF LAND OWNERSHIP % of national income, lowest quintile 5.5 % owned by top 107 of owners highest quintile 58.0 % owned by smallest 10% of owners ACCESS TO PIPED WATER (1971) ACCESS TO ELECTRICITY ( % of population - urban 87.8 % of population - urban - rural 66.4 - rural NUTRITION (1964-66) EDUCATION (1970) Calorie intake as % of requirements 111.9 Adult literacy rate % 91.0 Per capita pr6tein intake (gr. per day) 105.5 Primar'y school enrollment % 94.5 GNP PER CAPITA IN 1970 US $820 GROSS NATIONAL PRODUCT IN 1971 ANNUAL RATE OF GROWTH (%, constant prices) US $ Mln. % 1960-65 1965-70 1971 GNP at Market Prices 2,720.0 100.0 0.7 2.2 -0.5 Gross Domestic Investment 258.4 9.5 -9.0 6.6 -2.6 Gross National Saving 187.7 6.9 5.8 -4.0 -9.4 Current Account Balance -63.6 -2.3 Exports of Goods, NFS 252.6 9.3 7.0 0.6 -5.9 Imports of Goods, NFS 302.9 11.1 -7.0 9.5 -1.2 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1971 Value Added Labor Force //b V. A. Per Worker US $ Mln. % Mln. % $% Agriculture 278.7 12.4 0.18 17.9 Industry 625.7 28.0 0.26 25.8 Services 1,334.1 59.6 0.49 48.2 Unallocated . . 0.08 8.1 Total/Average 2,238.5 100.0 1.01 100.0 .. 100.0 GOVERNMENT FINANCE General Government- Central Government (Ur$ Bln.) % of GDP ( Ur$ Bln. % of GDP 1972 1972 1969-71 1972 1972 1969-7] Current Receipts 369 27.9 31.7 160 12.1 13.2 Current Expenditure 375 28.4 31.7 161 12.2 13.4 Current Surplus -6 -0.5 0.1 -1 -0.1 -0.2 Capital Expenditures 56.7 4.3 4.3 17 1.3 1.4 External Assistance (net) 2.7 0.2 0.7 -l -0.1 1.2 1/ The Per Capita GNP estimate is at 1970 market prices, calculated by the same conversion technique as the 1972 World Atlas. All other conversions to dollars in this table are at the average exchange rate prevailing during the period covered. 2/ Total labor force; unemployed are allocated to sector of their normal occupation. "Unallocated" consists mainly of unemployed workers seeking their first job. not available not applicable a/ By income fecipient b/ 1963 census c/ Total Public Sector.  Page 2 of 2 pages COUNTRY DATA - URUGUAY MONEY, CREDIT and PRICES 1965 1969 1970 1971 1971(June) 1972(June) (Billion Ur$ outstanding end period) Money and Quasi Money 19.3 98.1 116.6 189.3 139.7 223.0 Bank Credit to Public Sector 3.0 17.0 17.3 55.0 26.0 72.3 'Bank.Credit to Private Sector 17.1 51.9 82.6 122.0 98.9 166.4 (Percentages or Index Numbers) Money and Quasi Money as % of GDP 36.8 19.7 19.2 24.5 General Price Index (1963 = 100) 221 1972 2313 1859 2710 4793 Annual percentage changes in: General Price Index 56.6 20.9 16.4 23.9 20.8 72.7 Bank credit to Public Sector 145.5 123.7 1.8 217.9 188.9 178.1 Bank credit to Private Sector 48.1 27.6 42.5 47.7 45.6 68.3 BALANCE OF PAYMENTS MERCHANDISE EXPORTS (AVERAGE 1969-71) 1970 1971 1972e US $ Mln % (Millions US$) Exports of Goods, NFS 280.5 252.6 257.0 Meat 73.2 35.4 Imports of Goods, NFS 286.5 302.9 265.0 Wool 69.8 33.7 Resource Gap (deficit = -) -6.0 -50.3 -8.0 Hides 23.3 11.3 Vegetable Oil and By-Products 21.2 10.2 Interest Payments (net) 13.4 12.6 13.2 All other commodities 19.5 9.4 Workers' Remittances . . . Total 207.0 100.0 Other Factor Payments (net) 8.6 9.0 11.8 Net Transfers 5.2 8.3 8.0 EXTERNAL DEBT, DECEMBER 31, 1972 Balance on Current Account -22.8 -63.6 -25.0 US $ Mln. Direct Foreign Investment Net MLT Borrowing 4.7 10.4 29.0 Public Debt, incl. guaranteed 312.6 Disbursements 43.6 53.8 91.5 Non-Guaranteed Private Debt .. Amortization 38.9 43.4 62.5 Total outstanding & Disbursed Subtotal 4.7 10.4 29.0 Capital Grants 3.2 2.7 3.8 DEBT SERVICE RATIO for 1972 Other Capital (net) 7.8 .. .. % Other items n.i.e. -43.2 25.4 -23.8 Increase in Reserves (+) -50.3 -25.1 -16.0 Public Debt, incl. guaranteed 29.5 Non-Guaranteed Private Debt .. Gross Reserves (end year) 197.5 204.4 *- Total outstanding & Disbursed Net Reserves (end year) 54.1 28.4 12.4 RATE OF EXCHANGE IBRD/IDA LENDING, (January, 1973) (Million US$): March e, 197a IBRD IDA US $ 1.00 = Ur$500 Ur $ 1.00 = US$0.002 Outstanding & Disbursed 57.4 - Undisbursed 20.2 - February 21, 1973 Outstanding incl. Undisbursed 77.6 US $ 1.00 = Ur$832 Ur $ 1.00 = US$0.0012 1/ Ratio of Debt Service to Exports of Goods and Non-Factor Services. not available not applicable e estimate  SUMMARY AND CONCLUSIONS 1. U ruguay is a small country endowed with abundant fertile land and notable for its well-educated population of three million (over 90 percent literate) and low birth-rate (about 2.1 percent). Its per capita product is one of the highest in Latin America (estimated at US$820) and income appears to be more evenly distributed than in any other country in the region. Notwithstanding these high standards, the country had known better times in the past. By the mid-1950's, after half a century of almost uninterrupted prosperity, its per capita income had reached levels similar to those of some of the industrialized Western European countries. 2. During the period of prosperity, however, some structural imbalances emerged -- inefficient import-substitution industrialization and serious neglect of the export sector -- which served as obstacles to further develop- ment. The combined effect of these imbalances, the decline in prices for Uruguay's major exports (livestock products) which followed the termination of hostilities in Korea, and the weakness of a "collegiate" system of govern- ment which based its economic policy on short-term political expediency, subjected the country to a prolonged period of economic stagnation and rampant inflation. By June 1968, after years of declining per capita income, the country came periously close to political chaos and economic bankruptcy. The crisis appears to have served as a turning point in the management of economic affairs. 3. To better cope with the severe economic and social problems, the country discarded the "collegiate" system of administration in favor of a presidential one. The newly elected government introduced in 1967-68 a number of measures designed to staunch inflation and curtail capital flight. These measures had a prompt salutary effect. The inflation rate declined to an average annual rate of about 20 percent in 1969-70 as compared with 125 percent in 1968 and output grew annually by almost 6 percent in the two-year period. The private sector, after years of disinvestment, responded favorably to the government's policies, stepping up investment in machinery and equipment. Moreover, as a result of substantial improvements in price incentives to livestock producers, a reorganization of the meat packing industry and a firming-up of world beef prices, the balance of payments was strengthened and the Government was able to pay off external arrears accumulated during the mid-sixties. The favorable results of 1969-70, however, were soon dis- sipated. An impending general election weakened the government's resolution to pursue unpopular economic measures and with their relaxation, price in- flation accelerated once again and the financial and economic situation deteriorated rapidly. Overall output stagnated during 1971, and the balance of payments registered a large deficit. 4. A new Administration took office in March 1972 and moved swiftly to bring the economic situation under control. It designed an outward growth- oriented development strategy to stimulate private agricultural and manufac- turing production and implemented a number of concrete measures. It (a) devalued the peso from Ur$250 to Ur$500 per US$1 for commercial transactions and declared its intention to adjust the exchange rate frequently in line  - ii - with internal price changes; (b) created a secondary exchange market for certain financial transactions and for tourism in which the exchange rate is permitted to fluctuate freely in response to supply and demand; (c) raised export taxes and the domestic prices of petroleum products which resulted in increased fiscal revenues; (d) reduced its current expenditures budget for 1972; and (e) raised electricity and telephone rates by 90 percent. 5. The devaluation and the adoption of a flexible exchange rate system were welcome, if long-overdue, steps. The effective implementation of the flexible exchange rate policy (i.e., "crawling peg") has permitted a substantial rise in beef producers' prices and brought to a halt the balance of payments deterioration. Fiscal and monetary policies restrained aggregate demand, with the central government deficit declining from over 4 percent of GDP in 1971 to only about 1.3 percent in 1972. Although the domestic sector continued to be plagued by supply scarcities and labor strife, the economy appeared to be on the way to recovery. In 1972 the price level rose by 95 percent as a consequence of the spill-over of the 1971 inflationary policies, a poor harvest, and official price increases for beef, petroleum products, and electricity. To compensate for higher than anticipated price increases and because of serious labor strife, the government was forced to grant wage increases in 1972 beyond its original targets. However, the increases lagged behind price rises and real wages fell, to a level slightly below that of 1968. 6. While success has not yet been reached in combating inflation, this Administration, in contrast to preceding governments which placed heavy emphasis on policies designed for the short-run, has begun to create the institutional basis for sustained economic growth. It has initiated an educational reform which involves a reorientation of the training system towards greater emphasis on vocational and technical education; a reform of the tax system; a revision of the financial system; the creation of a new development bank; and adjusted prices and public utility tariffs in order to rehabilitate the enterprises and other sectors decapitalized by inflation-bred distortion in relative prices. In addition, the government has formulated a land development policy aimed at increased production and reduction in the size of the extremely inefficient land holdings. However, a serious short-coming in the government's program is the lack of an adequate mechanism to maintain relative prices in equilibrium while inflation persists. This would require extension of the application of monetary correction to all financial transactions of more than a year and to certain tax payments and arrears. This measure is critical to increase private and public savings in an inflationary environment. Another important element of economic management that the Government has so far failed to tackle is the operation of its price control mechanism. Price controls as presently applied often result in sanctioning cost-push inflation rather than controlling it. The controls as exercised either seem to have been ineffective with respect to both wages and prices or when effectively applied to prices have ended up in control of profits. An economy with low savings and investment rates, pronounced differences in the size of industrial units and a dependency on export markets, needs to be concerned about problems relating to organization and productivity. Probably the most efficient system of controls would be  one which would establish general guidelines for wages and limit price controls to some 40 to 50 articles of basic necessity. This would permit a focusing of efforts on those items which have the most important impact on the cost of living and avoid the present unrealistic, wasteful effort to control the price of the products of about 4,000 enterprises. If the suggested more limited system of controls is adopted and provided the authorities administered it even-handedly, it might reduce inflationary pressures and improve the allocation of resources. 7. One of the most significant obstacles to stabilization and economic growth in Uruguay during the recent past has been the poor financial perfor- mance of the public sector. The steady deterioration of the fiscal situation has made it increasingly difficult for the government to sustain moderate levels of public investment. Moreover, heavy recourse by the public sector to the monetary authorities has seriously hampered the commodity-producing sectors' ability to obtain adequate credit. As indicated above, Uruguay has recently implemented a series of beneficial measures -- a flexible exchange rate and realistic public utility tariffs. As long as these measures continue to be applied, the tax reform is carried out, a serious effort to improve tax administration is made, and current expenditure increases are held to a rate not in excess of GDP growth, public sector savings could increase gradually and significantly. It is estimated that public sector saving by 1978 could rise to 3.8 percent of GDP from a dissaving of 0.5 percent in 1972. This may prove a difficult task but it should not be impossible since in 1970 public savings rose to almost 2.4 percent of GDP. 8. Provided public sector finances are strengthened, along the above lines, public investment in relation to GDP could increase to about 5.3 percent for the period 1976-78 compared with about 4 percent in the 1970-72 period. Much of this investment calls for repassing public resources to the private sector for the pasture improvement program, land redistribution and improvement of small farm units, etc. Within the public sector proper the most important investments include improving the nation's electricity generating capacity; construction and maintenance of roads; cement plant modernization, expansion of the oil refinery and the construction of a terminal for on-loading oil tanks. Ongoing projects will satisfy much of the public investment require- ment up to 1975-76, but new projects will have to be developed if the public investment target is to be achieved subsequently. Although the Government has so far made some efforts to improve the coordination of public sector acti- vities by upgrading the Planning Office, unless further efforts are made to improve project identification, preparation and execution, even the modest public investment target postulated in this report will not be accomplished. Given favorable prospects in agricultural-and-livestock-based export industries, private investment in the 1973-78 period may be expected to expand. However, the success of the economy in attaining the goals for private investment will depend on the ability of the authorities to devise and implement a set of policies which would grant the private sector adequate incentives, mainly in livestock and agricultural products and their processing for export markets. The Government has already made a good if somewhat limited start in this  - iv - direction. However, further successful efforts are required in the areas of price and wage stabilization, and in credit policies in support of the com- modity-producing sectors. 9. The government's goal at the time of the mission was a 5 percent GDP growth rate for the next five years as compared with the annual average of 2.5 percent in the past five years. In the light of existing constraints, there is reasonable doubt that the five percent target is feasible. Although a higher overall growth rate is possible, there are many constraints on such an endeavor. Among them the most important are the small size of the market and the difficulties that could be encountered in the process of expansion of exportable production. Moreover, the saving and investment effort that the higher growth rate would require appears excessive in light of the present socio-political set up and recent performance. Nevertheless, provided sound and appropriate agricultural and livestock policies are followed and that the authorities take the necessary measures to strengthen public finances, a sustained rate of growth of approximately 4 percent appears realistic. To achieve the four percent target, gross capital formation would have to increase from an average of 9.1 percent of GDP in 1970-72 to about 11.6 percent in 1976-78 and attain a level of 12.4 percent by 1978. This means that invest- ment will have to increase much faster than total product. The required growth in investment would still allow per capita consumption to increase by 2.2 percent per annum. 10. Uruguay's balance of payments experienced sharp fluctuations in recent years. Both the trade balance and the current account registered small surpluses, while the overall balance of payments was in deficit. The periodic balance of payments crises drained foreign exchange reserves and led to the accumulation of short-and-medium-term debt. In order to cover the import needs to sustain even low levels of economic activity, the authorities were forced to resort to borrowing on unfavorable terms. As a consequence, the debt service ratio rose to nearly 30 percent by 1972. 11. The medum-term outlook of the balance of payments is quite promising. Export prospects for the 1973-78 period appear to be very favorable, partic- ularly because of an expected rise in beef output and high world market demand and prices. However, relatively high levels of imports will be needed to sustain a reasonable rate of growth of the economy. These will include fuels, semi-processed products and capital goods for the replacement, modernization and expansion of largely obsolete existing capacity. Similarly, rising service payments, particularly factor payments, are envisaged and these may be expected to more than offset the trade surplus. To meet the projected heavy amortization payments on existing and newly acquired external debt and to allow for some build-up of foreign exchange reserves, gross capital inflow will have to rise moderately to an average annual level of about US$63 million. 12. Toward the end of 1972 the authorities made significant progress in amortizing a large part of coumercial arrears accumulated in 1971 and early 1972. In addition some maturities of short- and medium-term commercial credits  were stretched out. On the basis of the now established exchange rate policy, balance of payments prospects appear good. With the gradual replacement of consolidated short-term debts by long-term loans and a reasonable increase in the overall external indebtedness, the debt service ratio may be expected to decline from 22 percent in 1973 to less than 10 percent of projected exports of goods and non-factor services by 1978. Provided the authorities take the necessary measures in the exchange rate, fiscal, pricing and interest rate policy areas, the economy should be able to grow satisfactorily with a viable balance of payments. Under these circumstances, Uruguay may be regarded as creditworthy for the external capital requirements previously indicated.   I. INTRODUCTION 1. Uruguay is a small country with a population of three million, bordered by the two largest countries in South America -- Argentina and Brazil. It is endowed with an abundance of fertile land uniquely suited to agriculture and grazing and enjoys a pleasant temperate climate. Moreover, its population, notable for its low birth-rate, is culturally homogeneous, having attained an educational level characteristic of countries with a much higher stage of development. Despite all these attributes, the country has been experiencing economic paralysis in recent years. With declining production and income and rampant inflation which reached a rate of 183 percent during the twelve-month period ending June, 1968, Uruguay came perilously close to political chaos and economic bankruptcy. Social and political unrest became widespread and a sense of frustration and impotence prevailed. This crises was long in the making with its roots deeply sunk in the country's past development pattern. The crisis appears to have been a turning point in the management of economic affairs. 2. Uruguay's economic development falls into four distinct periods: (a) the period up to the mid-1930s was one of rural predominance with growth generated by expansion of agricultural and livestock production for the European markets; (b) the period of rapid industrialization, which covered some two decades -- from the mid-1930s to the end of the Korean War -- and first emphasized the processing of agricultural and livestock products for export but subsequently became subordinated to import substituting industry, mainly for the domestic market; (c) the period of the unhappy coexistence of economic stagnation and rampant inflation which lasted for almost fifteen years after the mid-1950s; and (d) the period of rehabilitation following the crisis of 1967-68 when political and administrative changes were intro- duced to lay the foundations for the resumption of economic growth. 3. The period of rural predominance was in large measure an extension of colonial times, the major difference being that the benefits of export trade accrued to the national economy instead of the colonial power. With the passage of time and especially-under the influence of the dominant political figure of the period, President Jose Battle y Ordonez, the country began to move toward a welfare state which subsequently became the central element in national economic life. The welfare state survived the Great Depression surprisingly well, and by the mid-1930s, Uruguay's per capita income compared favorably with that of a nuimber of countries in Western Europe. Moreover, as a portion of the agricultural and livestock surplus (with the land tenure structure and the low input-output system of production remaining unaltered) was being transferred to the urban population in Montevideo and its surroundings, a less skewed income distribution began to emerge. This transfer of income occurred through direct government action, with the public sector expanding its functions in the fields of education, public health, social security and infrastructure. The authorities encountered only moderate resistance from the big landowners to this process because overall output was growing and the economic and social power remained in their hands, while political power was increasingly transferred to the emerging urban middle class.  4. The inauguration of the industrialization period coincided with shortages of imported raw materials because of foreign exchange problems in the 1930s and supply limitations during World War II. The industrial growth that occurred, therefore, during those years, was based almost exclusively on industries using domestic inputs. With the end of the War imported supplies of capital and intermediate goods were no longer a constraint and industrial production for the domestic market prospered. Concurrently, development of export industries, especially the livestock industry, came almost to a halt. Industrialization assumed the familiar pattern of progres- sive substitution of imports by means of controls and subsidies, largely facilitated by a multiple exchange rate system. The industrial structure which resulted was highly vulnerable in the face of its high costs and limited market. Moreover, the lack of fuels and industrial raw materials, rendered Uruguayan industry almost completely dependent on imported inputs and, there- fore, on the performance of the export sector. Although by the end of the industrialization period in the mid-1950s, Uruguay was probably the most urban and prosperous country in Latin America, its prosperity and great social progress rested on shaky foundations. Having neglected the development of its export sector, especially livestock, it was singularly unprepared to cope with the precipitous drop in international meat and wool prices following termination of hostilities in Korea. Although some economic growth took place during this period, its imbalance served as a prelude to the long and painful decade of "stagflation". 5. The decline in prices for Uruguayan exports was not the sole cause of the economic stagnation and severe inflation. The "collegiate" system of government was another major contributor. The annual changes of Chief Executive which the system required resulted in practice in annual replace- ments of key government officials in line with the political or personal inclinations of the Chief Executive. This institutionalized the supremacy of short-term political expediency over the longer-term socio-economic needs of the country as a basis for formulating economic policy. Moreover, the complexity of the administrative machinery made it almost impossible to mobilize support and achieve consensus regarding national objectives. Through- out this period economic policy-making by improvisation brought about a gradual transfer of resources from the low-cost agricultural and livestock sectors to the high-cost industry and social services. This process discouraged investment in agriculture and livestock and their output actually declined, thus compounding the economic problems stemming from deterioration in the terms of trade. In their search for alternative investment opportunities, the livestock producers either shifted to highly lucrative urban real estate or transferred their capital abroad. One led to misallocation of resources and the other to balance of payments crises. 6. The inflation which accompanied economic stagnation for over a decade can be attributed to several interrelated factors: the reluctance of a population accustomed to a high level of consumption to accept austerity; the unsupportable cost of established welfare programs; the huge budgetary  and public enterprise deficits; and the excessive wage increases extracted by powerful groups of well organized urban workers. Toward the end of the "stagflation" period the country became deeply aware of the predicament created by the "well intentioned experiment that became a total failure" and searched for a more viable approach. The desperation manifested itself in the rise of urban political terrorism. The majority, however, chose to meet the challenge presented by the economic chaos by approving a constitutional amendment in 1966 which put an end to the "collegiate" form of Government. This measure and the subsequent election of a Government which adopted as its program a vigorous attack on inflation and a campaign slogan of "for great evils harsh remedies", marks a new watershed in Uruguay's economic and social history. 7. The new government instituted a combination of price, wage, monetary and fiscal controls and was remarkably successful in restraining inflation. It also addressed itself to the nation's external credit standing and managed to repay a considerable part of the accumulated external arrears. Only a few of the measures implemented by the new government addressed structural defects in the economy, but those that did were important and covered the reorganiza- tion of the all important meat packing industry, the substantial improvement in producers' prices and-the introduction of a progressive land tax (IMPROME). The promising start made by the government and the favorable results which its policies yielded in 1969-70, however, were soon dissipated. The impending general elections weakened the government's resolve to pursue unpopular economic measures and with their relaxation the economic situation deteriorated seriously once again in 1971. 8. The present government has the same general sense of purpose as its predecessor -- an awareness of the need for basic changes in the nation's economic and social policies as a prerequisite to economic recovery. It also shares in the belief that at this juncture Uruguay cannot afford the luxury of a weak administrative system. However, in contrast to the heavy emphasis other governments placed on short-run policies, the present administration has committed itself from the outset to measures which will create the social and economic conditions essential to longer-run economic growth and political stability. In line with this approach the government's first measures to restrain inflation and cope with the balance of payments crisis included steps directed towards the elimination of prevailing serious price distortions. In particular, it sought to establish a more realistic exchange rate policy. Thus, in the process of seeking to stabilize the economy, the authorities addressed themselves to a basic element essential to healthy growth. Moreover, the government has declared its intention to introduce measures designed to provide additional incentives to stimulate production and exports; to reform the tax system; to reform the financial system; to establish a new development bank; and to implement a land redistribution scheme. The successful implemen- tation of these objectives will be at best a difficult and lengthy task.  9. Uruguay has the physical and human resources to resume economic growth. This growth in the foreseeable future will have to rely in large part on increased production of agricultural and livestock products for export. This will require removal of institutional barriers which have perpetuated the low input-output system of production and discouraged the traditional landowners from becoming commercially oriented entrepreneurs. The present favorable world outlook for meat and agricultural product is almost certain to render efforts in this direction highly beneficial. Once the growth process is resumed, it should become feasible to meet social needs which were neglected under the depressing impact of stagnation. Whether or not the objectives will be attained will depend on the government's success in carrying forward its outward growth oriented strategy.  - 5 - II. STABILIZATION AND GROWTH A. Structure of the Economy Population and Manpower 10. Uruguay's present population is estimated at about three million. It is predominantly urban in spite of the great importance of agriculture, in the economy. Only 20 percent of the population can be classified as rural and only one department (San Jose) has a rural population in excess of 40 percent. Greater Montevideo (the departments of Montevideo and Canelones) account for almost three-fifths of the total population. 11. The economically active population is probably about two-fifths of the total which constitutes the highest activity rate for any country in South America. A very high proportion (27 percent) of the active population is employed in the services sector, reflecting the proliferation of govern- ment services typical of a welfare state such as Uruguay. About one-half of those engaged in services are estimated to be employed by the public sector. 1/ 12. Unemployment in Uruguay, as in many other developing countries, consists of open urban unemployment and disguised unemployment. However, the situation in Uruguay differs in that most of the disguised unemployment appears to be urban rather than rural. The unemployment problem is reputedly most serious in Montevideo. Although according to statistical data the unemployment rate in Montevideo fluctuated in recent years around 8 percent of the labor force, this figure does not take into account underemployment and thus understates the problem. Some indication of the magnitude of under- employment may be derived from the chronic pressures on the public sector to continuously provide employment opportunities. These pressures have resulted in the inordinately high share of public sector employees in the labor force (cf. para 11). Output and Productivity 13. The structure of employment in Uruguay suffers from a serious im- balance. This conclusion emerges from a comparison of employment and produc- tivity in the commodity-producing sectors and in other branches of economic activity in Uruguay with corresponding figures for Denmark -- a country subjected to similar constraints in terms of smallness of the domestic market and a one-sided natural resource base (agriculture and livestock) but with a reasonably satisfactory growth rate of 4.6 percent per annum in recent years. 1/ Estimated as an extrapolation from 1963 census data.  - 6 - Table 1: STRUCTURE OF EMPLOYMENT AND PRODUCTIVITY (Percentages) Uruguay (1963) /1 Denmark (1965) /1 Employ- G. Value Productivity Employ- G. Value Productivity ment Added Index ment Added Index Commodity Producing Sectors 49.4 42.9 86.4 54.9 51.1 93.1 Other 50.6 57.1 112.8 45.1 48.9 108.5 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 /1 The use of two different years does not bias the comparison. Assuming that Uruguay's employment structure in 1965 was approximately the same as in 1963, the productivity indices would have been unchanged. The differences between the two countries appear to be significant and point clearly to the distortions in the pricing policies of Uruguay. While the performance of both economies depends in large measure on merchandiser exports, Uruguay has been placing a considerably higher premium than Denmark on employ- ment services. 14. An analysis of the structure of the two countries' economies suggests that it is somewhat misleading to separate value-added by agriculture and by manufacturing, because of the close connections of the sectors. In Uruguay, it is relatively easy, however, to get an idea of the interdependence of these sectors by comparing the structure of value-added with the composition of exports. On the one hand, the shares of agriculture and manufacturing in GDP (in real terms) have averaged 12 and 25 percent, respectively. On the other hand, exports of agricultural and livestock products, mainly meat and wool, which are included in value-added by manufacturing, account for almost 80 percent of commodity exports. This large discrepancy is only in part the result of differences in classification; it also reflects the low domestic pricing of agricultural factor inputs as compared with those of industry. These figures help explain the relatively high share of industry in total product while the fact remains that the core of the Uruguayan economy lies in the agricultural and livestock sector. Income Distribution 15. Uruguay has one of the highest per capita incomes (US$820) in South America. According to scattered information, income distribution by income  - 7 - recipient appears to indicate that income is more evenly distributed in Uruguay than in most Latin American countries. A study carried out by the Economic Comrnission for Latin America (ECLA) of income distribution by income recipient, based on 1960-64 data, indicates that the difference in income shares for the two ends of the scale between Uruguay and LAFTA countries taken as a group 1/ are large enough to suggest that they are significant -- 1.4 percentage points at the bottom of the scale, and 6.5 percentage points for the top of the scale, or 34 and 21 percent differences in relative terms, respectively. The income recipients who fall in the 20 percent lowest income bracket in Uruguay get a higher share of total income than the corresponding group of the LAFTA countries taken as a whole, and conversely those who fall in the top 5 percent income bracket in Uruguay get a share of total income which is considerably smaller than the one received by the same group in the region. This income pattern of Uruguay's income recipients, less skewed than for other Latin American countries, could probably be explained in the first place, by the high share of wages arnd salaries in national income since it is often assumed that "there is generally much less inequality in the distribution of wage and salary income, so that a larger wage and salary share will be reflected in a lesser degree of total inequality." 2/ In the second place, the virtual absence of subsistence agriculture, and a productivity per rural worker as high as 70 percent of the national average would tend to reduce in- come inequalities. Needless to say, the same reservations apply in this in- stance as in the case of most income distribution studies. Table 2: PERCENTAGE SHARE IN TOTAL INCOME GOING TO INCOME RECIPIENTS BY INCOME LEVELS Country Lowest Middle Highest Top 20% 60% 20% 5% Uruguay 5.5 36.5 58.0 25.0 Argentina 5.2 40.7 54.1 31.2 LAFTA 4.1 37.9 58.0 31.5 Source: ECLA 1/ Argentina, Bolivia, Brazil, Colombia, Chile, Ecuador, Mexico, Paraguay, Peru, Uruguay and Venezuela. 2/ Income Distribution in Latin America (ECLA, 1971), p.91  - 8 - 16. Assuming that the relations between income distribution by income recipient and by family unit prevailing in Argentina 1/ (which has a socio- economic structure similar to that of Uruguay), in the early 1960s also applied to Uruguay the country's income distribution by family unit would have been even less skewed than that obtained by income recipient. The families in the lowest 20 percent income bracket would have received 7.3 percent of total income, and the families in the top 5 percent income bracket would have received only 23.5 percent of total income. This pattern is explainable by the high proportion of the Uruguayan population over 14 years of age in the lower income brackets which is either employed or receives retirement benefits from one or more of the various state pension funds. This condition increases the number of contributors to family income. While income distribution by family unit does not strictly reflect income distri- bution by individuals (whether income recipients or dependents), it probably approximates it in a country like Uruguay where welfare benefits, including family allowances, are so widespread. Structural Changes: 1960-68 17. The structure of gross value-added at the aggregated level and in real terms remained almost stable through the period 1960-68; all sectors shared in the responsibility for the stagnation of the economy. A slight increase took place in the share of total services at the expense of the primary and secondary sectors which can be attributed mainly to the growth of public administration services, where employment seems to have increased faster than in other sectors. At a more disaggregated level, some changes in the structure of production took place within the several sectors, e.g., in the crops sub-branch wheat shows a declining trend, while rice production has grown fast; in manufacturing non-durable consumer goods show some gains, while production of durables has markedly fallen. The shift in crops would appear to be attributable mainly to the government's pricing policy and. the shift in manufacturing to the sluggish demand which necessarily affects durables more than other products. 18. Although the structure of the economy in real terms, as indicated above, was practically unchanged in 1960-68, in monetary terms some major structural changes took place, as could be expected in an economy suffering from rampant inflation. The internal terms of trade show very unfavorable developments for the agricultural and livestock sector, indicating a steady transfer of resources to other branches of the economy. The major relative gains belong to manufacturing, transport, public administration and other services. This outcome reflects the long-standing government policy oriented in favor of urban consumers at the expense of agricultural and livestock producers. 19. With respect to the use of resources, whether in real or monetary terms, an increase in the share of public consumption with a parallel decrease 1/ Economic Development and Ihcome Distribution in Argentina (ECLA, 1969).  - 9 - in the rate of investment are evident. The shares of-exports and imports show pronounced annual variations but no visible trend. In contrast, private con- sumption in real terms appears to have kept a relatively stable high share of GDP, over 75 percent on the average, which in the face of a stagnant gross product entailed a declining per capita consumption. Thus, significant struc- tural changes in the use of resources and in the internal terms of trade of the economy took place in the 1960s. All these changes appear to have been in the opposite direction from that required to foster sound economic development.  Table 3 : AVAILABILITY AND US,E OF RESORCES- Percent Distribution Average Annual Grovwb 1960 1965/66 i949/70 1971 l972 1965-70 1969 1970 1971 1972 I. Crovs Domestic Product 100.0 100.0 100.0 100.0 100.0 2,8 6.5 5.0 -0.5 1.0 at Market Prices (a) Net Ps-tot Payments 0.2 0.9 1.2 1,0 1.2 6.9 12.5 -25.7 -3.7 22.0 (b) Groas National Product 99.8 99.1 98.8 99.0 98P8 2,2 6.4 5.6 -0.5 0.8 II. lesouree Balance 3/ -3.1 3.7 0.6 -1.3 0.3 - - - - (a) Exports of Goods and NFS 10.6 13.7 13.1 12.5 11.4 -06 -0,2 7.0 -5.1 -7,6 (b) Imports of Goods and NF3 13.7 9.5 12.5 12.8 11.1 9,5 23.0 11.8 -1.2 -12.1 III. Avdilable Resources 103.1 96.3 99.4 100.3 99.7 3.2 9.2 5.6 - - IV. Consmiption 90.4 88.3 89.8 91L0 91.9 2.9 7.6 6.0 0.4 2.0 V. CGrss Domestic Invetents 1217 8.0 9.6 9.3 7.8 6.6 27.0 1,8 -2.6 .1530 (a) Fixed Investments (11.3) (8.0) (10.0) (9.4) (8.2) (6.1) (27.1) (5.4) (47:0) (-1l.N) VI. Domestic Savings 9.6 11.7 10.2 9.0 8.1 -3.2 -1.9 -3.3 -8.9 -8.8 VII. National Savings 9.4 1-.8 9.0 8.0 t.9 -4.0 -3.8 0.2 -9.4 -12.6 GROSS DOtESTIC PRODUCT DiST51RWTIO ANM CROWTR BY SICTORS 1. Primary 11.4 12.8 1. 11.6 11.2 0.7 15.0 1.7 -0.3 -3.0 Livestock 9 5 9.1 8.4 6.4 8.1 0.9 -0.2 4.3 -1.0 -1.7 Crops and others 1.9 3.7 3.4 3.2 3.1 0.1 81.9 -5.0 -1.4 -6.4 II. Secondar& / 79.8 30.0 Z.4 28.0 28.5 3.4 5.2 .1 17 2.8 Manufacturing - 25.3 25,0 25.6 25.1 25.3 2.4 5.8 4.1 -2,0 2,0 Construction 4.5 5.0 2.8 2.9 3.2 2,0 - 0.4 - 10.0 III. Services 58.8 59.2 59.8 60,4 60.4 2.4 5.6 6.1 - 1,0 Basic Services 15.5 15.7 13.1 15,0 15.1 1.1 3.0 3.0 0.1 2.0 Other Services 43.3 43.5 44.7 45.4 45.3 2.9 6.5 7.2 - 0.6 IV. Gross Domestic Frodsct 100.0 100.0 100.0 100.0 100.0 2.2 6.5 5.0 0.5 1.0 at facctr cost 1/ At 1969 tonstant prices. 2/ Negative signs indicate Inflow. 3/ Includes mining. Source: Tables iD Scatietical Appendix  .- 11 - B. RECENT EVOLUTION OF THE ECONOMY Production 20. A difficult stabilization program was launched in 1968 and the Uruguayan economy began to emerge from the prolonged period of stagnation, with GDP rising by 6.5 percent in 1969 and 5.0 percent in 1970. The increased production during these two years was led by a strong recovery of agricultural and industrial sectors. This recovery can be explained by the upsurge of crop production under favorable climatic conditions, the long overdue improved price incentives granted to livestock producers and the boost in internal demand stimulated by rising real wages generated by the Government's incomes policy. Despite the continuation of rigorous price controls, increases in taxes through improved tax administration and very high financial costs, the overall productivity and profitability of industrial enterprises appeared to have improved because of high utilization of capacity. In short, there was considerable evidence that the economy was beginning to respond to appropriate Government policies. 21. The recovery, however, was shortlived and in 1971 gross domestic product declined by about one percent. This decline mainly reflected a sharp fall in the output of the meat processing industry and beef exports. The most important factor explaining the shortage of beef is that while cattle prices in 1971 rose much faster than the cost of living, they rose more slowly than cattle prices in neighboring Brazil when converted into Uruguayan pesos at the parallel exchange rate. The faster rise of prices in Brazil provided increased incentives to smuggle and caused a very sharp decline of cattle slaughtering in the meat packing houses which supply mainly the export market. Poor crops, difficulties in certain sectors of industry due to widespread labor disputes, shortages of supplies (for example, leather), and lower private investment were also factors contributing to the down-turn in production. 22. Although some of the major elements responsible for the downswing have persisted, some of the key economic indicators point to an upward move- ment in 1972 with gross domestic product estimated to have increased by about 1.0 percent in real terms. Of the principal commodities, beef production appears to have risen somewhat, whereas output of wool and of all major crops except rice, is believed to have declined. The increase in beef output re- flected investments made in pasture improvement and the introduction in early 1972 of a more flexible exchange rate which permitted a rise in beef producers' prices and an improved relationship between Uruguayan and Brazilian beef prices. This resulted in a drop of clandestine live cattle sales to Brazil and a rise in industrial meat output for export. The fall in crop production was due to a combination of poor weather and continuation of inappropriate credit and price policies. Overall agricultural output in 1972 is believed to have declined by about 3.0 percent. Despite considerable time lost through strikes as labor protested the government's strong incomes policy, industrial  - 12 - production is estimated to have exceeded the low levels of 1971 by about two percent. Construction activity also increased in 1972 as a result of a housing program which was started by the government in 1970 and is now reaching its peak. 23. The reversal in 1972 of the previous year's recession provides evidence of the economy's resiliance and ability to respond favorably to even a minimum of sound management. The improved performance in exports was stimulated by the more realistic exchange rate policy and further bolstered by rising world meat prices. Although the domestic sector continued to be plagued by supply scarcities, labor strife and a high degree of inflation (about 95 percent for the year), nevertheless the economy appeared to be on the way to recovery. However, for the country to capitalize on this momentum economic management will have to be strengthened in the years to come. Major Use of Resources 24. The use of resources by the Uruguayan economy registered significant variations in recent years. During the recovery years 1969-70, consumption, investment and imports grew at rates considerably higher than GDP. At the same time exports increased only moderately and domestic savings actually declined. In spite of the rapid growth of imports, export surpluses remained, i.e., Uruguay was still transferring abroad some domestic savings. However, the savings transferred abroad declined to 6 percent from 20 percent in earlier years. However, while in the earlier period transfers basically represented capital flight, in 1969-70 a major portion of the transfers served to curtail external arrears accumulated during the 1965-66 balance of payments crisis. With the onset of the 1971 recession, investment and savings fell and capital flight resumed, while consumption increased somehow in the face of declining GDP. The new stabilization program with its balance of payments retrenchment initiated in March 1972, appears to not only have raised GDP but also to have had some succes in curtailing consumption in the second half of the year. Preliminary estimates for the year as a whole, however, suggest that con- sumption grew moderately while investment, savings, exports and imports de- clined in real terms. Prices and Wages 25. A wage and price control law was enacted in 1968, establishing a Council of Productivity, Prices and Incomes (COPRIN). The law prohibited private sector price adjustments except in cases specifically authorized for individual firms by the Council. In this manner, the Council was given powers to control the price of the products of some 3,500 to 4,000 enterprises. The individual firms were required to demonstrate cost increases to justify their applications for price increases. The Council has been using a 10 percent profit margin on basic necessities and a 15 and 18 percent profit margin on other products. The law allowed wage increases in the private sector only to the extent of demonstrated improvements in productivity in  - 13 - individual firms. Since such increases should not raise unit cost, they would not constitute a legitimate basis for price increases. 26. The administration of the law and its effectiveness in combating inflation have varied greatly since its adoption. At the outset it produced a wage and price freeze. This freeze, combined with a stable exchange rate, greatly decelerated the rate of inflation. Price increases dropped to an annual average of 20 percent during 1967-70 while intensified capacity utilization permitted productivity to improve substantially and real wages to rise during these two years by an average of some 5 percent. 27. Application of controls over wages and prices became much less effective in 1971 as a result of the impending national elections in November. Wage increases in the private sector began to be determined by the bargaining power of trade unions. Given the great strength of the unions, wage increases. in excess of productivity gains were condoned and led to increased costs. Since product price increases were based on cost increases, the Council allowed price increases to compensate for such increased costs. In essence, the Council's one-sided administration of the law -- not enforcing a limitation on wage increases to productivity gains while permitting price increases in line with rising costs -- led to the classic wage-cost-price spiral. Nominal wages rose in 1971 by some 30 percent and prices by about 24 percent. Since overall output declined and productivity was not rising, the 6 percent increases in real wages resulted from a profit squeeze. 28. The inflationary policies of 1971 spilled over into 1972 and by March when the new Government came to office prices had already risen by 20 percent as compared with 5 percent during the same period of the preceding year. Although the Government had originally intended to limit the inflation rate for the year as a whole to 45 percent, it recognized that there was little chance of achieving it because of what transpired in the first quarter. In line with its stabilization efforts, the government limited the first rounds of wage increases to 20 percent. In view of higher than anticipated price increases and serious labor strike the government granted an additional 25 percent wage increase to private sector employees in October. Since the price level rose in 1972 by about 95 percent, it is estimated that real wages fell to a level slightly below that of 1968. The high rate of price inflation resulted from a poor harvest, official price increases for beef, petroleum products and electricity, and sharp increases in the price of beef substitutes consequent upon the government's prohibition of beef slaughtering for domestic consumption during the July-November period. Unlike in 1971 neither monetary expansion nor public sector operations contributed to inflationary pressures.  - 14 - Table 4: PRICES, NOMINAL WAGES AND REAL WAGES (Annual percent change) Consumer Prices Nominal Wages Real Wages Dec-Dec Average Dec-Dec Average Dec-Dec Average 1969 14.5 20.9 20.0 34.7 4.7 11.5 1970 20.9 16.4 17.8 14.8 -2.6 -1.5 1971 35.6 23.9 34.1 30.3 6.9 5.7 1971 (Sept/Dec) 16.3 24.7 34.0 40.3 1.8 4.2 1972 (Sept/Dec) 56.5 90.0 30.0 26.5 -13.1 -10.0 Source: Tables 9.1 & 9.4 in Statistical Appendix. 29. The measures adopted by the new government constituted a sharp break with the past. The introduction of a flexible exchange rate and realis- tic beef prices were both important steps for economic growth. The immediate effect of these measures was, however, to exert pressures on the domestic price level. In the face of the economic power of labor, the authorities were probably over optimistic at the rate at which inflation could be reduced without producing serious labor unrest. Moreover, the authorities did not face up to the fact that price controls as presently applied result in sanctioning cost-push inflation rather than in controlling it. As previously described, the Council's functioning is ineffective with respect to wages and ends up controlling profits rather than prices. An economy with low savings and investment rates, pronounced differences in the size of industrial units and a dependency on export markets, needs to be concerned with problems relating to organization and productivity. The operation of the Council need to be reformed with emphasis on expansion of the economy and the promotion of increased productivity. This should include limiting effective control over some 40 to 60 articles of basic necessity rather than dispersing efforts to control the price of the products of the 3,500 to 4,000 enterprises presently under control. This is likely to achieve the desired results, rather than cause inflation and distortion in the allocation of resources.  - 15 - III. DEVELOPMNT PROSPECTS A. Sectoral Problems and Policies Agriculture and Livestock 30. Although almost the entirety of Uruguay's land area is utilized productively for agriculture or livestock, most land use is very extensive in nature. More than 90 percent of the area is in pasture -- almost all in unimproved natural grassland grazed extensively by sheep and beef cattle. The cropped area makes up only 7 percent of the total, and is largely con- centrated in the south and south-west. Agricultural land use is dominated by cereals and oilseeds (wheat, maize, linseed and sunflower occupy about 85 percent of the cropped area), generally under low-input-output systems of exploitation. The total cropped area has declined steadily since the mid 1950's. Intensive land use is limited to small areas of fruit and vegetable production, mostly around Montevideo. Dairy production also is common in areas around the capital. 31. As befits a sector based largely on a system of extensive exploita- tion, a major part of the land is in relatively large holdings - more than 70 percent was in holdings of more than 500 ha in 1966, and more than 90 percent in holdings above 100 ha. Census data also reveal, however, that there is a large number of minifundia within the sector, with nearly half the farm units having less than 20 ha. These minifundia are heavily concentrated in the departments adjacent to Montevideo, particularly Montevideo, Canelones and San Jose, where about one-third of the total farm holdings of the country are located compared to less than 5 percent of the total land area. The mean farm sizes of the three departments in 1966 were 8 ha, 21 ha and 70 ha re- spectively, compared to the national average of 210 ha. As would be expected, land use in these departments is much more intensive than for the nation as a whole - 30 percent of the land is cropped, and of this 36 percent is in fruits or vegetables, compared to the national averages of 8 percent and 9 percent, respectively. 32. Data on land tenure show that about 60 percent of both total holdings and total farm area were owner-operated by share-croppers or squatters. Some security of tenure is provided by existing legislation, but this is insufficient to encourage long-term investments by tenants, and therefore results in con- siderable underutilization of resources. The 1966 census estimated the agri- cultural labor force at 192,000 persons (compared to 211,000 in 1961) of which 74 percent were members of the farm family and 26 percent were non-family laborers. Not only is overall agricultural employment both relatively small and declining, but only very few workers (50,000 in 1966) are employed as wage-earners in agriculture.  - 16 - 33. Both livestock and agricultural production in Uruguay are based largely on extensive, low-input systems of land use. Traditional management attitudes still dominate the livestock sector, with minimal investment, current expenditure, or managerial input in the ranch enterprise. Despite the con- siderable efforts made by the government over the last decade to expand re- search and technical assistance and to establish long-term credit lines, more than 90 percent of the nation's grassland area remains as unimproved natural pasture. However, the pasture improvement program extended through the Plan Agropecuario (with IBRD financing) has gained momentum in recent years and has led to significant increases in beef production since 1968. In agriculture, too, production is generally of an extensive nature on rela- tively large land units with a high degree of mechanization but with little use of fertilizer, improved seed, insecticides or other yield-rising tech- nology. As a consequence, yield levels are generally low in absolute terms and, with few exceptions, have not risen in the past 20 years. Recent Performance 34. In aggregate terms, the value of agriculture and livestock produc- tion has stagnated over the past decade. Although there have been large annual fluctuations in sectoral product, these have been around a level trend, with a slight increase after 1967. Livestock production has shown fewer fluctuations, especially over the past four years when it has remained steady at a level slightly below that of the early and mid-1960's. The value of crop production has fluctuated considerably, demonstrating the strong impact on output of weather conditions and changes in pricing and credit policies. 35. At the commodity level, there have been considerable variations in production performance, among commodities and over time. On the basis of five--year averages, production of the four major crops (wheat, maize, snm- flower and linseed) was lower in the period 1966-71 than in 1951-55. Pro- duction of several other crops has increased over the past 20 years, partic- ularly that of rice, sugar beet, sugar cane and, in recent years, grain sorghum. These crops remain relatively unimportant in terms of total land use, however, and in many cases the high growth rates have been obtained from a very low base. 36. Production performance over the past five years was heavily in- fluenced by climatic factors and by the short-term supply response to govern- ment credit and pricing policies. 37. Although the long-run changes in crop yields have been minor, yearly fluctuations have been significant. In the case of wheat and maize, annual yields appear to show positive correlation to area sown; thus compound- ing output fluctuations. However, wheat output has declined steadily since 1968 and the 1972/73 crop is estimated to be less than 200,000 tons, slightly over half the previous year's harvest. The decline in the yields can be attributed to bad weather conditions, and the decline in area sown to the Government's unfavorable pricing policy and credit shortage.  - 17 - 38. Data on beef production are rather weak, particularly concerning production for the local market that is not handled by the major slaughter- houses. It appears, however, that production since 1968 has been somewhat higher than in the first half of the decade and substantially above that of the 1950's largely as a result of the program of pasture improvement. Exports have risen sharply over the past four years, in both volume and value terms, as a function of increased production and a decline in domestic per capita consumption. There was a drop in 1971, however, because of the extremely high rate of cattle contraband in that year, and it seems that registered exports in 1972, while above the 1971 level, will be lower than the peak of 1970, in part because of continuing contraband. 39. Skin and hide production and exports are obviously linked to cattle slaughter, and recent performance has closely followed that of beef. In the case of wool, recent years have seen a decline in sheep numbers, and therefore also in the size of clip, as international price movements caused producers to shift from wool into beef production. Although world wool prices increased sharply by the end of last year, and this may result in an increase in the wool clip in 1973, long-term prospects are not good and a return to the levels of production of the early 1950's cannot be expected. In relation to milk, 1/ it appears that after a fairly rapid output expansion in the 1950's, there has been little or no increase over the past decade. The reason for this is principally the rigidity of the processing and marketing systems. Development Issues and Policies 40. Uruguay differs from most developing nations, including many of its South American neighbors, in being no longer a rural society. The great majority of the population live in towns and cities and are employed in the secondary and tertiary sectors. As a consequence, the problems of maldistri- bution of income, unemployment and underemployment have been transferred in large part to the urban environment. This does not mean that these problems do not exist in the rural areas -- they do -- but only that rural poverty occurs on a much smaller scale than is typical in developing countries. On the other hand, the primary sector, particularly livestock and agriculture, continues to be of crucial importance to the national economy. The primary objectives of a sectoral development strategy therefore are defined by the nation's economic needs, particularly in production and export growth. 41. The potential for expanding agricultural and livestock production under traditional extensive technology is extremely limited. All productive land is already utilized in the case of livestock; in agriculture, production could be expanded (at the expense of livestock) by increasing the cropped area, but the high production costs resulting from the prevailing low input- output system of exploitation exclude the possibility of exports for most 1/ Data on milk production are scarce and unreliable, particularly outside the "cuenca lechera".  - 18 - commodities and thus limits production to the slowly-growing domestic market. Both in livestock and agriculture, therefore, any long-term program of expan- sion of output will have to be based on increasing the productivity of the existing land area. There is little doubt that potential exists for such an increase. The substantial rise in livestock production obtained by improving natural grassland is already well demonstrated, and the greatly superior yields of most crops obtained by the few progressive farmers reveals the possibilities that exist in agriculture. 42. The primary objective of a sectoral development strategy, therefore, must be to formulate policy measures and an investment program that will develop productive potential in a form that exploits Uruguay's long-term competitiveness in agriculture and livestock and that it is consistent with market constraints. This will require changes in three main fields: first, the correction of sectoral policies (particularly pricing, exchange rate and credit policies) that have in the past acted as disincentives to investment and increased input use in agriculture and livestock; second, a shift in the attitude of farmers and ranchers towards managing farms as commercial enter- prises with income maximization objectives, and a committed willingness to investment and increased physical and managerial inputs; and third, an increase in productivity -- induced by fiscal and legislative measures that would make underutilization of land and stock increasingly unattractive to landowners. Expressed in terms of government action, implementation of this agricultural strategy will involve the formulation of appropriate pricing and credit policies; institutional reforms so that these policies can be implemented effectively; and the political will to legislate and administer effectively appropriate tax (IMPRONE) and land redistribution measures. In other words, effective sectoral development in the future will require new policies effi- ciently applied. Pricing Policy 43. Traditionally, pricing policy in Uruguay has been consumer-oriented. The primary objective has been to maintain retail food prices in Montevideo as low as possible, and to restrict price increases to a politically tolerable level. Exchange rate policy decisions were based on a number of factors only loosely related to the cost structure of agricultural production. Similarly, export taxes and duties were based almost exclusively on revenue considerations rather than on their impact on production. Marketing and processing channels are, for many commodities, poorly developed and producers are subjected to oligopsonistic market influences or the hazards of inefficient, underfinanced government price support operations, e.g. wheat and sugar. 44. As a result of these factors, commodity prices at producer's level have behaved in a manner that can most generously be described as erratic. The six major commodities have undergone considerable price fluctuations, and for all commodities the general price trend has been lower than that of inter- national prices. While ranch-gate prices began to increase in real terms  - 19 - from previous low levels during the 1969-71 period, the effect of these increases was in large part offset in 1971 by inadequate exchange rate policies. Domestic price indices of all the major commodities have risen less than the cost of living index, i.e., have fallen in real terms, over the past five years. There has, however, been an improvement over the last few months as a result of devaluation and the price policies of the new govern- ment, with most commodity prices rising substantially in real terms. This is particularly true for wool and beef for which producer prices in real terms in the latter part of 1972 were respectively about four times and twice the levels of a year earlier. 45. Prices have failed to act as incentives to production for a number of reasons. First, extensive measures have been taken to lag food price inflation behind general price inflation, or at least to prevent food prices leading inflation. Second, in an inflationary economy the rate at which individual commodity prices move in relation to overall cost inflation is important, and for many agricultural commodities there has been a considerable lag in price movement. This has been particularly pronounced for annual crops, where prices have been held at levels set early in the season, despite the fact that these prices may have been eroded substantially in real terms by the harvest. For those commodities in which prices are directly controlled (particularly beef), the graduated price curve invariably results in a lag in increases in real prices. Third, government policy on exchange rate and export taxes and duties has also succeeded in depressing producer prices. The over-valued exchange rate in 1970 and 1971 depressed producer prices for those commodities traded internationally (particularly beef, wool and lin- seed), and export taxes absorbed a major share (20-30 percent) of the FOB value of beef exports. Fourth, the government directly controls producer prices of a number of commodities, including wheat, sugar beet and cane and beef cattle, and both the formulation and the implementation of pricing policy for these products leaves much to be desired. The rationale behind cattle pricing in the past has been somewhat obscure -- it was neither related to world prices, nor the rate of inflation, nor changes in the cost structure. Price changes were decided largely on the basis of short-term criteria -- such as increasing the supply of cattle to the slaughterhouses in a given period, or reducing seasonal contraband -- and did not comply with any apparent long-term strategy for cattle development. As a consequence, ranchers had no basis on which to make the long-term investment decisions necessary for an expansion of the herd. This lack of confidence in government manipulation of price, tax and exchange rate policies is a major factor impeding development of this essential sector, and a similar situation exists with wheat and other crops. 46. The first priority in future agricultural development policy must be to correct existing price distortions and restore producer confidence in the price mechanism. Such changes are an essential (but not sufficient) precondition for raising future investment in agriculture. The basic objective should be to relate producer prices to world prices for these commodities which Uruguay does or could export -- primarily cattle products, wool, linseed,  - 20 - sunflower and wheat- while maintaining prices at the incentive level necessary to substitute imports of the remaining products. The present government has moved a considerable way towards this objective, and the prices for most live- stock and agricultural projects are now set at realistic levels. Particularly in the case of beef, the price changes during the latter part of 1972, which brought Uruguayan prices to within 20 percent of Brazilian prices, should encourage further the development of this sector. Nevertheless, it will require considerable determination on the part of the government to ensure that com- modity prices are changed frequently enough to keep pace with inflation and so maintain their value in real terms. If this can be done, the present pricing policy should be adequate to encourage expansion of agricultural and livestock output in the coming years. Credit Policy 47. National credit policy is also of critical importance to the develop- ment of the agricultural sector. Farmers as a group are accustomed to using institutional credit to finance production costs and the great majority (an estimated 80 percent of all farmers) utilize the rural credit lines of the state-owned Banco de la Republica Oriental del Uruguay (BROU). About half the total agricultural credit is supplied by BROU, but in fact, its importance is much greater because the so-called agricultural lending of the commercial banks is almost entirely restricted to financing of trading and does not go to farmers. The only significant source of farm credit outside the BROU is under the Plan Agropecuario financed with IBRD loans. This program is of particular importance because it is the major source of medium- and long-term financing available within agriculture, and it is, with the exception of one USAID loan, the only source of institutional credit with an interest rate subject to price adjustment. In the context of Uruguay in recent years, this means that it is the only source of institutional credit in agriculture that carries a positive interest rate. 48. Institutional credit is well developed in Uruguayan agriculture. However, the slow growth of agricultural output in recent years indicates that the impact of the credit system on sectoral development has not been commensurate with the financial resources committed. Indeed, the evidence suggests that the credit system has done little to stimulate investment or improve resource use. There are three basic reasons for this: first, the failure to tie interest rates to the rate of inflation; second, the terms of lending -- the very great majority of institutional credit is lent on short- term for production rather than development financing; and third, the institu- tional weakness of BROU, which suffers from chronic organizational and adminis- trative deficiencies. While it cannot be expected that problems of this magnitude will be solved easily or quickly, a program aimed at a fundamental restructuring of the credit system is essential to the future development of the agricultural sector.  - 21 - 49. The widespread use of unadjusted interest rates in an inflationary economy precludes the establishment of viable revolving fund credit lines and, through distortions in the cost of capital, leads to serious resource misallocations. BROU charges interest at an annual rate of 7.0 - 22.0 percent; commercial banks of 34 - 50 percent, while the rate of inflation is expected to be around 95 in 1972. Distortions as such cannot fail to have a major adverse impact on resource use, and are also the primary reason for the very heavy dependence of farmers on BROU financing for crop production costs. The existence of such cheap money deters individuals from committing their own resources, and prevents utilization of other development programs or credit lines operating under more realistic interest rate policies. Another effect has been the considerable fluctuation in real terms in the total credit avail- ability, and the need for constant budgetary commitments to maintain the supply. Clearly, any long-term stability of credit supply and allocation is not feas- ible when the financial resources are declining so rapidly in real terms. 50. The second major defect of the credit system is the strong emphasis on short-term (most commercial bank lending is for 90 or 180 days), and the consequent scarcity of longer-term development credit. In a sector heavily dependent on livestock production where the main production potential lies in long-term investment in pasture improvement, the lack of credit on suitable terms is critical. No commercial bank credit and only a small proportion of BROU funds are available on medium- or long-terms (i.e., more than one year). Existing credit lines are particularly inadequate with respect to the financing of cattle purchase, land development (as in the Instituto Nacional de Coloni- zacion settlement schemes), and land purchase (there is no source of mortgage credit for land purchase, which is a major cause of the inflexibility of land use and the weakness of the land market). If the government's targets for expansion of beef production are to be achieved, a substantial increase in the level of investment in livestock enterprises will be necessary. It is unrealistic to expect that such an increase will be forthcoming with the dis- tortions resulting from a continuation of the existing interest rate policy. 51. Because of its overwhelming importance in the field of agricultural and livestock credit, the inefficiency of the BROU is a major obstacle to rationalization of the credit system. Its poor operation is due to: the extreme diversity of its functions and responsibilities; the lack of any consistency or continuity in its lending policy; its excessive labor force and use of seniority as the principal criterion for promotion; and, as dis- cussed above, its almost complete dependence on unadjusted loans. The BROU is chronically inefficient in processing loan requests, with the result that loans consistently arrive late to the farmers. Its criteria for lending are largely financial, and the constant changing of credit lines results in "pescando formulas" by farmers rather than a rational analysis of production opportunities and credit requirements; indeed, the availability of subsidized credit from BROU is frequently the major factor determining farmers' investment and production decisions. While it is not reasonable to expect that an improve- ment in BROU's internal efficiency will be achieved easily or quickly, a drastic  - 22 - reorganization of this,important institution must be a primary objective of agricultural development policy in Uruguay. Land Development Policy 52. The need for the government to evolve a specific land development policy is brought about by three factors: first, the political climate in the country requires that at least some action should appear to be taken to reduce the size of the extremely large landholdings; second, the substantial incomes attainable from large holdings under traditional low-input systems of management deter many ranchers from making the investment and applying the managerial input necessary to raise production to a semi-intensive level; and third, the presence of tenancy in mixed agricultural-livestock regions in some cases results in inefficient land use. On the other hand, certain socio-economic characteristics of Uruguay dictate that any program of land redistribution be implemented only very gradually: first, the nation's economy relies very heavily on production from the extensive livestock sector, and future economic development will depend not only on maintaining but in- creasing rancher confidence and investment; and second, Uruguay's most serious social problems affect mainly the urban sector; thus the social impact at national level of land redistribution would consequently be rather small. 53. The government's proposed land development policy therefore is based on a gradual application of pressure on large landowners to intensify land use. Specifically, the government proposes to introduce a program of compulsory sale of parts of those large holdings on which productivity per unit area falls below the average for that region. The owner will be left with a viable holding, and payment will be made in the form of inputs for the intensification of production on this remaining area. The objective is to assure the owner of an income comparable to his existing one but from a smaller unit. The purchased land will be developed in units of about 500 ha by farmers selected for their managerial capacity and financed by a series of long-term development loans. A high level of technical assistance will be given to both the existing owner and the new one. In order to maintain rancher confidence, the program will start at only about 30,000 ha in the first year increasing to a rate of 100,000 in the third and subsequent years. It is not expected that any compulsory sale will be necessary in the first couple of years, as suf- ficient undeveloped land is already owned by INC. 54. There is a strong economic case for implementing a program along the lines proposed by the government. The importance of expanding livestock production over the next ten years demands that some action be taken to penalize ranchers who do not make the investments in intensification that are so essential from the viewpoint of the national economy. Experience to date indicates that price and credit incentives alone will not stimulate investment in the scale desired -- they must be matched by disincentives against holding land in unimproved condition. The proposed program of compulsory sale to- gether with an effectively enforced IMPROME tax (see following section) could provide such a disincentive and would be the 'stick' to complement the  - 23 - 'carrot' provided by improved pricing and credit policies. The program would have the added advantage of being politically popular (although it would receive some if not total opposition from ranchers as a group). It would also have some impact on the highly-skewed land distribution pattern, although it must be emphasized that the direct impact of the program on Uruguay's social set up would be minimal. It is also important that this program be supported by improved legislation to provide security of tenure to leasehold tenants and sharecroppers, and by the establishment of long-term credit lines to finance the purchase&of land. Tax Policy 55. The Tax policy has a major role to play in the development of the agricultural sector, granting incentives to production and to the efficient use of land. Two groups of taxes are particularly-important: the several taxes and retentions on agricultural exports, particularly beef and wool; and the progressive IMPRONE tax on land, based on farm size and productivity. At the present time, export taxes continue to be the major source of tax revenues from the agricultural sector. Although they have the advantage of being easy to collect and control, they act as a production disincentive and are therefore counter-productive from the point of view of the agricultural sector. The IMPRONE, on the other hand, is designed specifically to press on landowners for improvement in productivity. It is both economically and socially progres- sive, by penalizing inefficient farmers and by favoring small landowners over larger ones. 56. IMPROME is a progressive tax levied on presumed income estimated on the basis of a minimum "normal" production achievable from a given holding. Certain deductions are made for investments in improvement and for some export taxes ('retenciones') already paid on wool. In 1970-71, this levy on net presumed income began at 25 percent and rose in five steps to 50 percent on income in excess of Pesos 10.9 million (about US$40,000 at the then current exchange rate), which was equivalent to the presumed income from about 4,500 ha. A progressive farmer will benefit not only through being able to deduct his on-farm investments but also to the extent that all production beyond the average will be tax free. The tax will be punitive on large, unimproved hold- ings, will not touch small ranchers or small agricultural holdings, and will provide much stronger production incentives than the flat rate export taxes that it will eventually replace. Today, export taxes (retenciones) on wool and beef are applied against payments of IMPROME tax liabilities. IMPROME is, however, a difficult tax to control and implement, and progress in the four years since it was introduced has been disappointing. Collections remain at a very low level, and its incentive impact on land use so far appears to have been small. Nevertheless, INTROME does provide the necessary means for introducing the changes in tax policy needed to complement reforms in pricing and land development and it could become a potent instrument for economic and social change. The implementation of this tax, however, needs much stronger political and administrative backing than it has received in the past. The reduction of export taxes in parallel with the implementation of IMPROME is equally important, as part of the overall policy to bring producer prices for  - 24 - livestock products in line with international levels. Their use should be retained only for absorbing surpluses resulting from cyclical fluctuations in world prices or it might otherwise result in sub-optimal investment patterns. Prospects for 1973 57. The prospects for livestock output in 1973 are excellent, but the outlook for crop production is much less favorable. It is estimated that beef production and exportable surplus were higher in 1972 than in 1971, and that registered exports (exportable surplus less contraband) were about 100-105,000 tons of end product. The substantial improvement in beef and wool prices in the second half of 1972, combined with the satisfactory increase in the size of the cattle herd over the past two years indicate that beef production should approach record levels in 1973, and that wool output will at least cease to decline. These trends have been reinforced by unusually favorable climatic conditions, with a wet, mild winter and an exceptionally wet spring and early summer, both favoring good pasture growth. In addition, the successful im- plementation of a four-month veda in 1972 and the substantial increase in retail prices when beef again came on the market suggest that the reduction in domestic beef consumption can be maintained, thus increasing the surplus available for export. 58. The actual level of beef exports in 1973, however, will be linked closely to princing policy in the coming year. Produce prices for beef cattle in November, 1972, were fixed at an incentive level which both stimulated investment and discouraged contraband. Given the high rate of inflation and the frequent adjustments in the exchange rate, however,.frequent increases in cattle prices will be necessary if these incentives are to be maintained and prices are not to decline in real terms. On the assumption that the government will continue to enforce its current policy of keeping domestic cattle prices within 20 percent of those prevailing in southern Brazil, it is reasonable to expect that registered beef exports in 1973 will reach 130,000 tons (of end product). Wool export earnings in 1973 are likely to increase mainly due to a sharp rise in world prices. 59. The combination of inappropriate policies and bad weather will result in a forthcoming wheat crop substantially below even last year's very low level; it is estimated that as much as 250,000 tons may have to be im- ported. Of the other crops, linseed may show a slight gain over last year's level, but production problems will probably prevent any major increase in sunflower. Rice production and export can again be expected to increase, and if the proposed price changes are introduced for sugar beet a substantial increase in production can be expected, with a-consequent decline in the volume of sugar imports. The area planted to sorghum is likely to increase substantially, using land prepared for but not planted in wheat, and produc- tion should similarly increase provided that climatic conditions are not too unfavorable.  - 25 - Medium-Term Prospects 60. Uruguay's Agricultural Development Plan for the period 1973-77 is currently under preparation. Although proposals on policy issues and on a specific investment program have not yet been detailed, the general development strategy and production targets have been outlined in the recently-published first volume of the plan. The basic elements to the sectoral development strategy are that beef production should expand as rapidly as possible, that wool production should be held at recent levels, and that the rate of growth of crop production be dictated primarily by market constraints. In terms of quantitative production targets, this translates into growth rates of 3.2 - 4.0 percent annually for the livestock sector (low and high production targets for the period 1970-77), and 4.8 - 5.9 percent annually for crop production. Annual growth rates for specific cormmodities range from negative (wool) to 18.3 percent (poultry) in the livestock sector, and from 0.9 percent (roots and tubers) to 11.4 percent (sugar) in the agricultural sector. 61. To achieve even the lower of the production targets will require an expansion of output at a very much faster rate than the last few years (3.8 percent forecast annually compared to 1.0 percent annually over the period 1965-67 - 1969-71, and only 0.2 percent annually over the period 1961-63 - 1965-67). At first sight, therefore, it would seem that the pro- duction targets for 1977 are overly optimistic. As will be discussed in the following paragraphs, however, these targets are well within the range of technical feasibility, and indeed have been approached or exceeded in the past for many individual commodities. The major constraints to their achieve- ment are organizational and institutional, and Uruguay's long history of inability to formulate and implement development programs and introduce appro- priate policy measures warns against optimism in accepting the plan targets. Although the present government is keenly aware of both the potentials and problems of the agricultural sector - probably more so than any of its recent predecessors - and has shown in its first six months in office a willingness to deal firmly with priority pricing issues, it seems advisable to apply a coefficient of governmental and institutional inefficiency to the production targets and to reduce them accordingly. It should be repeated, however, that if the government is successful in implementing its proposed policy and in- stitutional reforms, then the plan targets are not inconsistent with either productive potential or market opportunities. The following paragraphs dis- cuss briefly the potential and key constraints in the livestock and crop sub-sectors. 62. Livestock. There is good reason to believe that Uruguay's livestock sector (specifically beef cattle production) could develop very rapidly over the next five years. Despite strongly adverse policies including exchange rate, export tax and pricing policies, output has shuwn.a- moderate growth over the past few years, Exports have also increased somewhat (when account is taken of unregistered exports to Brazil). Most importantly, the cattle herd sample survey made in July, 1972, showed that total cattle stock had risen by 8.6 percent over 1970 and by 13.6 percent over 1966. Consequently,  - 26 - the major improvement in profitability brought about by devaluation and new pricing policies in the second half of 1972 sets the stage for a substantial increase in production over the next few years. This has been assisted by very favorable climatic conditions over the past year, resulting in unusually high levels of forage production. 63. The ground work for the expansion of the livestock sector has been laid by the pasture improvement program implemented by the Plan Agropecuario, which has received financial and technical support from the IBRD. This program began slowly, starting with pasture research and then relatively small pilot operations. Since 1968, however, the level of operation has increased rapidly, and the program is currently covering about 250,000 ha of pasture annually. The sound technical and economic basis of the program, the competent technical team that has been built up, and the initiative that its strong leadership has shown in overcoming organizational and institutional obstacles, has led to the success of this program. If it can be maintained at or close to its present level of operation, sustained long-term growth of the livestock sector should be assured. 64. Although the prospects for increases in beef production are good, they could be destroyed by inappropriate sectoral policies or programs. The following three conditions are indispensable for the expansion of beef produc- tion: (a) Maintenance of producer prices at incentive levels. (b) Continuation or expansion of the pasture improvement program. (c) Further restructuring and investment in the meat processing industry. 65. In addition to these three conditions, there are a number of comple- mentary policies and programs which are also needed if maximum growth of production and export is to be achieved. These include: (a) Continuation of efforts to reduce domestic beef consumption, through the annual veda, high retail prices, and an increased supply of other meats and fish. (b) Implementation of policies to penalize ranchers who fail to improve pasture - full application of the IMPROME, and initiation of the proposed land development program. (c) Improvement in export marketing. 66. The prospects for production of other livestock products are directly related to the performance of the beef sub-sector. Wool production is likely to remain close to the present level as incremental forage is utilized primarily for beef production, and as the flock composition and management is shifted  - 27 - towards supplying lamb and mutton for the domestic market in preference to wool. Only if the present very high international wool prices should prevail for several years (which seems unlikely) would a change in this strategy need to be considered. Pork and poultry are, and will continue to be, produced for the domestic market as beef substitutes; in this context maintenance of retail pork and beef prices at the appropriate levels is the critical issue. The production targets for these commodities, therefore, do not seem unrealistic as it is not anticipated that major production problems will arise. 67. Crops. The crop production targets established in the Medium-term Plan also imply a growth rate three or four times greater than those achieved over the past decade. However, for the major commodities the projected produc- tion levels are no higher than levels achieved in the 1950's; only for certain minor crops (barley, rice, sorghum, sugar beet and cane, and some fruits) have the production targets not been approached or exceeded at any time in the past. In the field of crop production, therefore, there is clearly the physical potential to reach the 1977 targets. The major constraint to achieving such levels in recent years has been a set of sectoral policies discriminating against the producer and failing to provide incentives for production. There has been little effort to introduce yield-increasing (and cost-reducing) technology, and lower profits have led to the gradual reduction in area planted. 68. There is no reason, however, why this trend cannot be reversed, or why, with appropriate pricing and credit policies, production of the major crops should not regain its previous level. The physical potential certainly exists for expanded output of wheat, maize, linseed and sunflower, and there is considerable scope for raising yields through improved production practices and increased input use. The introduction of coordinated production programs should be able to produce a prompt impact on output. However, to assure long- term future growth in production it will be necessary to raise productivity levels through a shift in the location of crops and through the introduction of improved varieties, particularly for linseed and sunflower. Both sugar beet and sugar cane production should also respond rapidly to suitable pricing policies and supervised credit programs. Of the other crops, major increases are projected for rice, malting barley, sorghum and some fruits. Rice farmers have proved to be very progressive in recent years and have rapidly expanded output without government assistance. Nevertheless, some government involve- ment in expanding irrigation facilities and restructuring land ownership in the production areas will be necessary if recent rates of growth in output are to be maintained in the future. Malting barley production should continue to expand if new marketing channels can be opened. Sorghum production has grown very rapidly in recent years, albeit from a small base, and this should continue. Expansion of fruit production may be more difficult, as both supply and marketing problems will have to be tackled simultaneously, but again there is no reason why a well-implemented production program should not succeed in approaching the output targets. 69. As with livestock production, by far the most critical policy issue affecting the future expansion of crop production is pricing policy. If producer prices can be kept at incentive levels (which, for most crops, would  - 28 - be no higher than world prices), there is no doubt that the physical production potential to meet the apparently ambitious output targets exists. Because most crops are annual and the supply is highly price elastic, these output levels could be achieved rapidly under appropriate policies. The critical point is to ensure that prices are kept sufficiently flexible to reflect inflation, so that time lags between planting and harvest or between delivery and payment do not result in a decline in real prices to the farmer. To achieve this will require basic improvements in marketing for many crops, particularly those to which government price support programs are oriented. Similarly, it is essential that an adequate supply of short- and medium-term credit-be made available to farmers, under greatly improved conditions of administrative efficiency and supervision than currently provided by BROU. If these improvements can be made and if pricing policies are suitable, there is no reason why a full interest rate should not be charged to the farmer, in place of the heavily subsidized (and often negative) interest rates currently charged by BROU on its loans. On the other hand, relatively little physical investment will be needed in the crop sector. Only on-farm and terminal storage facilities and some small-scale irrigation infrastructure appear essential at the present time. 70. To sum up, the crop production targets should be readily achieved provided that: (a) Product prices are raised to incentive levels, and are adjusted frequently to maintain their value in real terms. (b) Marketing mechanisms are improved and delays in payment reduced for most commodities, but particularly wheat, oilseeds and dairy products. (c) The supply of short- and medium-term credit is increased and the efficiency of BROU in handling its rural credit program is substantially improved. (d) Necessary investments are made in on-farm and terminal storage and in small-scale irrigation infrastructure. Industry 71. Uruguay's manufacturing sector is relatively small for a country with a per capita product in excess of US$800. Moreover, the share of the real value added by the sector in total GDP has stagnated around 25 percent since the mid-1950s.- The nominal gains in industry's share in GDP resulted from favorable internal terms of trade. The causes of this situation are manifold and interrelated. During World War II and the Korean War, Uruguay, like Argentina and Chile, embarked on a full fledged import substitution program for industry, heavily protected by customs duties. As in the other countries this pol-icy resulted in some high cost, inefficient lines of pro- duction -- attributes which in the case of Uruguay, were magnified by the  Table 5: GROSS DOMESTIC PRODUCT BY SECTOR, 1960-78 Value Added in Millions of UR$ of 1969 Actuals Proiections _ Average Annual Growth Rates (%) As b of GDP 1960 1965 1970 1973 1975 1978 1960-65 1965-70 1970-75 1973-78 1960 1970 1978 Primary Sectors 45,654 52,134 53,946 53,449 60,322 66.555 2.7 0.7 2.3 4.5 11.4 11.6 11.3 Livestock 37,954 37,386 39,136 39,224 42,415 47,025 -0.3 0.9 1.6 3.7 9.4 8.4 8.0 Crops & Others 7,700 14,748 14,810 .14,225 17,907 19,530 13.9 0.1 3.9 6.5 2.0 3.2 3.3 Secondary Sectors 119,707 117,148 131,656 139.097 152.056 172.319 -0.4 2.4 2.9 4.4 29.8 28.3 29.1 Manufacturing 101,679 105,148 118,425 123,817 135,210 152,819 0.7 2.4 2.7 4.3 25.3 25.5 25.8 Construction 18,028 12,000 13,231 15,280 16,846 19,500 -7.8 2.0 5.0 5.0 4.5 2.8 3.3 Services Sectors 236,173 248,252 279,672 293.597 313,434 352,593 1.0 2.4\ 2.3 3.7 58.8 60.1 59.6 Basic Sectors.Y 62,344 65,890 69,539 73,647 79,656 90,080 1.1 1.1 2.7 4.1 15.5 14.9 15.2 Other Services | 173,829 182,362 210,133 219,950 233,778 26-,513 1.0 2.9 2.2 3.6 43.3 45.2 44.4 GDP at factor cost 401.534 417,534 465,274 486.143 525,812 591.467 0.8 2.2 2.5 4.0 100.0 100.0 100.0 1/ Transportation and storage; communications; electricity, gas and water; housing. 2/ Commerce, public administration and other services. Source: mission estimates.  - 30 - smallness of the domestic market. Export industry have been prevented from developing because of unrealistic exchange rate policies, which have served as disincentives to investment and production, and have affected negatively the supply of domestic inputs from the livestock sector. Moreover, the situation of industries producing for the domestic market has constantly deteriorated because of inconsistent wage and price control policies. Recent Trends 72. Production: A deliberate policy of industrialization which has supposedly been in effect for a number of years has failed to promote the development of the manufacturing sector in the last decade. On the average, value added by manufacturing has done no better than total GDP, both growing at 1.5 percent per annum. Consequently, the share of the sector in total GDP has remained constant, 25 percent as indicated above. This share com- pares unfavorably with the corresponding shares for countries at similar stages of development - about 32 percent, on the average, for countries with per capita incomes of $500-999, if major oil producers are excluded. 73. During the first half of the 1960's, manufacturing production was virtually stagnant. In 1971, after three years in which output rose about 5 percent per annum, a decline of 2 percent occurred. This decline, to a large extent, reflected the sharp slowdown in the meat-processing industry due to the low level of cattle deliveries. Output in the meat packing industry fell about 30 percent, which in itself would have accounted for a 2.5 percent decline in the overall index. The difficulties in the livestock sector were also reflected in the shoe and leather industry and in certain branches of the chemical industry which use raw materials of animal origin. Very preli- minary estimates for 1972 would indicate that industrial production might have gone back to its 1970 level. 74. The growth of the various sub-branches of manufacturing has been uneven, inducing significant changes in the manufacturing sector structure. Food products, mainly of animal origin, in which Uruguay has a comparative advantage in world markets, have grown since the mid-1960s considerably faster than the sector as a whole, increasing their share in the value of total manufacturing production between 1965 and 1970 by a whole percentage point (from 21.4 percent to 22.5 percent). In contrast, textiles, because of shortages of raw materials, both imported and domestic, reduced their share from 14.2 to 10.3 percent in the period. Other industries which have been negatively affected by the general weakness of the economy are the consumer durables industries producing for the domestic market; in particular sharp declines have been registered in the production of electrical appliances and metal industries. An exception to the latter category is the transport equipment industry, where auto assembling has grown under almost unlimited legal protection from foreign competitors. Other sub-branches which show significant growth in recent years are the fertilizers-mixing industry, which has received a strong inducement from the broad pasture improvement program the country is carrying out, the construction materials industry favorably affected by the Housing Plan, and the beverages industry where import sub- stitution appears to have continued.  - 31 - Table 6: GROWTH OF INDUSTRIAL PRODUCTION 1970 Value Average Annual Structure (%) Volume Growth (%) 1965/70 1970/71 p Food Products 22.5 3.4 -11.2 Beverages 11.1 8.9 1.4 Textiles 10.3 -4.0 -8.2 Non-metallic Mineral Products 7.8 8.1 5.8 Chemicals 6.6 5.3 10.0 Shoe and Clothing 5.0 -2.2 -5.6 Petroleum Products 4.7 -0.6 1.9 Tobacco Products 3.6 2.2 14.0 Printing 2.8 2.3 -6.4 Electrical Equipment 2.5 -6.7 7.5 Paper and Paper Products 2.3 3.0 15.3 Metallurgical Products 1.7 -8.2 2.6 Rubber Products 1.7 2.6 -9.1 All Others 17.4 4.4 100.0 2.4 -2.1 p preliminary Source: Table 8.7, Statistical Appendix, and Central Bank of Uruguay. 75. Gross fixed investment in the manufacturing sector as a whole, since the mid-60s, has been so limited that it would appear as if it has not even covered depreciation, i.e., net investment in manufacturing for the period would 'have been negative. The relatively small amounts of investment in machinery and equipment and of imports of capital goods during the period would also tend to confirm that net investment in the sector may have been negative. However, not all sub-branches of the manufacturing sector have participated in this poor performance. For example, two years after the Government changed the system of operating Frigonal (State slaughterhouse) in mid-1969, private slaughter houses had already made investments of the order of US$11 million. In the same period about 10 shoe factories were re-equipped and expanded through duty free imports financed by suppliers' credits. ANCAP has also made significant investments, in particular, for the expansion of cement production.  - 32 - 76. In the second half of the 1960s, exports of manufacturing goods have grown considerably faster than total exports, increasing their share in the total from about 62 percent in 1965 to 79 percent in 1970. The most important single items among these exports are meat, wool and hides. The share of agricultural-based industrial products exceeds 90 percent of total industrial exports, and although the degree of processing is small it has been increasing steadily. It is only recently that exports of shoes, leather clothes and other leather goods have started. However, because of the inward orientation of past development strategy the share of total manufactured exports, including meat and other processed agricultural products, is estimated not to surpass 15 percent of total manufacturing output. 77. The information on employment and productivity in the manufacturing sector at a national level is scanty and subject to a considerable margin of error. However, from the limited data available, it is possible to infer that the new employment opportunities offered by the sector have lagged behind the increase in urban labor force. By 1971, it was estimated that about 7.5 percent of the sector's labor force was unemployed. A major factor which may have deterred industrialists from hiring more labor may have been the high cost of social security and continuous labor conflicts. Table 7: MANUFACTURING EMPLOYMENT AND PRODUCTIVITY Year Employment in Manufacturing Gross Value Added Per Worker In thousand /1 thousand UR$ Index (1963=100) 1963 218 45.2 100.0 1965 226 46.5 102.9 1966 228 46.9 103.3 1967 224 45.7 101.1 1968 219 49.1 108.6 1969 222 51.2 113.3 1970 241 49.1 108.6 1971 247 47.0 104.0 /1 1963, Census; 1967, Central Bank; 1968, UN; all others are mission estimates based on information for Montevideo.  - 33 - 78. The productivity index shown above has to be interpreted with extreme caution. The sharp variations may partly be due to errors in the basic data, and to the fact that the employment figures relate to number of people employed and not to number of hours worked. If the necessary adjustment for work stoppages and absenteeism were made, the index might be substantially altered. However, there are indications that productivity may be low. A contributory factor to low productivity may be the widespread practice in Uruguay for workers to hold multiple jobs. Other contributing factor to low productivity can be found in the high ratio of administrative workers to technical workers, by international standards, for instance, in the United States in the textile industry the ratio is one office worker per 9 technical workers, while in Uruguay the relation is 1:7. The relatively small scale of the majority of Uruguay's industrial enterprises has also to affect adversely productivity per worker - in 1967 over 50 percent of the industrial workers were employed in industries of less than 20 workers. Finally, the obsolescence of industrial equipment in Uruguay must result in low productivity per worker. 79. A major problem industrial employers are faced with are the cost of contributions to social security and fringe benefits which have been esti- mated to amount to about 75 percent of cash salaries, or to 100 percent of take home wages. Whenever wage increases are decreed by the Government, all these added items increase proportionately, and often producers are unable to obtain price rises for their controlled price product which cover for whole cost increase. In addition, price rises are usually granted with a considerable lag in relation to cost increases. Employers also complain that the establishment of sickness insurance has brought up absenteeism from 8 percent to 22 percent contributing to increased cost of labor. 80. By the end of the 1960s it was estimated that excess capacity in the industrial sector amounted to almost 50 percent. However, this estimate probably did not take into account the obsolescence of much of the sector's equipment which does not really represent economic capacity, thus exaggerating the problem. The situation has somehow improved since 1969 but there are still some lines of production where excess capacity prevails, although in some cases it may only be temporary. Excess capacity exists in the flour mills, oilseed processing plants and some slaughter houses, because of a shortage of domestic inputs. Large excess capacity exists also in electrical equipment and tire industries, but in these cases obsolescence is evident. In contrast large textile mills and garment manufactures, as of mid-1972 appeared to have been operating at normal capacity, with some mills working two shifts. The petroleum refining industry was operating at full capacity. 81. As far as credit is concerned, industry has been adversely affected by the general credit squeeze from the private sector, resulting from the government's excessive use of the credit available, as a means of compensating for the poor public savings performance and from the unsatisfactory general credit pricing policy. The extent of the effects are difficult to assess. With respect to long-term credit, USAID made a US$15 million loan for capital goods imports in 1969. Only US$2.5 million of this remain uncommitted and the applications under review for the balance of the funds exceed the amount  - 34 - available. IDB in 1970 made available lines of credit to the Banco de la Republica for financing small and medium-sized industry, but the demand, at least for small industry credits, has been very low. Some foreign suppliers' credits and a small volume of subsidized pre-embarkation export credit have been available for specific industries in recent years. Issues and Policies 82. A consistent set of policies directed toward the promotion of efficient industry has never existed in Uruguay. Most of the policy decisions represent a sort of an ad-hoc patch work intended to cope with particular situations or enterprises. The fact that government measures change frequently and imply cumbersome legalistic procedures has imposed on industrial managers the task of making the rounds at the various ministries and agencies in search of special "deals", be those foreign exchange allocations, a price increase, inexpensive credit, imposition of a surcharge on a competing product, or ob- taining as large a drawback as possible in the case of potential exports. The undue time spent by managers in the negotiation of the "deal" and further in the protection of the "arrangement" almost completely withdraws them from any other managerial functions within the enterprises, the damaging effects of this situation being reflected in the productivity of the industry. 83. The wage and price policies which affect industrial production have been fairly inconsistent. (See Chapter II, paras. 25-27). The enforce- ment of price ceilings without similar action on wages has frequently dis- couraged output. Moreover, the producers' application for product-price in- crease is a lengthy and cumbersome operation. It requires extensive docu- mentation on cost increases resulting from price rises in individual inputs. Finally, when product price increases are granted, they usually come only after considerable delay and often do not take into account legitimate costs such as employee fringe benefits. 84. Policies followed to promote import substitution industries in order to save foreign exchange have also been inconsistent. On the one hand, extremely high protection has prevailed for finished products in the form of import duties, quotas and even outright prohibitions of imports. On the other hand, a continuously overvalued peso has tended to encourage imports of raw materials and intermediate products because of the favorable treatment afforded them. In this manner, high import components industries have been promoted and defeated the objective of relieving balance of payments pressures. 85. As far as export industries are concerned, the almost permanent unrealistic overvaluation of the peso, has consistently hampered their development. The damaging effect has been particularly strong on export industries which have not been favored by tax rebates and have had to pay relatively high export taxes. Moreover, since most of these traditional industries are based on livestock, foreign exchange policies have frequently deprived them of the necessary input -- livestock having been smuggled to Brazil instead of channelled to processing plants. This situation has im- proved since March 1972, as a result of the sharp devaluation of the peso,  - 35 - and the establishment of the crawling peg. The non-traditional export in- dustries have also experienced difficulties in the form of frequent policy changes. A case in point was the suspension in March 1972 of tax credit certificates (in existence since mid-1964) in conjunction with the devaluation and their reintroduction two months later. Such abrupt changes in policy give an indication of the volubility of industrial policy and explain the atmos- phere of uncertainty under which the Uruguayan industrialist has to operate. 86. In order to promote industrial development the Government recently presented a draft Industrial Development Law to Congress. Under the draft law a commission for Industrial Promotion would be created consisting of the Minister of Industry and Commerce, the Minister of Finance and Economy, and the Director of the Planning Office. The Commission would be assisted by an Advisory Committee on which the Central Bank and the proposed Development Bank would be represented in addition to the two Ministeries and the Planning Office. The Commission would have the power to declare, on its own initiative or on request, that certain industrial sectors, firms or groups of firms, or specific industrial activities are in the national interest. The decision would have to be taken in view of the development Plan(s) and considering whether the sector, firm, etc., contributes to: (i) the increase and diversi- fication of exports which have a high value added component; (ii) the decen- tralization of industrial activity; (iii) the improvement of productivity; and (iv) the promotion of training programs for the labor force; and (v) the use of untapped domestic raw materials. 87. Sectors, firms, etc., of national interest would, under the draft law, qualify for preferential lines of credit to be extended by the Development Bank and the Bank of the Republic. Credits would be made available for invest- ment, feasibility and market studies, and for the purchase of raw materials used in production for export. Some of the credits would be readjustable according to law 13728 of 1968 which established a complicated formula for the readjustment of mortgages based on changes in the wage index. 88. The Commission for Industrial Promotion would also be empowered to grant exemptions or rebates of various taxes; to determine which industries would receive special incentives to establish enterprises in Industrial Zones which would also be selected by the Commission; and to supervise the bene- ficiaries' compliance with the Industrial Development Law. 89. It is not clear, however, whether the Commission will have a permanent staff or who will be responsible for the actual implementation of the law. The fear is that decisions will be taken on an ad-hoc basis and result in a give-away of fiscal revenues if priorities and proper criteria are not estab- lished in advance. The government's intention to create a public Development Bank is discussed in another section of this report.  - 36 - Public Administration of Industry 90. In 1972 the Ministry of Works and Industry was reorganized into two ministries, the Ministry of Industry and Trade and the Ministry of Labor. Up to the reorganization, the Ministry of Works and Industry had been absorbed by labor problems and had systematically neglected industrial development. The new Ministry of Industry and Trade at this stage has no planning unit, planning functions being performed by the Planning Office in the Ministry of Economy and Finance. Moreover, under the present set up, the Ministry of Industry fails to assist either the private or public industry and not even collects or maintains any information for the sector. 91. The term "planning" in the existing context means that physical targets are set with little regard to their implication vis-a-vis net foreign exchange earnings, value added or employment. The criteria used in setting priorities, and the priorities themselves are not spelled out specifically. For instance, the concept of domestic resource cost of earning foreign exchange is not a part of the industrial planning process. 92. In order to assist the Planning Office and the Ministry of Industry, the UNDP has been supporting, since 1969, Uruguay's Productivity Center (CPU). The purpose of this Center is to serve as consultant for both private industry and for certain state enterprises. CPU provides consulting services for general management as well as selected technical services, mainly in textiles and leather. CPU undertook an assignment of its own, studying the salary structure of various industries. The UNDP is also providing funds associated with the CPU for the Analysis and Trial Laboratory, an organization which was started in 1966 with AID support. The original UNDP grant will expire in 1973 but it is likely that its support for CPU will continue. 93. A major reorganization of the Ministry of Industry is under consideration, with a view to making the agency better equipped to function as an institution concerned with the promotion of industrial development. As indicated above, at present the Ministry has no economic planning unit. However, the Planning Office has about 10-12 staff members in its industrial section, several of whom would clearly benefit from some training overseas. The government may wish to examine the possibility of either seconding some of the Planning Office staff to the Ministry of Industry or have the former do some or all of the staff work for the latter. The main problem, however, within the present framework is that public employees are so poorly paid that they hold multiple jobs and do not concentrate on one function. The Government could consider the creation of "super-grades", based strictly on competence and/or promise of such, and pay scales equivalent to private industry's for the "super-grade" personnel. Such staff could then begin to plan in a meaningful way. It could look at cost structures (available from COPRIN and DGCE) and domestic and world prices (partially available from DGCE) and thus begin to determine the country's comparative advantage by specific industries and products. The planning methodology could be transmitted either through training abroad or through resident or visiting experts. J  - 37 - Future Prospects 94. The government is in the process of preparing a Five-Year Development Plan for industry, which tentatively projects a 5 percent annual growth for industrial production and emphasizes the need for a fast rise of industrial exports, expecting the largest increases to come from "traditional" exports, primarily meat processing. The government's export projections relate to physical targets and have not been determined on the basis of their ability to, say, earn foreign exchange. Similarly, the Plan gives no justification for the overoptimistic projections of investment in the sector and the high share of its external financing. A less ambitious target based on more realistic assumptions regarding investment prospects appears to indicate a 4.5 percent per annum for the growth of the industrial sector. The total investment projected by the mission is consistent with projected potential domestic and external financing. That industrial export expansion is crucial for the development of the sector is a concern shared by the plan and the mission. The major sub-branches in which this expansion appears to be pro- mising are indicated below. 95. Assuming that an industrial promotion law is implemented and sound fiscal, exchange rate, monetary, price and incomes policies are enforced, the prospects for the development of the industrial sector are promising, in particular for agriculturally-based export industries. Moreover, some in- dustries, which would serve both the domestic and foreign markets, appear to have good prospects for development. A case in point is the fishing industry. As far as industries producing for the domestic market are concerned, if economic growth is resumed, they will be favorably affected by the strength- ening of demand. In this category, consumer durables (demand for which has been very sluggish in recent years) and petroleum products would probably register highest gains. The latter has been operating at full capacity, and ANCAP has already embarked on an expansion of its refining facilities. 96. The meat export industry can be considered the most important element in the development of the industrial sector. The increasing world demand and high prices for meat and meat products assure the necessary in- centives and markets. Some major expansion and improvement has taken place in slaughter house operations in Uruguay since the government changed in mid-1969 the system for suppLying meat to Montevideo through FRIGONAL, leaving more efficient slaughterhouses free to bid up livestock prices. However, many of the expansion and improvement programs proceeded at an excessive speed, and a serious liquidity crisis ensued for a number of slaughterhouses, which was apparently not resolved until refinancing arrangements were worked out with the Banco de la Republica. 97. At present, the rising world market prices together with the improved Government pricing and exhange rate policies make prospects for slaughterhouses margins sufficiently attractive for efficient beef processors. While slaughtering capacity is not at present a serious bottleneck to the sector, a problem could arise unless additional cold storage facilities are erected relatively soon and unless recent improvements in sanitation standards  - 38 - continue. Low levels of hygiene and sanitary conditions in the past had re- sulted in production rejection in some European markets. Conservative pro- jections of cattle availability for slaughtering in 1975 would indicate that by that time slaughtering capacity will have to be expanded through remodelling of existing facilities and probably through the erection of two additional plants in the interior of the country, a 2-shift arrangement remaining as an alternative. Further processing can easily be accomplished, for exports specially of selected cuts some of which have a high premium in world markets. 98. The Fishing industry is very underdeveloped in Uruguay although the country is considered to be in a privileged position in terms of natural resources in this field. The advantages of developing the fishing industry are two-fold in relation to foreign trade. On the one hand, domestic con- sumption of fish could be considerably increased -- at present it is less than 4 kg per capita, below the Latin American average - so as to replace beef which could be exported. On the other hand, the country should be able to produce a considerable exportable surplus which could easily find foreign markets. FAO projections for 1985 puts world demand for fish products 60 percent above its present level. However, success in this industry will re- quire that an efficient fishing fleet is put into operation and that produc- tion is established along modern enterprise lines. SOYP's role in the promo- tion of this endeavour will have to be clarified and probably confined to research and advisory functions. 99. The Wool and Wool products industry has been sluggish in recent years because of depressed wool prices in world markets. Current high wool prices provide incentives for the industry revival. An extension of the processing stages can be expected in the future. Wool or wool-mix materials of high quality can be produced for domestic consumption as well as for export. 100. Hide and Leather industries have had a very small weight in Uruguay's manufacturing. However, their importance is crucial as suppliers of domestic inputs for finished products for export. The degree of processing is a determinant of broad price-differentials. For instance, the price of cured hides is two to threefold that of untreated hides. Some easily solvable problems adversely affect the quality of Uruguay's hides, e.g. skin damage on the farms, during slaughtering and skinning processes, and through deficient conservation. In view of the recently adopted more favorable exchange policies, tax incentives for exports and a rationalization of the industry underway, the prospects for further development of this industry are promising. 101. The Uruguayan Shoe industry is composed of several hundreds of small establishments, which can be classified as cottage industries, and 15 bigger establishments which can be regarded as medium scale enterprises. These 15 larger enterprises have established a shoe producers' organization and are now increasing their exports. This represents a step in the right direction considering that the-value of export of shoes as compared with that of the tanned leather used as input is 4 to 5 times higher.  - 39 - 102. Uruguay's shoe producers have recently imported some new equipment and the shoe manufacturers' association estimates that output could be in- creased to 30 million pairs per year. Even at a substantially increased level of shoe exports, Uruguay would always be in a position of a residual supplier in the world market. Therefore, exploitation of Uruguay's potential in shoe production will depend on the ability to organize the industry, to improve the styling and quality of the product, and to further develop export channels, as Uruguayan shoe producers should be able to make a profit at present inter- national prices and with an appropriate level of government export subsidies in the form of drawbacks. 103. Other non-traditional industries which may have good export pro- spects are cheese and dairy, citrus, garments and textiles. Another possi- bility is the mechanical precision industry in which the Uruguayan skilled labor force could be made use of. 104. Among the new industries under consideration, the fishing industry appears to offer by far the greatest potential both because of the apparent ample supply of fish in the South-Atlantic and the rapidly increasing world demand for fish and fish products. Investments- in this industry may be con- sidered as of a high priority. Incentives for Export Promotion 105. The strongest incentive for the promotion of industrial exports, both.traditional and non-traditional, was undoubtedly the initial 1972 de- valuation of the peso and the subsequent establishment of the crawling peg system. Traditional exports became more profitable for producers and even some non-traditional exports, such as foot-and-mouth-disease vaccines, also became profitable and have not required additional export incentives. The government by exempting non-traditional exports from the income tax has fur- ther augmented the incentive to export. 106. Subsequent to the August-September 1972 mission, the government modified the prevailing "drawback" system and introduced new "drawback" rates to promote non-traditional exports. The determination of the "drawback" rates for individual products was based on a study of costs for enterprises considered to be representative of the industrial sub-branches. Under the system a 20 percent profit margin was allowed as compared with the previously existing margin of 12 percent. The margins for the more efficient enterprises greatly exceed the permitted 20 percent. 107. All "drawbacks", probably with the sole exception of that for combed wool, have been set as percentages of the value of exports. These percentages vary within a broad range which range from 4 percent in the case of fresh whole fish to 36 percent for bottled beer made from domestically produced barley. Clothing made from domestically produced materials has an additional adjustment to the "drawback", resulting in an effective rate of approximately 42 percent. In the case of semi-processed hides, the 12 percent "drawback" will be reduced in June 1973 to 8 percent as a means of promoting  - 40 - the domestic processing industry. "Drawbacks" for fishing industries based in Uruguay, operating with ships under foreign flags will be reduced by 50 percent as of January 1, 1974. This measure is intended to promote the ex- pansion of the Uruguayan fishing fleet. 108. The favorable effects of the new exchange rate and the "drawback" system are already visible, with many industrial exports expanding rapidly. Moreover, some industries such as the fishing industry are not being able to cope with world demand because of capacity constraints. Deficiencies in marketing organization have prevented some industries from taking advantage of the generous incentives. According to some government sources, the present level of incentives appears to be adequte for export promotion of most in- dustrial products. The government intends to reduce gradually the level of incentives to induce higher industrial efficiency. 109. To assist non-traditional exporters in their expansion and modern- ization programs, a Development Bank would be an attractive financial inter- mediary, both for the Government and for external financing. Besides pro- viding risk capital, the Development Bank would be in a position to provide technical assistance to non-traditional exporters. Such a Bank should be authorized to index both deposits and loans. However, the success of the Development Bank will depend, to a very large extent, on the Government's exchange rate and/or incentive policies and on its posture toward price controls. Transportation 110. Uruguay's flat terrain has made the development of railways and roads systems less difficult than for most Latin American countries. At present Uruguay has a rail network of about 3,000 km and a national highway density of 52 km per 1,000 sq. km, the third highest in Latin America, after Brazil and Chile. The existence of abundant surface transportation and the relatively short distances between centers of economic activity have not called for major developments of internal air transport. River transport, which has a good potential has failed to develop because of high labor costs at ports. All transport networks, radiate from Montevideo, where almost half the country's population is concentrated. In addition, the major port used for 90 percent of the external trade and the major international airport are located in Montevideo. This excessive concentration of activity around Montevideo determines the domestic transportation of goods to be for practical purposes, a one way flow from the point of production towards the capital city, thus increasing the cost of transportation across the board. 111. The Ministry of Transport, Communication and Tourism (MTCT), created in 1967, is responsible for the regulation of the road transport industry and has nominal jurisdiction over the railways, airline, and water transport, since these autonomous entities continue to function independently. The Ministry of Public Works has jurisdiction over road construction and mainte- nance. Airports operation and maintenance are entrusted to the Ministry of Defense - all airports are us,ed jointly by military and civil aircrafts.  - 41 - 112. Five-year investment plans for the transport sector are prepared by the Planning Office on the basis of investment plans of the individual sub-sectors. The Planning Office is responsible for determining priorities in the transport sector (as for the other sectors) in consideration of Govern- ment's overall development strategy. However, the Planning Office lacks expertise in this area and, therefore, has not been able to perform an adequate evaluation of transport investments. The problem is compounded further because of little or no coordination among the various sub-sectors. In particular, coordination between highways and railways, the two major modes of transport, has been completely lacking. Their independent and sometimes inconsistent pricing and investment policies in the past have resulted in mis-allocation of resources. A general transport sector review is called for, to assist the Ministry of Transport and the Planning Office in the redefinition of investment priorities and pricing policies for highways and railways. 113. Railways. The railways are owned and operated by the Administration of State Railroads (AFE), an autonomous state enterprise under the control of MTCT. The network connects capitals of all Departments to Montevideo, competing in every single line with roads and highway transportation. Significant improve- ments in the national highway network during the last ten years - combined with poor operating performance of the railroads - has resulted in a steady decline both in passengers as well as freight transported by the railways. By 1971 the average traffic density of railroads had fallen to less than 250 thousand traffic units 1/ per km. of track in operation. In many countries lines generating 500 thousand traffic units would have been discontinued for being uneconomical. 114. Since the 1950s, AFE has been running a deficit which has been financed by subsidies, from general government revenues. The situation has turned out to be so serious in recent years that although since 1966 em- ployment has been reduced by 12 percent, current revenues of AFE, at present, do not even cover the wage bill. This poor financial performance has pre- vented any major investment outlays for modernization of the railways and limited to critically inadequate levels the amounts channelled to maintenance and repair. In 1972, 60 percent of the diesel locomotives were out of commission for lack of spare parts. Major sections of the rails were in very poor condition, thus limiting the train speed; wagons were also very old and lacking in spare parts. This general deplorable situation of the railroads plus the steady decline in traffic has reinforced the financial problems. In addition, the government has failed to set adequate fares, and there are indications that the competitor trucking industry has been indirectly subsidized by the government by means of liberal credit for the purchase of trucks, and low fuel charges. 1/ A traffic unit is one ton - km of freight or one passenger - km.  - 42 - 115. The government is anxious to find some solution to the AFE's prob- lems which would ensure long-term stability, and has recently appointed a Commission to study the situation and make recommendations. Among the most urgent measures which will have to be taken are the closure of portions of the present network which are no longer economically justified, the upgrading of the remaining network, the rehabilitation of equipment and the establish- ment and permanent revision of tariffs which should reflect operating cost, except for certain routes and commodities in which a subsidy may be explicitly justified. Moreover, these tariffs will have to be determined in the con- text of an overall transportation policy which would consider competitive means of transportation. 116. Highways. Uruguay has a road network consisting of 9,740 km. designed as national highways and an estimated 40,000 km. designed as depart- mental or vicinal highways. About 45 percent of the national highways and 5 percent of the departmental highways are paved. The primary network of high- ways which constitutes the main grid is generally in good condition and is adequate for the present and projected road transport demands of the coming decade. The secondary highways, in contrast, are usually of low standard and poorly maintained rendering them impassable during the rainy season. This situation reflects the deficiencies of maintenance equipment, which is in general 30 to 40 years old, the lack of spare parts and the ineffi- ciencies of the labor force due mainly to the inability to pension off over- age personnel. 117. The financial basis for the construction and maintenance of roads is the road user tax system. The major source of road revenues is the tax on fuel. Even though there are no road revenues which are earmarked for highways, in practice, a major portion of revenues from road taxes is allo- cated to highway expenditure. These allocations are made with no economic evaluation of the implication they may have on other means of transportation, in particular the railways. The lack of planning and coordination in this sector is not confined to the allocation of fuel taxes; major deficiencies are present in project evaluation which is not done with an economic criterion but solely on the basis of engineering requirements. 118. Rail and Road Freight Transportation. Railroad freight rates since the 1950's have been determined mainly on political grounds and have lagged behind operating costs. In real terms, in 1971 revenues per ton-km of general cargo were only at 60 percent of its 1961 level, even after substantial in- crease in tariffs in 1969 and 1970. Truck transportation has also maintained for long periods of time freight rates which do not cover operating costs including depreciation. These low fares have been due to excess capacity which originated in the speculative buying of trucks between 1961 and 1963 when the Banco de la Republica granted liberal credit terms for purchase of trucks. In 1966, it was estimated that truck freight rates were only 65 per- cent of operating costs. A 40 percent increase in these rates in real terms since 1967 would indicate that by now they reflect full cost. In short, for most of the 1960s freight rates have been subsidized both by the government  - 43 - and trucking industry. Moreover, the subsidies granted by the trucking in- dustry may have induced higher government subsidies for the railroad. 119. Although truck rates for freight since the early 1960s have been increasing faster than railroad rates, trucks have been steadily increasing their share on total freight for major commodities such as cattle and wheat. From 1961 to 1972, the share of trucks in cattle freight has increased from 30 percent to about 75 percent of the total, and for wheat from 30 percent to 90 percent. The situation can be explained by considerable improvement in the road network with a simultaneous deterioration of railways services. 120. Air Transport. Carrasco, the main international airport at Montevideo, can handle most jets used by the international airlines. The passenger terminal facilities at the airport, however, are inadequate to handle the summer tourist demand. A new terminal building is planned for construction within the next five year plan to correct this deficiency. Besides Carrasco, there are 12 other airports of certain importance of which the one in Punta del Este provides service to flights to Buenos Aires during the summer tourist season. All airports are used jointly for military and civilian purposes. 121. PLUNA, the national airline, is an autonomous state enterprise whose aircraft fleet consists of 4 Vickers Viscounts and one Boeing 737/200 of which all but one aircraft were out of service, undergoing repairs, by the end of 1972. PLUNA, which provides international service between Montevideo and Buenos Aires and domestic service to a limited number of places (the air force provides some of the domestic flights), has been in- curring increasing deficits in the last five years. As there appears to be no economic justification for continuing government subsidies to PLUNA, a rationalization of its operations is needed to make it viable. Domestic service should be provided to only a few selected points at substantially increased fares, and its international operations should be limited to regional service only. 122. Water Transport. The port of Montevideo handles the bulk of export and import trade of the country, which amounted in 1971 to about 2.7 million tons, of which less than one million was dry cargo. Productivity of the port in the past has been low because of lack of proper equipment and old age of the infrastructure. A port modernization program which includes acquisition of new cargo handling equipment, dredging equipment and construction of new deep water berths is underway with financial assistance of the 1DB. Signifi- cant improvements in the port operations are expected when the program is com- pleted in 1974. 123. There are several secondary ports along the Rio de la Plata and Rio Uruguay. Even though these ports offer good potential, domestic water transport has failed to develop because of labor conflicts at ports which have frequently interrupted operations. These ports are underutilized, with traffic limited to oil imports and sand and gravel movement along the Rio Uruguay. Traffic is expected to decline further in the 'future and consideration should be given to closing some of them.  - 44 - 124. The maritime fleet of Uruguay consists of 20 vessels, of which 6 oil tankers and 3 cargo ships are used for international trade. The na- tional fleet carries about 30 percent of all imports and 25 percent of all exports of the country. The government is contemplating the acquisition of 6 cargo vessels for the national merchant marine. Considering the small volume of trade of Uruguay, it is doubtful whether the expansion of the national merchant marine would generate significant economic benefits to justify the purchase. Power 125. Power supply in Uruguay is the direct responsibility of USINAS Y TELEFONOS DEL ESTADO (UTE), an autonomous Government agency, which also operates the nation's telecommunications system. UTE now has a reliable power generating capacity of 464 MW in its main system; 236 MW are provided by two hydroelectric plants on the Rio Negro and the remainder by thermal plants in Montevideo. This total assumes adequate run-off in the Rio Negro which, however, is subject to extreme irregularity and energy rationing has been necessary in the past. Peak demand against this system in 1971 reached 444 MW, ten percent more than in 1970. Annual increases in electricity con- sumption have averaged 5.5 percent over the 1966-71 period. Considering restraints on supply experienced during this period, UTE estimates that demand can be expected to increase about twice as rapidly as the rate of economic growth in the future. Assuming the 4 percent economic growth rate projected in this report, therefore, electricity demand could be expected to reach 3,000 GWH by 1978. 126. To meet the demand and avoid power shortages in the future, the Government has to make immediate decisions since additional capacity will be already needed by 1976 and timely commissioning of an additional 125 MW steam unit can only be assured if the decision to proceed with the installa- tion of this unit is being made now. Alternative hydro-power-projects have been studied but cannot be completed in time. An international hydro-power project to be developed jointly with Argentina on the Uruguay river at Salto Grande cannot be commissioned before 1979, at the earliest. A contemplated 270 MW hydro plant on the Rio Negro (Palmar) has received much attention in Uruguay but after some delays UTE turned down as too costly a turnkey pro- posal received from the international consortium including contractors from Germany, Italy, Russia and Argentina. If Palmar were to be built on the basis of procurement in lots submitted to international competitive bidding, the earliest commissioning date would be 1978. 127. With respect to the decision which the Government and UTE have to make in 1973 concerning Palmar (with procurement based on international bidding in lots) and Salto Grande, a recent IBRD financed study by SOFRELEC concluded: (a) if construction of Salto Grande starts in 1973, UTE should opt for participation and defer construction of Palmar by at least six years, and  - 45 - (b) if the Government decides to go ahead with Palmar, it should not participate in Salto Grande before the mid-1980s. 128. UTE reached an 8.1 percent rate of return on revalued fixed assets in 1971. A 95 percent tariff increase for power and 100 percent for telephone were implemented on March 1, 1972. However, a drastic restriction in elec- tricity consumption due to low flows in the Rio Negro in the first half of the year; considerable increases in wages and salaries and the high rate of inflation are expected to offset somewhat the positive effect of the March tariff increases. The combined impact of these factors caused the rate of return on revalued fixed assets to fall short of the level projected at the time of the tariff adjustment, 20 percent. 129. The installation of the IBRD financed'sixth steam unit at the Battle plant in Montevideo is about six months behind the original 1970 time- table because of the late award of the contract; however, progress is now in accordance with the contract schedule and commissioning is expected in September 1974. The rehabilitation and extension of the Montevideo distri- bution system, also partly financed by IBED, is progressing well except for the installation of 30 KV underground cables, for which the Government has delayed the award of the contract on balance of payments grounds. Work on parts of UTE's construction program not financed by IBRD - in particular transmission projects in the western and central systems, distribution facilities in the interior, and the telephone program - has fallen far be- hind schedule mainly because of lack of foreign financing. 130. Late procurement and difficulties in obtaining financing have caused considerable delays in UTE's 1967-72 telecommunications program. This program comprises: (a) expansion of telephone exchanges, local networks, and subscribers' installations; (b) construction of long distance networks; and (c) installation of a telex system. Slightly more than half of the planned program was completed by the end of 1972. 131. In the past, the fixing of adequate power and telephone rates was the most important problem facing this sector. W4hile the new government has taken some steps to solve this problem and power rates have been adjusted to yield adequate rates of returns, there are many administrative shortcom- ings, including delays in invoicing and collecting procedures, which are affecting the cash position of the enterprise. The solution to these administrative bottlenecks together with an effective rate policy must be a first priority; otherwise UTE will not be in a position to generate enough cash to finance a significant portion of its investment program. Tourism 132. Foreign exchange earnings from tourism had been one of the dynamic elements in Uruguay's balance of payments until fairly recently, increasing from US$10 million annually in the mid-1950s to about US$40-50 million since 1964. The main source of tourists has been Argentina, although recently the number of visitors from Brazil has been increasing at a much higher rate.  - 46 - Tourism centers around the excellent beaches between Montevideo and Punta del Este, which are closer to Greater Buenos Aires--with its 11 million in- habitants-than the nearest beach resorts on the Argentine coast. At times, favorable price relationships have provided an important inducement for tourism in Uruguay. Montevideo flourishes as a tourist center when relative price favors shopping in Uruguay. The main summer resort, however, is Punta del Este, which was an exclusive summer-home location for wealthy Argentines before the automobile and before income growth made the Uruguayan coast accessible to middle-income tourists. Extra-regional tourists, mainly from the USA, visit Montevideo and Punta del Este as brief stop-overs on in- clusive tours of South America. Lack of facilities is probably the chief rea- son why Uruguay has not developed as a center for conventions or group travel. 133. The quality of hotel accommodation in Uruguay is generally poor. Most hotels are family enterprises, operated without orthodox accounting. Very little new hotel construction has been started in Uruguay in the past ten years. The almost total absence of bank credit for both working capital and investment needs has left hoteliers dependent on their own liquidity and the parallel financial market at high real interest rates. 134. Recently, an unatrractive exchange rate and terrorism caused a drop in tourist numbers. Since the authorities have been quite successful in changing the situation with respect to both the price relationships and the threat of terrorism, the number of visitors to Uruguay is expected to return to the level and trend observed in more normal years. Table 8: TOURISTS VISITING URUGUAY, 1950-70 By origin 1950 1960 1969 1970 '000 Z '000 % '000 % ''000 X Argentina 187 89 465 90 450 73 418 74 Brazil 7 3 13 3 88 14 83 15 Chile 2 1 12 2 21 3 15 2 USA 4 2 10 1 17 3 13 2 Other 10 5 19 4 45 7 39 7 TOTAL 210 100 519 100 620 100 567 100 135. The most crucial problem for the tourist sector is the brevity of the summer season. Uruguay has not explored to a significant extent solu- tions developed elsewhere for the common and acute problem of tourism sea- sonality, such as low-cost summer villages and a network of camping sites. 136. In the long term Uruguay's tourism potential is enormous. Regional tourism is booming in southern South America. Income growth, automobile production, road transport improvements, and more frequent and cheaper air travel provide an impetus to that boom. Argentina's shortage of beaches  - 47 - and warm sea for its growing population in the greater Buenos Aires area will continue to create demand for Uruguay's facilities. Ongoing construc- tion of bridges across the Uruguay river and connecting road improvements will provide easy direct road access to Uruguay's attractions for the first time. The improvement in connections with Brazil makes Uruguay an inevit- able corridor to Argentina for Brazilian traffic and it rests with local initiative to induce travellers to stay in Uruguay. In addition, develop- ments in international air travel and Uruguay's reverse climatic conditions with North America and Europe open up the possibility of international re- sorts on Uruguay's coast, quite apart from specialized travel for fishing (both river and deep sea) and hunting. 137. In the short term, however, constraints on tourism growth are: the inconvenience of road access to and from Argentina; lack of strong, efficient institutions to organize, administer and promote tourism; lack of financing and incentives for hotel improvement; the inability to extend and to create non-resort tourist attractions outside the summer season. Social Sectors 138. The educational levels attained by Uruguay are one of the highest in Latin America, with the literacy rate exceeding 90 percent and school enrollment ratios at all levels of education similar to those of industrial- ized countries. However, the educational system lacks integration at the different levels and does not encompass the country's development. Basically, the problems of Uruguay's education are not quantitative - 26 percent of the national budget in 1970 was assigned to education - but qualitative. There is a need to reorient resources to the preparation of medium level techni- cians in the various fields. Some steps have been taken in the right dir- ection within the Universidad del Trabajo, which with IDB assistance is carrying out a program for the improvement of technical education and the training of skilled labor for the basic sectors of the economy. In addi- tion, recently the Congress approved a far reaching and substantive educa- tional reform. Under the new structure, there is a reorientation of the educational and training system, with a greater emphasis on vocational and technical education. This important step should redress the past imbalance in the system where greater emphasis was given to formal education. 139. In the early 1960s, the housing situation prevailing in Uruguay was relatively good. Since those days until the end of the decade, condi- tions deteriorated significantly, mainly due to the changes in rent regula- tions, which discouraged private sector housing construction, and lack of compensatory programs within public agencies. During the period, new construction hardly replaced obsolescence. A major recovery has taken place in housing construction since the inception of the 1970s under the National Housing Plan. A 2 percent tax on payrolls was established in January 1969, and earmarked for this Plan. DINAVI (Direccion Nacional de Vivienda), the Plan's executive agency expected to have completed about 9,000 new units by the end of 1972, which would have resulted in the rehous- ing of about 1.5 percent of the population, assuming an average of 5 persons  - 48 - per house. The targets have been exceeded, because from early 1970 to mid- 1971, under the Plan, 400 had been completed, 8.900 were under construction and 11 thousand had been approved. 140. If health conditions in Uruguay are roughly measured by general and infant mortality rates, the country ranks within a narrow margin from advanced countries, and probably first in Latin America. Moreover, the low mortality rates show no significant differences between urban and rural areas, placing the country in a privileged situation within the continent, and giving an indication of the substantial efforts made by Uruguay for several decades in the past. In relation to human resources in the medical profession, the country has the second lowest ratio of population per physician, following closely Argentina. In contrast, paramedical personnel is scarce, even in Montevideo, where the number of nurses is less than 6 per 10,000 population. In terms of physical resources, Uruguay's availability of 6.1 hospital beds per 1,000 population puts the country in an advantageous position over the rest of Latin America. These very high health standards are coupled with very high nutritional standards, with both calorie and protein intakes ex- ceeding requirements. B. Investment Requirements 141. The preceding section focused on the problems confronting the key sectors of the economy, while it identified serious problems, it also painted out to substantial opportunities to overcome them and improve the performance of the Uruguayan economy. MIoreover, the expected favorable prospects of world markets for Uruguay's exports of livestock products should put the country in an advantageous position for the next few years. 142. At the time of the economic mission's visit in September, the new government was working on the preparation of an overall economic development plan and a public investment program; neither the plan nor the investment program was sufficiently advanced to permit a rigorous analysis. The gov- ernment planned to propose an economic growth rate of 5 percent for the next five years. For reasons indicated previously and below, this appeared some- what optimistic. Nevertheless, provided that sound policies are followed the mission believes that for the period 1973-78, a sustained rate of growth of approximately 4 percent is feasible. The corresponding rate for the period 1965/67-1970/72 was 2.1 percent per annum. Although a higher growth rate is possible, there are two major constraints to this endeavor, the smallness of the domestic market and the difficulties that could be encountered in the process of expansion of exportable production. However, underlying the 4 percent total growth rate target, there is an assigned increasing leading rate to the primary and secondary sectors - agriculture and livestock; value added by manufacturing could also be in- creased substantially in the processing of livestock products for export.  Table 9: AVAILABILITY AND USE OF RESOURCES Percentage of GDP/- Average Annual Rate of Growth- 1965/67 1970/72 1973/75 1976/78 1965/67-1970/72 1970/72-1973/75 1973/75-1976/78 GDP at market price 100.0 100.0 100.0 100.0 2.1 2.8 4.0 Net factor income f.a. -1.1 -1.1 -1.4 -1.2 GNP at m.p. 98.9 98.9 98.6 98.8 2.1 2.7 4.1 Exports of g. and n.f.s. 12.7 12.2 12.3 12.6 1.1 3.3 4.7 Imports of g. and n.f.s. 10.1 12.0 11.1 12.1 5.7 0.3 6.9 Resource Balance 2.6 0.2 1.2 0.5 Total Resources 97.4 99.8 98.8 99.5 6.4 2.5 4.2 Consumption 89.0 91.0 89.6 87.9 2.5 2.3 3.3 Private 74.8 74.9 75.0 73.7 2.1 2.9 3.4 General Government 14.2 16.1 14.6 14.2 4.6 -0.4 3.0 Total Gross Investment 8.3 8.8 9.2 11.6 3.4 4.3 12.3 Fixed Investment 8.4 9.1 9.2 H1.6 3.9 2.9 12.3 Private 5.9 5.1 5.0 6.3 -0.7 1.7 12.4 Public /2 2.5 4.0 4.2 5.3 12.4 4.4 12.3 Change in Stocks -0.1 -0.3 - - Gross Domestic Saving 11.0 9.0 10.4 12.1 -1.9 8.0 9.4 Gross National Saving 9.9 7.9 9.0 10.9 -2.3 7.1 10.9 Private 10.6 8.2 6.5 7.4 -3.1 -4.8 8.5 Public -0.7 -0.3 2.5 3.5 Terms of Trade Adj. 0.3 -1.2 0.9 0.4 GNY 99.2 97.7 99.5 99.2 1.7 3.4 3.9 Net current trans. from abroad 0.5 0.3 0.3 0.3 Gross National Saving (adj.) 10.7 7.0 10.2 11.6 -6.2 16.3 8.5 /1 Derived from data in constant 1969 prices. /2 These figures correspond to financial flows of the public sector and do not reflect fixed capital formation of the public sector. Source: Table 2.3, Statistical Appendix.  - 50 - 143. The period 1965-71 has been characterized by minimal rates of growth of GDP (1.7 percent per annum) and, fixed investment (3.8 percent per annum) and a high incremental capital output ratio (5.1). This last coefficient has been affected by capital obsolescence and excess capacity characteristic of a stagnant economy. However, the coefficients have not behaved evenly during the whole period 1965-71. In 1969-70, the situation improved considerably as a result of reforms in the livestock sector, successful implementation of stabilization and incomes policies, and favor- able weather conditions for crop production. The government policies reduced labor unrest and gave the private sector an incentive to increase production in livestock and manufacturing through increases in the utilization of idle capacity and replacement of obsolete equipment. As it is shown in the table below, the normative projections for 1973-78 are not unrealistic, if the appropriate government policies are devised and implemented. The rates of growth projected are significantly more modest than those observed between 1968 and 1970, and, the incremental capital-output ratio higher, although significantly more favorable than the one prior to the 1968-70 strong re- covery owing to a shift in growth strategy - from high cost import substi- tution to export expansion based on livestock and agricultural products processing - a policy upon which the government has already embarked. Average Annual Incremental Rates of Growth (Z) Capital Output Ratio Period GDP Gross Fixed Inv. 1965-71 1.7 3.8 5.1 1968-70 5.8 15.7 1.6 Projected 1973-78 4.0 12.4 2.5 144. The rates of investment 1/ in the period 1965-71 have been con- sistently low and have fluctuated around an average of 9 percent within a very narrow margin which goes from 7.8 percent in 1966 to 10 percent in 1969-70. These rates of investment appear to be inversely related to rates of inflation. For the period 1973-78, the rates of investment projected which average 10.5 percent, are expected to increase gradually, so as to recover the 1969-70 level by 1975 and attain the level of 12.4 percent in 1978. Aggregate fixed investment is also projected below the 1970 peak in 1973 and 1974, growing at an average annual rate of about 12 percent in the period 1973-78. Annual investment in housing will have to be held at approximately the 1965-71 level but investments in the goods-producing sectors, agriculture and manufacturing, having priority for the revitaliza- tion of the economy, are projected to increase substantially. 1/ Gross fixed investment to GDP derived from data in constant 1969 prices.  - 51 - 145. For Uruguay to achieve a rate of economic growth higher than 4 percent - say 5 to 6 percent per year - would require an internal savings effort which would be difficult to realize in view of Uruguay's internal political difficulties and its weak public administration. Despite the widening of the external gap which could be anticipated at this higher growth rate -- exports in the medium-term could not be expected to increase more rapidly than has been projected above - Uruguay's domestic savings would have to increase to about 20 percent of GDP if 5 to 6 percent growth were to be achieved. The higher growth rate, with no increase in imports, could only be achieved by increasing investment in projects requiring solely domestic inputs such as construction with very high capital output ratios. This would require a much higher investment and a greater marginal savings effort over the 1973-78 period than the 25 percent marginal savings rate presently projected. More importantly, however, there is no evidence of ca- pacity to absorb higher levels of internal and external investment resources than those projected for the accomplishment of the 4 percent GDP growth rate. Public Investment 146. Uruguay's constitution calls for the preparation of a five-year public sector 1/ investment,budget at the onset of each five-year presiden- tial term and for its annual updating. The last such budget was formulated in 1968 and authorized by the legislature - the 1973-77 budget was completed and submitted to Congress in September 1972. For the decentralized agencies and even for the Central Government, this budget has never served as more than a general guideline because - in the case of decentralized agencies - of the lack of any central coordination or control and - in the case of the Central and Local Governments - of the scarcity of investment financing. Moreover, poor performance with regard to project preparation reflects - inter alia - the severe lack of coordination of public sector activities in Uruguay and constitutes an important impediment to effective transfer of resources. Recently the government has taken an important step to improve the situation by giving the National Planning Office the right to review as part of the budgetary process, investment proposals of all public sector entities. The Government so far has given encouraging support to Planning Office recommendations. What is needed now is an updating of the office's capacity to analyze public sector investment programs and priorities. 147. In relation to the 1973-77 budget, the Planning Office and .the eco- nomic mission collected preliminary information on investment plans from the various entities of the public sector. The aggregation of projected invest- ment derived from the lists submitted by the entities would imply that the rate of public investment to GDP would have to increase from 4 percent in the period 1968-72 to 9.3 percent in the period 1973-77, on the assumption that GDP would grow at 5 percent per annum. These totally unrealistic 1/ The public sector is defined as including the Central Government, Local Governments, autonomous agencies and some state financial intermediates.  - 52 - intentions - in the absence of the Planning Office preliminary judgment - have obliged the mission to make very crude alternative projections which, although of a normative nature, would appear to be more consistent with Uruguay's potential and needs. 148. Total public sector investment - including investment in housing and in pasture improvement financed indirectly by transfers of public funds to the private sector - in relation to GDP increased only slightly between the periods 1967-79 and 1970-72, from 3.9 percent of GDP to 4.1 percent, respectively. However, the structure of investment between these two periods changed drastically, with the goods-producing sectors - agriculture and manufacturing - increasing their shares in total investment from 14 percent to over 20 percent, with the most dramatic change taking place in the hous- ing sector which increased its share from 1.3 percent of total investment to 15.6 percent, as the money which had accumulated from the 2 percent tax on payrolls established in January 1969 and earmarked for the Housing Plan was used for construction mainly in 1971 and 1972. A major decline for investment in electricity and telecommunications that took place between the two periods, would indicate a serious misallocation of resources, since electricity shortages may now be said to constrain the growth of economic activity. The share of the rest of the sectors taken together was approximately the same in both periods. 149. Public investment projected by the Bank's staff for the period 1973-77 is based on the assumption that sound foreign exchange, monetary and fiscal policies will be implemented by the authorities. The projections are in no way overoptimistic and the necessary changes are expected to take place smoothly. The rate of public sector investment to GDP is projected to rise from the 4 percent of the last six year period 1967-72 to 4.8 per- cent for the period 1973-78. Even this modest increase is expected to be gradual with the major effort falling in the second half of the period in which the economy is projected to be operating on a firmer basis. The pro- jections of public investment by branch assign priority to the goods-produc- ing sectors and supporting economic infrastructure. These projections were formulated having in mind the need to foster economic development and eliminate bottlenecks, such as energy shortages. The viability of domestic and foreign financing in reasonable terms were also major determinants in the allocation of investment to the various sectors (see Chapter IV).  - 53 - Table 10: PUBLIC INVESTMENT BY SECTOR OF DESTINATION, 1967-78 (In billions of 1969 UR$) Actual Projections 1967/69 1970/72 1973/75 1976/78 billion Percent billion Percent billion Percent billion Percent Sector UR$ of total UR$ of total UR$ of total UR$ of total Transport 14.3 25.8 13.0 20.3 11.1 15.3 19.0 18.4 Electricity & Telecom. 26.7 48.1 16.3 25.5 23.3 31.9 22.3 21.6 Water Supply & Urban Dev. 2.8 5.0 5.1 8.1 3.0 4.1 4.6 4.5 Housing 0.7 1.3 10.0 15.6 10.5 14.4 11.6 11.3 Education 1.0 1.8 1.8 2.8 2.0 2.7 4.6 4.5 Agriculture & Livestock 3.3 5.9 6.7 10.5 12.7 17.4 22.4 21.6 Manufacturing & Fishing Ind. 4.5 8.1 7.8 12.2 8.4 11.5 14.1 13.7 Other 2.2 4.0 3.2 5.0 1.9 2.6 4.5 4.4 TOTAL 55.4 100.0 64.0 100.0 72.9 100.0 103.1 100.0 Public Invest- ment as % of GDP 3.9 4.1 4.2 5.3 Source: Tables 5.8 and 5.14, Statistical Appendix. 150. Transportation. A major portion of the investment projected for the transportation sector is expected to be channelled to highway construction and maintenance. In the first half of the period (1973-75), about 80 percent of this investment will correspond to the completion of on-going projects for route 26, the international highway Montevideo-Porto Alegre, including works in route 9, and bridges over Rio Uruguay at Paysandu and Fray Bentos, all of which are being carried out with IDB financial assistance. The second most important component of investment in the transportation projection for the first half of the period is in the on-going project for the reconditioning of the Port of Montevideo, which is expected to be completed by 1975, and which has also received substantial financing from the IDB. In the second half of  - 54 - the period (1975-78), investment in transportation will have to concentrate primarily on improvement and maintenance of secondary roads which support the agricultural sector. Public investment for air transportation and the railroads have been projected to be modest for the whole period. These investments include replacement of some railroads equipment and the construc- tion of the Carrasco Air Terminal. No major investment for the railroads should be programmed before the overall transportation policy has been re- viewed. A proposed purchase of six ships for the merchant marine as well as investments for PLUNA have been excluded from the projections because of lack of economic justification. 151. Electricity and Telecommunications. The highest share in public investment (26 percent) for the period 1973-77 has been assigned to power and telecommunications under UTE (Usinas y Telefonos del Estado). In the first half of the period, the share is projected to be even higher (32 percent) because the construction of the 6th and 7th thermo-electric units, both with IBRD and suppliers' financing, will overlap all along the period. The inter- national hydroelectric plant at Salto Grande is not expected to start until the end of the projection period, when the 7th thermo unit will be nearing conclusion. In addition to the thermo unit, several smaller projects of connection, transmission and distribution of electricity are contemplated in the investment. Electricity development has been given first priority in the public investment projections, because with the actual generating capacity, power shortages would be expected to become critical in the short run. The projections exclude the construction of the Palmar hydroelectric plant pro- posed originally by the government, to start in 1973; on the grounds that with the completion of the 6th and 7th thermal units and the IDB approval of of the Salto Grande project, energy requirements should be met in the medium term future. 152. About one-third of investment for UTE has been projected for the national Telephone Plan for the expansion and modernization of the telephone network and installation of a telex system. A considerable proportion of this investment represents the backlog of the 1968-72 program, of which only slightly more than one-half was completed during the period. This in- vestment is expected to have some' foreign financing from the IDB and sup- pliers' credits. The projection is somehow lower than what UTE had in its original program because the Bank expects some delays which will carry part of the investment outside the projection period. 153. Water Supply and Urban Development. Public investment for 1973-75 in water supply and urban development has been projected at a lower level than the unusually high one at which it has taken place in recent years. This high level of investment in 1970-72 has been made possible by credits granted by the IDB. All on-going projects being financed with IDB assistance are expected to be completed in 1973 or early 1974. If new foreign financing is obtained in this field, it will probably not affect investment in the first half of the projection period. Moreover, as the main source of finance of municipal works are the transfers from the Central Government, and these are expected to be limited in 1973-75, no major investment outlays have been projected  - 55 - for this period. In the second half of the projection period, when most urgent needs in other sectors have been taken care of, investment in this field is projected to increase considerably. 154. Housing. DINAVI (Direccion Nacional de Vivienda), the public agency in charge of the execution of the Housing Plan, has made over-optimistic projections, on public investment in housing which would exceed on an annual basis .the high levels of investment which took place in 1971 and 1972 and which were attained by the use of cumulated funds from the 2 percent pay- roll tax established in January 1969. The Bank's projections, would appear to be more realistic and are based on two main considerations: first, the cumulated funds had been almost exhausted and second, expected invest- ment in housing will have to be limited to the annual savings of the Housing Plan. On these premises, the projections for 1973-75 and 1976-78 will ex- ceed actual investment in 1970-72 by only 5 percent and 16 percent, respec- tively. 155. Education. The main single project which is included.in the in- vestment projections is the Universidad del Trabajo which is being financed with the assistance of a US$4.5 million loan of the IDB. For the first half of the projection period, a modest increase in investment in education has been projected, but for the second half, when budgetary constraints will be less stringent, an investment two and a half times as great as actual in- vestment in 1970-72 has been projected. In this second half of the period, a considerable amount of school construction is projected to take place. This projection takes into consideration that with the recent approval of a major reform of the educational system, secondary and technical school con- struction will take place. 156. Agriculture and Livestock. Public investment in agriculture and livestock in 1970-72 doubled its level of 1967-69. The projections assume this trend to continue in the coming years, as a necessary element for the economy to attain the projected growth and export levels. This investment which largely constitutes public sector financing of private investment is projected to be channeled in a major part to the continuation and expansion of the Plan Agropecuario, with substantial IBRD assistance. The Plan is expected to include financial resources to promote the production of beef for exports, through pasture improvement, to expand the milk and pork pro- duction and to extend a program of land distribution and settlement of small holders. Additional investment is projected for the development of citrus and other fruits for exports (which may receive financial assistance from the IDB and AID), silos, seed improvement, extension equipment and animal health. 157. Manufacturing and Fishing Industry. Public investment projections for industry for the period 1973-78 imply a substantial increase from previous levels. Part of this investment is assumed to go to public enterprises and the remaining amount to represent a transfer of resources to assist the private sector. The main projects into which direct public investment is expected to be channelled are the modernization of the Alcohol Distillery, for import substitution purposes: the expansion of the Cement Plant at Paysandu, justified  - 56 - by increased domestic demand for housing construction and roads and potential exports; expansion of the Oil Refinery which at present cannot cope with domestic demand inducing substitutable imports; construction of a terminal for unloading oil tanks, the gas pipeline to the oil refinery and oil products storage. The foreign components of these investments are expected to be fi- nanced from suppliers' credits and probably from some credits from the IDB. In addition to these projects, some smaller investments in fishing industries, with good export potential are included in the projections. The purchase of an oil tanker of 125,000 tons has been excluded from the investment program since it is not entirely clear why ANCAP would want to buy a tanker when one can be chartered. 158. Other Investment. The main investment categories included in this item are health, flood control and public administration buildings. Most of these investments can be considered of second priority and these have been projected at a relatively low level for the first half of the projection period. In contrast, by the end of the period, with projected considerable improvement in the general economic conditions, investment in these fields have been set at higher levels than in the past. Private Investment 159. Since the mid-60s, annual aggregate private fixed investment has fluctuated around a low of UR$32 million (about 6 percent of GDP on the average), attaining its highest level in 1969-70, over UR$37.5 billion an- nually. Of this investment, on the average 15 percent has been financed by the public sector, mainly in the fields of agriculture and housing. Of total private fixed investment since 1965, one-half or more has been chan- nelled to housing construction except in 1969 and 1970, the years of con- siderable economic growth, in which investment in the goods producing sectors - agriculture and manufacturing - exceeded the one in housing by a considerable margin. Previously, private producers of export goods, mainly cattle-raisers and industrialists concerned with agriculture-based industries, have had little or no incentive for investment because of un- realistic exchange rate policies. The combined effect of these exchange rate policies, price controls in the domestic market and rampant inflation has often resulted in smuggled exports and capital flight. 160. That the level as well as the structure of private investment are very sensitive to government policies in relation to livestock (including beef pricing in the domestic market, export taxes, etc.), and price stability is demonstrated by the favorable reaction of this sector to the sound policies implemented in 1969 and 1970. Consequently, the success of the economy in attaining the goals projected for private investment for the period 1973-78 will almost exclusively rely on the ability of the authorities to devise and implement a set of policies which would grant the private sector incentive to increase the overall level of investment and to channel an increasing share of this investment to priority sectors, mainly agriculture and manufacturing for export markets. Some of the policies conducive to the projected goals, such as flexible exchange rates and more favorable internal beef prices, have already been introduced y the government in the course of 1972. The channelling  - 57 - of investment into agriculture and manufacturing will make some demands in terms of capital imports. In the past, higher levels of investment in the productive sectors have always been coupled by higher capital imports. 1965 1966 1967 1968 1969 1970 1971 Inv. in Agri. & Manufact. (UR$ billions, 1969 prices) 13.1 10.6 13.4 12.1 20.0 20.1 15.8 Imports of capital Goods (Constant US$ million of 1969) 37.4 23.9 41.9 35.8 55.4 48.5 41.6 However, imports of capital goods will not necessarily have to grow at the same rate as investment in the goods-producing sectors because, at least for agriculture, a considerable amount of investment is expected to take place in fertilizers and pasture improvement with a small capital goods import component. 161. Increased investment in the agriculture sector which should result in higher levels of production, would have multiple beneficial indirect ef- fects, among others: (s) higher export earnings, and thus an increase in the capacity to import the badly needed machinery and equipment for replace- ment and expansion; (b) reduction of the incentives for rural workers to move into urban centers, thus alleviating the continuous pressures on the labor market and housing facilities in the cities; (c) increased inputs for agriculture-based industries, thus helping their expansion and job genera- tion function, which should result in absorption of some urban unemployment. Investment in manufacturing is seen as being induced, to a certain extent, by agricultural expansion given that the most promising prospects are for agri- culture-based export industries, the domestic market being very narrow. This investment would be intended to expand and increase the stages of processing of food, textiles and leather industries for exports--increasing value added in the domestic economy. Although it has been estimated that 36 percent of manufacturing industries are directly based on agriculture, this percent would probably increase to as high as 50 percent if industries which are indirectly based in agriculture were included, i.e., industries which use industrial in- puts resulting from industrial processing of agricultural products, such as some chemical industries based on by-products of slaughtering. 162. The private investment projected for 1973-78 1/, 54 percent of total investment, is consistent with both past experience and projected private savings. The aggregate savings in real terms of the private sector for the 1965-71 have been estimated slightly below total national saving - the public sector savings being practically nil. Although this situation is expected to change, with the public sector contributing positively and with increasing shares to total saving, the level of private saving would suffice to finance projected private investment, as long as the trend of capital flight is stopped or reduced significantly. A certain amount of shift from private to public savings can be expected as a result of new income tax policies and the eli- mination of consumption subsidies through the adjustment to economic levels of public utility tariffs. 1/ The protection of private investment excludes that part of private in- vestment financed by the public sector.  - 58 - IV. FINANCING OF DEVELOPMENT A. Introduction 163. The fiscal and monetary imbalances which have become a part of the socio-economic fabric of Uruguay, prevent the government from implement- ing in the short-run drastic fiscal and monetary stabilization programs which would rapidly change the prevailing saving-investment pattern of the economy. This has been amply demonstrated by the short-lived boomlet of 1969-70 and the 1972 experience. Under these circumstances, the most important medium-term goals of the authorities could be a gradual stabilization and de- velopment program which would consist of the following elements: (a) the maintenance of relative prices in equilibrium while the inflation persists; (b) the implementation of policies designed to increase pro- duction and the exportable surplus; (c) a gradual improvement in domestic savings effort, and (d) an income policy that would take into account such limits as labor unrest. 164. To some extent, a mechanism to maintain relative prices in equilibrium while the inflation continues is already in operation. The foremost example being the flexible exchange rate and beef pricing policy. However, especially needed at this time is a mechanism to stimulate private savings and forestall capital flight. The government is seeking ways to achieve this by broadening the application of monetary correction and has proposed legislation for the establishment of a new development bank that would issue adjustable savings instruments. The implementation of this major financial reform should attract voluntary private savings and would constitute an important achievement in the field of monetary and development management. Also needed, however, would be the application of monetary correction to the medium and long-term loans and credits administered by the Banco de la Republica. Partially, monetary correction is applied now only to IBRD-financed livestock loans and the operations of a housing fund. Ex- tremely important too is to expand the saving capacity of the public sector, particularly the central government. This will require major in- creases in the incidence of taxes other than beef and wool export taxes, unless the authorities are willing to accelerate the exchange rate devalu- ation, and restrain to a minimum the rate of increase of public sector cur- rent expenditures over the medium term. In short, adequate financial in- centives for private savers and increased public sector savings are at the utmost priority in the immediate future since to achieve the growth objective of a 4 percent annual path in the 1973-78 period, increased levels of investment and correspondingly higher levels of savings will be required.  - 59 - 165. While the targets are modest, they would represent a turn around from recent experience. However, this should not be an impossible task since domestic savings have reached higher levels in the past. In judging the likelihood of this improved performance, it should be noted that the re- quired marginal savings rate would permit total consumption in the future to increase at the rate of about 3 percent annually. Moreover, if an appropriate and realistic exchange rate policy continues to be followed, the achievement of the domestic savings requirements would be facilitated by expected favor- able developments in external trade, as the prospects for livestock products world markets should put Uruguay in an advantageous position for the next few years. A commodity by commodity review, as examined in Chapter V, indicates that earnings from goods and non-factor services (including tour- ism) can be expected to increase at an annual average rate of 7.0 percent over the 1973-78 period. This compares favorably with the rate of about 2 percent for the period 1965-70. B. Public Sector Financing The Organization of the Public Sector 166. The public sector in Uruguay is made up of the Central Government, 10 autonomous entities, 5 social security funds, and 19 local governments. In addition, there are 2 large special programs, the Agricultural Develop- ment Plan and the National Housing Plan, whose operations are controlled by the Central Government but not incorporated in the national budget. The operations of the Central Government would represent about one-half of the total expenditures of the public sector thus defined. 167. The autonomous entities can be grouped in two categories: first, those engaged in commercial activities including the State Railways Adminis- tration (AFE), the National Petroleum, Alcohol, and Cement Administration (ANCAP), the State Power and Telephone Corporation (UTE), the State Airline (PLUNA), the National Ports Administration (ANP), the State Insurance Bank (BSE), the State Waterworks (OSE), and the Oceanographic and Fisheries Services (SOYP); and second, those which provide public services but are not operated on commercial lines, these are the National Institute for Colonization (INC) and the National Institute for Economic Housing (INVE). 168. There are two special funds whose operations are not included in the central government budget. Of these, the Agricultural Development Fund has received substantial resources in the form of credits from abroad, mainly from the IBRD, for the development of cattle production. These funds are channelled to the private sector through the Bank of the Republic. Operating expenditures are covered with budgetary transfers, which are also used to finance subsidy programs, such as that for fertilizers. 169. The National Housing Fund was created in 1968 for the implementa- tion of the National Housing Plan. The functions of planning, promoting, financing, evaluating, and controlling of the National Housing Plan are  - 60 - assigned to the National Housing Directorate, established in 1968 as a dependency of the Ministry of Public Works. The resources of the National Housing Fund derive mainly from a 2 percent payroll tax, the proceeds on the sale of special indexed bonds, and indexed savings accounts kept in the Mortgage Bank, while the implementation of the construction program is the responsibility of the National Institute for Economic Housing. 170. There are five social security funds administered directly by the Central Government; the three most important of which have been consolidated in the Social Security Bank--funds for government employees, for employees of industry and commerce, and for rural and domestic workers. Recent Central Government Financial Trends 171. Central Government financial data provide a good index of the savings capacity of the public sector as a whole, especially since operat- ing deficits of the decentralized agencies by and large, are financed by transfers from the Central Government. Since 1960, there has been a general trend of deterioration of the fiscal situation resulting from a large decline in tax revenues in real terms, which could not be fully matched by a cutback in spending. Between 1961 and 1967, revenues dropped from almost 20 percent of GDP to about 12 percent, while current expenditures dropped to only 14 percent from 19 percent in 1961. This divergence would have been even more accentuated had there not been increasing resort to export retentions taxes - up from 6.6 percent of total revenues in 1964 to about 11 percent in 1967 - made necessary by the low elasticity of other tax revenues estimated at about 0.50 for the period 1964-67. This inelasticity is the result of a number of factors: the low level of income taxation - estimated at 5 per- cent of total tax revenues in 1970; the levying of many excise taxes on specific rather than ad-valorem basis and above all, a rapid deterioration of the administrative efficiency of the tax system. 172. The inability of the Central Government to reduce its surplus per- sonnel or to resist pressures to adjust salary levels more than proportion- ally with the increases in the cost of living has been almost as important a factor as the inelasticity of the tax structure in contributing to the continuous deterioration of government finances. Personnel expenditures have averaged approximately 9 percent of GDP since 1960, with some particular exceptions such as in 1966, when personnel expenditures were held to 8.4 of GDP because of a constitutional provision prohibiting public servants salary adjustments in an election year. 173. However, the fiscal performance improved markedly in the 1967-70 period. Compared to current account deficits (after transfers) averaging about 2 percent of GDP over 1965-67, the deficit was held to less than 0.1 of GDP in 1968 and less than 1 percent of GDP as an average for the three years 1968-70. This was accomplished by virtue of considerable austerity on the expenditure side and a sharp increase in beef and wool export taxes made possible by large exchange devaluations in November 1967 (from UR$100 to UR$200) and April 1968 (to UR$250/US$). In response to  Table 11: CENTRAL GOVERNMENT CASH FLOW (as a percent of GDP) 1965 1966 1967 1968 1969 1970 1971(Pre) Current Revenues 12.1 13.6 12.0 13.1 12.3 13.8 13.6 Export Retentions 77T I2.4 .1; 2.4 1.2 0.9 0.3 Import Surcharges 0.5 1.2 0.7 0.7 o.8 1.0 0.9 Regular Taxes 10.0 10.0 9.8 10.0 10.3 11.9 12.3 Current Expenditures 15.2 13.4 14.4 13.2 13.6 13.8 17.7 Personnel 9.8 .4 9.9 8.6 10.0 9. 11.7 Wages (9.1) (7-1) (9.0) (7.4) (8.9) (8-5) (9-1) Social Security (0.7) (1-3) (0.9) (1.2) (1.0) (1.1) (2-5) Materials and Services 2.4 2.5 1.9 1.4 1.5 2.2 3.7 Transfers and Subsidies to the rest of the Public Sector 2.4 1.8 2.0 2.8 1.6 1.5 1.8 Interest on Public Debt 0.6 0.7 0.5 0.5 0.5 0.5 0.5 Current Surplus or Deficit(-) -3.2 0.2 -2.4 -0.1 -1.3 _ _ -4.1 Investments 0.5 0.9 0.7 1.2 1.3 1.3 1.3 Financing (net) 3.7 0.7 3.1 1.3 2.6 1.3 5.4 Monetary authorities 33 2. 62 0.4 Ti7 o.5 Treasury Bills -0.9 - 0.5 0.6 0.1 0.5 0.8 Treasury Bonds - - - - - - 0.2 0.8 0.5 0.1 Foreign Financing _ _ - _ _ _ 0.5 0.3 0.2 _ _ Other 1.0 -0.1 _ _ -0.6 -0.5 -0.3 -0.3 Source: Ministry of Econozmy and Finance, Central Bank of Uruguay and mission estimates.  - 62 - strong labor unrest, the government increased its wage bill by almost 50 percent in nominal terms in 1969, and with no exchange devaluation, it was forced to reduce beef and wool export taxes. Although this reduction of taxes was partially offset by improved administration of regular taxes, a deficit equal to about 1.3 percent of GDP was generated. In 1970, however, despite additional reduction in export taxes and substantial increases in purchases of materials, the Central Government held its current account more or less in equilibrium. This progress was essentially attributable to an improvement of regular tax administration and, more importantly, to a fourfold increase in petroleum product taxes. 174. A marked deterioration of the central government finances occurred in 1971. This weakening of the budget was due almost entirely to an in- crease in current expenditures. Revenues held up fairly well, despite a decline in export taxes, and total revenues rose in line with money GDP. Current expenditures, on the other hand, rose by about 60 percent or to about 18 percent of GDP. The very large increase in current expenditures largely reflected a substantial increase in wages and the increase in trans- fers to pension fund which rose from UR$6.6 billion in 1970 to UR$19.3 bil- lion in 1971. The latter made possible the reduction of a large back log of pension payments that had accumulated on account of the austerity of previous years. In total, the wage bill rose by about 53 percent in nominal term or to an unprecedented 11.7 percent of GDP. The Fiscal Performance in 1972 175. The fiscal situation continued to deteriorate in the first quarter of 1972. The deficit for the first three months of the year was estimated at Ur$17.0 billion compared with Ur$5.0 billion in the same period of 1971. During this period, expenditure rose by 58 percent and revenue by 15 per- cent in nominal terms, while consumer prices were up by 40 percent. The new government, which assumed office in March, prepared a revised budget plan for 1972 and, despite the very poor performance in the first quarter, the government appears to be likely to reduce the current account deficit to about 10 percent of current expenditures compared to 23 percent in 1971. This will represent a decline in the deficit as a percent of GDP to about 1.3 percent from the 4.1 percent of 1971. This has been possible, mainly, because of the 100 percent devaluation in March 1972, which permitted to increase the export tax on beef from nil to 29 percent of the export price and because of increases in the tax yield from petroleum products, taxes which were raised by 100 percent - ex refinery peso price. These tax in- creases halted what otherwise would have been a precipitous decline in real tax revenues.  - 63 - Table 12: CENTRAL GOVERNMENT CASH FLOW, 1971-1972 (in billions of current pesos and as percentage of GDP) 1971 1972 Jan./July Actual % GDP Jan./July Projected % GDP Revenues 55.2 103.1 13.6 86.6 159.8 12.1 Export Retentions 1.3 2.7 0.3 6.3 10.5 0.8 Import Surcharges 2.9 6.9 0.9 5.7 6.9 0.6 Regular Taxes 51.0 93.5 12.3 74.6 142.4 10.8 Current Expenditures 66.3 134.5 17.7 97.8 177.6 13.4 Personnel 44.4 88.6 11.7 65.7 121.3 9.2 Materials & Services 12.8 28.2 3.7 18.3 31.0 2.3 Subsidies 7.3 13.9 1.8 10.1 16.9 1.3 Interest 1.8 3.8 0.5 3.7 8.4 0.6 Current Surplus -11.1 -31.4 -4.1 -11.2 -17.8 -1.3 Investment 5.0 10.2 1.3 4.2 8.0 0.6 Financing (net) 16.1 41.6 5.4 15.4 25.8 1.9 Monetary authorities 13.6 36.4 4.8 16.7 27.2 2.0 Net Treasury Bills 2.4 5.9 0.8 -0.8 0.9 - Net Treasury Bonds 0.5 1.1 0.1 -0.3 - - Foreign Financing -0.4 8.0 - -0.8 -1.2 -0.5 Other -2.6 -0.3 -1.2 -0.5 Source: Ministry of Finance and Economy and mission estimates. 176. With regard to current expenditures in real terms, the new govern- ment also appears to have been successful in accomplishing a substantial reduction. This was the result of much stricter expenditure controls than in 1971 made possible through heavy non-current payments affecting debt and arrears to the Pension Funds made in 1971. In addition, since tariff rates of the state enterprises were also raised - telephone and electricity by 90 percent and water by about 75 percent - the finances of the state agencies were strengthened and transfer payments were also reduced in real terms. Finally, a 20 percent decline in real civil service wage rates is expected to contribute heavily to the estimated reduction of 23 percent in real terms of current expenditures. These developments would result in a reduction of the current expenditures ratio to GDP of nearly 18 percent in 1971 to some- what slightly above 13 percent in 1972. In addition, investment expendi- tures, primarily public works - are likely to be cut drastically below the 1971 level in real terms. Nevertheless, despite these emergency measures, the treasury position still will remain relatively weak in 1972 and the government will have to borrow heavily from the monetary authorities, al- though about 50 percent less than last year in real terms. Moreover, the heavy cut in civil servants wages and salaries are likely to generate some pressures over the 1973 budget.  - 64 - Public Savings and the Financing of Public Investments Recent Trends 177. In spite of its rather poor performance, the Central Government of Uruguay - with the exception of the 1971 disastrous performance - is by far the most important single contributor to the country's public savings. Inadequate tariff policies, expansionary employment practices, and the high cost of a subsidized welfare program explain public enterprises' failure to generate a substantial amount of resources for investment. 178. However, in recent years there has been some evidence of certain improvements and the savings of the rest of the public sector have increased from an average dissaving of 1.4 of GDP in the period 1965-67 to a saving of almost one percent of GDP in 1970. This striking performance reflects the introduction of a 2 percent payroll tax to finance the operation of the National Housing Plan, large increases in electricity and water rates and a reduction in the operating deficits of the state operated abbatoir (FRIJONAL). Table 13: PUBLIC INVESTMENTS FINANCING, 1965-72 (as a % of GDP) 1965/67 1968 1969 1970 1971 1972(Estj Public Investment /1 3.8 3.5 4.7 4.0 4.2 4.3 Public Savings -0.9 2.2 0.5 2.4 -2. -0.5 a) Central Government /2 (0.3) (2.7) (0.3) (1.5) (-2.3) (-0.1) b) Other Public Sector (-1.4) (-0.5) (0.2) (0.9) (-0.4) (-0.4) Investment-Savings Gap 4.7 1.4 4.2 1.6 6.9 4.8 Foreign Borrowing (Net) 0.2 -0.4 0.6 0.8 0.5 0.2 a) Disbursements (1.2) (0.7) (1.5) (1.5) (1.2) (1.1) b) Amortization (-1.0) (-1.1) (-0.9) (-0.7) (-0.7) (-0.9) Internal Financing (Net) 4.5 1.7 3.6 0.8 6.4 4.6 /1 Includes IBRD disbursements to the Plan Agropecuario as well as govern- ment contributions to financial intermediaries, including the Plan Agropecuario and the Housing Fund to repass to the Private sector. /2 Before transfers and subsidies. Source: Tables in Statistical Appendix. In addition, ANCAP (the state alcohol, refinery and cement enterprise) who was incurring fairly sizable deficits for a number of years up through 1967 broke this pattern and substantial surpluses were recorded. Moreover, UTE which maintained small surpluses after 1967, became the most important  - 65 - savings earner of the state enterprises by end of year 1972. This has been the result of rate increases and an administrative rationalization program. During 1971 and 1972, public agencies performance with the exception of UTE and the Housing Fund deteriorated somewhat; this was mainly because of in- creases in the wage component and a weakening of tariff policies and re- emergence of a large deficit in FRIJONAL. This deterioration was partially offset in March by the new government's increase in tariff rates; neverthe- less, action came rather late to accomplish a strong recuperation for the year. 179. The biggest problem among the public sector agencies is the State Railways (AFE) whose financial position has been extremely weak since the mid-1950s; however, as a percentage of GDP, the deficit was reduced from over one percent of GDP in 1965 to about 0.6 percent in 1968. This improve- ment reflected the strong incomes policy instituted by the Government in June 1968. Afterwards, the deficit has been maintained more or less at the same percentage of GDP. While AFE problems are characteristic of those that have traditionally confronted the public enterprises in Uruguay, they are of a complexity and dimension which surpass all others. As indicated in Chapter III, lack of modern equipment, unduly high overhead cost of unprofitable lines, and excess manpower are all problems which present difficult solutions. 180. Throughout the 1965-72 period, the Social Security Bank, to which the bulk of the workers covered by social security are affiliated, has maintained its current account more or less in balance despite declines in revenues. This has been the result of a reduction in its annuity payments. In fact, the declining revenue trend has been temporarily reversed in some years with the suspension of annual upward adjustments in its annuity payments. Financing of Public Investments after 1972 181. One of the most significant obstacles to stabilization and economic recovery in Uruguay has been the poor financial performance of the public sector. The steady deterioration of the fiscal situation has made it increasingly difficult for the government to sustain moderate rises in the level of public investment. More important, the financing by the monetary authorities of the residual public savings gap - after inflows of external credit - has brought about serious monetary repercussions and has not per- mitted to meet adequately credit demands of the commodity producing sector. For the short period 1968-70, there was some improvement of public sector finances; however, the improvement did not last. 182. Recently, Uruguay has made some progress in establishing the basis for a gradual improvement in public sector finances. An important step in this direction was the adjustment of public utility tariffs to realistic levels. In fact, tariff adjustments as high as 100 percent took place in 1972. In addition, the drastic change in the foreign exchange policy together with an increase in export taxes and a very conservative current expenditures policy halted what otherwise would have been a disastrous central government  - 66 - financial situation. Moreover, the government has sent to Congress a proposal making some changes in the tax structure and improving the administration of tax collections. The implementation of the proposed tax changes will be an important factor influencing public sector savings in the future. 183. The tax bill is a serious effort to simplify tax collection procedures and widen the tax base. The most significant changes are: (a) an integral reform of the sales and services tax system (value added tax) including wider coverage, the elimination of a 2 percent tax on gross re- ceipts which had a multiple burden "cascade effect" and gradual increases in the present applicable rates; (b) rate increases on net profits and net wealth taxes, excise taxes on tobacco, alcoholic beverages and fuels; (c) a new tax of 10 percent on the consumption of electricity; (d) the gradual elimination of the cumbersome stamp tax which had a high degree of evasion as 'well as several other small inefficient taxes; (e) substantial adminis- trative reforms of the three major tax collecting agencies, and (f) an upward adjustment on the scales and base of the minimum productivity land tax (IMPROME). 184. While the implementation of these changes would be a substantial accomplishment and tax revenues could increase drastically in 1973 - about 18 percent in real terms - permanent and continuous increases in the elas- ticity of the tax system would be difficult unless other obvious serious structural deficiencies are corrected. A significant step in this direction would be the adjustment of tax liabilities for changes in the general price level. The value added tax is payable in the form of a quota based on the previous 6 months transactions with an adjustment at the end of the year. All other taxes are assessed on a fiscal or calendar year basis, but payment is made on the second quarter of the year following the assessment. A 10 percent discount is granted with minor exceptions on payment of taxes made within the presented due date. Conversely, payments made after the stipulated date are subject to a one-time 10 percent surcharge and an additional interest charge of 2 percent per month. The introduction of monetary correction - based on general price increases - of tax payment arrears would be most effec- tive in sanctioning and eliminating tax evasion. 185. A consistent and realistic financing plan for the public sector investment program along the lines discussed in the previous chapter is presented in the following page. The sources of financing for this plan cover public sector savings, domestic borrowing and external capital inflows. The main assumptions underlying the financing plan are that: (a) the exchange rate devaluation continues to hold page with internal inflation; (b) the major public enterprises will be permitted to keep their prices in line with increasing cost; (c) the government is successful in implementing changes in tax structure and administration so that tax elasticity would be at least 1.1 after the sharp increase of 1973; and (e) there would be enforcement of strict controls of government spending which would allow current expendi- tures to expand at a rate not to exceed GDP growth rate. Assuming that GDP growth is 4 percent per annum, public sector savings could increase gradually and significantly their share in GDP, i.e., from a negative 0.5 in 1972 to  3.8 percent by 1978. This is a difficult task, but it should not be impos- sible since in 1970, public savings rose to about 2.4 percent of GDP, almost doubling the level of the previous year and almost tripling the average of the previous four years. Table 14: PUBLIC INVESTMENT FINANCING, 1969-78 (as a percent of GDP) Annual Averages Projected 1969/ 1973/ 1975/ 1972 1973 1974 1975 1976 1977 1978 71 75 78 Est. Actual Projected 1. Public Investment 4.3 4.3 5.3 4.3 4.2 4.1 4.6 5.0 5.3 5.7 2. Public Savings -0.2 2.5 3.5 -0.5 2.1 2.5 2.8 3.2 3.5 3.8 a) Central Gov't. -0.4 1.8 2.1 -0.1 1.6 1.8 1.9 2.0 2.1 2.2 b) Other Pub. Sector 0.2 0.7 1.4 -0.4 0.5 0.7 0.9 1.2 1.4 1.6 3. Invest. Sav. Gap 4.5 1.8 1.8 4.8 2.1 1.7 1.7 1.8 1.8 1.8 4. Foreign Bor- rowing (Net) 0.6 1.2 1.3 0.2 0.9 1.5 1.1 1.4 1.4 1.0 a) Disburse- ments 1.3 1.9 2.0 1.1 1.7 2.2 1.9 2.1 2.1 1.8 b) Amortiza- tion 0.7 0.8 0.7 -0.9 0.8 0.8 0.7 0.7 0.8 0.7 5. Residual Cap 3.9 0.9 0.5 4.6 1.2 0.2 0.6 0.4 0.4 0.8 Source: Tables 5.10 and 5.16, Statistical Appendix. 186. The projected financing plan for the public sector for the period 1973-78 is predicated on a much heavier reliance on public sector resource mobilization than in the recent past. However, it is consistent with the pattern that emerged after the 1967 stabilization program with public sector savings financing about 40 percent of public investments during the period 1968-70. The contribution of public sector savings to public investment is projected to increase to 50 percent in 1973 and then it would gradually rise to about 67 percent in 1978, when the absolute level of investment would be some 60 percent higher in real terms than in 1972 and the ratio of public sector savings would rise to about 3.8 percent of GDP. The residual gap (after public sector saving and external financing, is projected to be less  - 68 - than 1 percent of GDP for the period as a whole, substantially smaller than the gap experienced in 1969/71, but not unrealistic if compared to the 0.8 percent of GDP that occurred in 1970, a year in which the government made an effort to improve financial performance. This projected limited availability of credit to the public sector in addition to the large allocation of resources to the commodity producing sectors, incorporated in the public sector invest- ment program, must be considered in the light of the government plans to grant high priority to increased production and exports of agricultural and live- stock products. 187. With public sector savings and internal borrowing behaving in the manner projected above, external capital inflow in the amount of Ur$178.9 billion 1/ would be needed to fill the public sector savings-investment gap for the period 1973-78. Of this total, about Ur$34.3 billion 1/, or 19 per- cent, can be covered by drawing on loans in the pipeline. What essentially emerges is that external lenders will finance only the foreign exchange com- ponent of the "projects" roughly 40 percent of the public investment program. 188. This financing plan should be regarded as being optimistic since it assumes - inter alia - a substantial improvement in the efficiency of the Central Government tax administration, a maintenance of proper tariff rates, and a strong government effort in reducing the deficits of some of the agencies to manageable proportions. Developments with regard to all these factors will be crucially important, but the effort could prove to be poli- tically very difficult. C. Private Savings and Monetary Management Structure of the Financial System 189. In Uruguay, the operations of the banking system are controlled by the Central Bank which - in 1967 - replaced the Bank of the Republic (BROU) as the nation's bank of issue. The Bank of the Republic had consisted of two departments, the Issue Department and the Banking Department; the latter being both the nation's largest commercial bank and the fiscal agent of the public sector. Since 1967, the Central Bank has taken over additional regulatory functions from the BROU, such as the handling of most official ex- change transactions and the custody of commercial banks reserve deposits. The BROU not only remains the depository of public sector funds, but it is also free of reserve requirements and other credit controls. Thus, for purposes of this analysis, the Central Bank and the BROU are taken together as the nation's monetary authority. 190. The private banking sector consists of 2 small savings banks and 28 commercial banks, including 8 foreign commercial banks. The number of 1/ At 1972 prices and an exchange rate of Ur$600 per US dollar.  - 69 - private banks has declined steadily in the past nine years. In 1963, there were 81 banks with 590 branches, but the number of banks was reduced to 67 in 1966, following the banking crisis of 1965. Since its establishment in 1967, the Central Bank has encouraged bank mergers and the reduction of branches. Of the 30 private banks remaining in 1971, five were being inter- vened by the Central Bank or the Bank of the Republic. Although the number of banks declined drastically over the years, the number of bank employees did not decrease proportionately because of labor policies which require for employees of a bank which ceases operations to be redistributed among the remaining banks. The total number of banks has declined since 1963 by about 50 percent, while the number of bank branches and staff have only declined by about 30 percent. Apart from the private commercial banks and the stock exchange, all major financial institutions in Uruguay are in state hands, including the Mortgage Bank, the National Housing Fund, the National Postal Savings Bank, the State Insurance Bank, and the Social Security Bank. Finance companies (financieras) are prohibitied. Data for the banking system given below refer to the operations of the monetary authorities and the private commercial banks, as the information for the other financial institutions is not available on a current basis. Nevertheless, the mission made some estimates of their current and investment operations and they are included under the section on public sector analysis. The main activity of the stock exchange consists of transactions in Treasury obligations (in Uruguayan pesos and foreign currencies) and mortgage bonds, rather than in shares. The shares of about 50 companies are listed, but trading is very inactive. At one time, private companies raised a significant amount of their financial resources from equity issues (an estimated 16 percent in 1960), but this is no longer the case. 191. Outside the recognized financial institutions, during the 1960s an important financial market, the parallel lending market (parabancario), developed. A study prepared by the Institute of Economics of the University of the Republic estimated that the volume of lending in the parallel market in 1970 was equivalent to about one-third of bank deposits in that year. In this market public notaries brought together private individuals and companies through the financial instrument of promissory notes with maturities of up to two or three years and annual interest rates which varied in the late 1960s and in 1970 from 40 percent to 60 percent. Some parallel market lend- ing was done even without the help of a notary public, as large companies could obtain loans directly from customers, employees, and the general public. Mainly because of the severe competition to commercial banks and other recognized financial institutions, several measures were taken late in 1970 to discourage parabancario lending. A decree was enacted in November 1970 prohibiting new short-term loans of Ur$100,000 or more for less than three years outside the banking system. Secondly, in order to try to pre- vent the funds previously lent in the parallel market from moving into foreign exchange, the monetary authorities imposed a moratorium on repayments of parallel market debts, offering to refinance such debt through the Bank of the Republic at a 24 percent borrower's interest rate with delayed re- imbursement to parallel market lenders. The actual volume of refinancing under this scheme, however, turned out to be quite small. Thirdly, facilities  - 70 - were established in the Mortgage Bank to bring together lenders and borrowers. In these cases, the Mortgage Bank merely registers the transaction, which usually is made with real estate as collateral, and charges 2 percent for its services. Recent Trends 192. The evolution of the financial markets of Uruguay over the past years presents a picture which is particularly unique among the countries of Latin America. As the following table shows, inflation has been accompanied by a substantial decline in total liquidity: Table 15: CONSOLIDATED BANKING SYSTEM (Year end values expressed as percentages of GDP) Net Foreign Reserves Net Domestic Credit Money Supply Total Public!-Private Other Currency Deposits Total Sight Time Foreign 1964 -1.7 33.3 3.8 34.7 -5.2 9.4 5.0 12.1 5.0 31.6 1965 -8.2 39.0 4.2 26.0 8.0 11.6 6.2 9.1 3.9 30.8 1966 -3.7 25.2 3.5 18.4 3.3 9.3 3.8 5.6 2.8 21.5 1967 -5.3 32.1 5.5 17.8 8.8 10.8 5.8 5.0 3.4 25.0 1968 -1.6 19.0 1.9 11.5 5.6 8.5 3.9 3.7 2.0 18.1 1969 -0.3 19.9 3.1 11.6 5.2 10.1 3.8 4.0 1.7 19.6 1970 -1.8 21.1 2.5 13.7 4.9 9.5 3.5 5.1 1.3 19.4 1971 -2.6 26.2 7.1 16.1 3.0 11.1 4.9 6.2 1.4 23.5 /1 Includes credit to official banks. Source: Central Bank of Uruguay. This decline in the liquidity coefficient represents continuation of a trend which began with the acceleration of inflation in Urugtiay. Although expand- ing rapidly in nominal terms - and occasionally constituting a leading factor in the inflationary process - the money supply simply failed to keep up with the rate of inflation. In more recent years, loss of confidence in the peso made the public unwilling to hold peso claims against the banks so that, while currency in circulation as a percent of CDP has maintained more or less its relative share stable, peso sight and time deposits have declined from 17 percent of GDP to about 11 percent in 1971. In some years this relationship has fallen below 8 percent. At the same time, foreign cutrency deposits have also declined from 5 percent in 1964 to somewhat above 1 percent in 1971. 193. The monetary authorities since the early 1960s, sought to implement a conservative policy which assumed that any increase in domestic credit in excess of the targetted rate of increase in money GDP would induce inflation and capital flight. However, since this policy was not accompanied by fis- cal restrian and a strong incomes policy, its main impact has been a decline  -71- in the supply of credit to the private sector and as well as in the opera- tions of the commercial banks. Outstanding private sector credit dropped from 34.7 percent of GDP at the end of 1964 to 11.5 percent in 1969. How- ever, as a result of a relaxation of this rigid monetary policy which was mainly enforced by establishing ceilings on commercial banks portfolios, private sector credit as a percent of GDP increased to about 14.0 percent in 1970 and overall liquidity increased somewhat. This monetary and credit expansion did not exert heavy pressures on the price level. This was probably attributable to the facts that the economy needed additional liquidity because of very rapid economic expansion in 1969 and 1970, effective price controls, substantial increase in imports and a sharp reduction of public sector credit in 1970. The rate of expansion of credit to the private sector accelerated during 1971, but, unfortunately, it was accompanied by a sharp increase of credit to the public sector as well. One half of total new bank credit in 1971 went to the Treasury. This contrasted very sharply with the 1968-70 period when the expansion of credit to the Treasury represented less than 20 percent of total credit expansion. This large expansion of credit to both the private and the public sector during 1971 resulted in a massive deter- ioration in Uruguay's net foreign reserves and.a substantial increase in short-term indebtness, since the Government's exchange and interest rate policies failed to induce private savers to increase their claims against the banking system. 194. The short-run financial program that the new Government adopted in March 1972 included a monetary budget that provided for a substantial slowdown in the rate of credit and money supply expansion. Surprisingly, in view of a much faster rate of price increases than originally anticipated expansion of the monetary authorities credit was not significantly in excess of the established target for end September. However, this appears to have caused a severe liquidity problem for the commodity producing sectors; the stock of credit provided by the authorities to these sectors declined by about 20 percent in real terms during the first eight months of 1972. Table 16: SUMMARY ACCOUNTS OF THE MfONETARY AUTHORITIES (In billions of Uruguayan Pesos) 1972 (Actual). 1972 Programmed Dec. 1971 March June Aug. Sept. Dec. Net Foreign Assets -21.6 -28.7 -46.9 -43.6 -28.7 -25.2 Net Domestic Assets 118.1 130.8 148.7 147.6 - 145.5 15ts.0 To Public Sector 53.4 62.7 66.3 67.2 To Official Bank -3.5 -6.9 -8.6 -8.0 To Private Banks 5.5 -0.5 - -0.1 To Private Sector 67.7 75.3 78.1 83.6 To Other -5.0 0.2 12.9 4.9 Money Supply 96.5 102.1 101.8 104.0 116.8 132.8 Currency in Circulation 88.8 93.1 91.5 93.3 - - Demand Deposits 7.7 9.0 10.3 10.7 Source: Central Bank of Uruguay.  - 72 - Monetary Management and the Capital Market 195. In principle, since 1967 - when the Central Bank was created - Uruguay's monetary authorities have developed a series of instruments to con- trol the direction and levels of bank credit; these include overall credit ceilings, reserve requirement and marginal reserve requirements. In practice, however, all these arrays of monetary instruments have been very weak partly because of the general inefficiency of the Uruguayan banking system and the threat of a banking crisis which has hindered the Central Bank in enforcing strong policies. In addition, there has been extreme variation in the cost of officially funded as opposed to privately funded credit. As the depository of public sector funds, the Banco de la Republica, has been able to afford to lend at negative real interest rates. At the same time by es- tablishing ceilings on interest rates paid on bank deposits and on some bank loans, the Commercial banks have been allowed ample margins between their lending interest rates and their deposit rates, thus condoning their opera- tional inefficiency. Annual rates on savings deposits range from 8 percent to 25 percent. In contrast, the Banco de la Republica subsidized lending interest rates range from 7 to 22 percent while those of the commercial banks range between 34 and 50 percent annually. The net result of these policies has been a failure to improve the savings performance of the private sector, since these rates have been well below the level which could be set by the market. Moreover, there is no evident correlation between these enormous variations in credit cost and national economic priorities. 196. At this time currency constitutes the bulk of monetary liabilities of Uruguay's banking system, as of end of March 1972, deposits amounted to only 49 percent of currency in circulation; deposits in commercial banks to only 26 percent of total monetary liabilities. Savings captured by the banking system - by the commercial banks, in particular, do not constitute a signifi- cant source of credit finance. Prior to 1971, the parallel credit market provided the bulk of the credit made available to the private industrial sector. However, the suppliers of funds to this market demanded lenders' interest rate commensurate with their anticipation as to the instability of the peso and the cost of credit to the borrowers was so great as to obstruct both stablization and development. Despite the Government's attempt to regu- late this market at the end of 1970 (see para. 191), the exchange crisis of that year caused these savers to withdraw their assets from the parallel credit market and to buy dollars. 197. What is now urgently needed is to replace the parallel credit mar- ket - particularly after the flexible exchange rate policy has been firmly established - by a mechanism which would equate the return on savings with movements of other prices in the economy. This would reduce the incentive to transfer funds abroad and would provide domestic financial assets with a rea- sonable rate of return in real terms. 198. The Government currently has under consideration various measures to increase the rate of return to private savers in Uruguay. One of the most important is the creation of, a public Development Bank for which draft law has been sent to Congress. The main purpose of this institution would be  - 73 - "to obtain and channel the resources needed for the medium-and long-term fi- nancing of national economic development in the priority sectors". A signifi- cant feature of the Development Bank would be the right to issue readjustable instruments denominated in national currency. Loans from the Development Bank would be also readjustable, thus the principle of monetary correction would be extended beyond the Livestock sector (IBRD loans channelled through the Livestock Fund), some AID funds and some of the Housing Fund loans. 199. Monetary correction of commercial bank deposits at this time probably is no answer; commercial banks are extremely inefficient and their intermedia- tion of savings captured in this fashion - unless they are restructured and reformed - would result in excessive borrowers' interest rates. Moreover, while it is easy to have readjustable contracts for savings deposits, time dcpusits, 1iurtgages, long - and medium-term loans and so forth, it is very difficult to organize the short-term credit market on a readjustable basis. On the other hand, it is quite feasible to encourage and perhaps induce the Banco de la Republica to charge interest rates on short-term loans that come closer to the market value, instead of rationing the available short-term credit among borrowers. A needed complementary reform would be the applica- tion of monetary correction to all the medium- and long-term loans adminis- tered by the Banco de la Republica. Monetary corrections of instruments to be sold by, at present, non-existent private finance companies probably would be another appropriate solution. Conclusions 200. In the past the authorities have used monetary policy only as a nar- row tool to staunch excess demand by reducing the stock of private sector credit in relation to GDP. However, in order to recover from the low activity level of the 1960s, the commodity producing sectors will apparently require real increases in the supply of bank credit or more than proportionate to in- creases in GDP. This could not be accompanied by only equal reductions in credit to the public sector. What is needed is a mechanism to increase private claims against the banking system in order to capture excess liquidity obtained in the secondary system and minimize the need for currency emission and stop capital flight. If the Government succeeds in implementing the application of monetary correction to fixed income instruments, Uruguayan savers should no longer be motivated to engage in capital flight and the public may display a willingness to increase in real terms its claims against the banking system, particularly, in the form of savings deposits. In addition, the application of monetary correction to loans will alleviate the distortions in other prices, i.e., the exchange rate. These two basic reforms - readjustable savings in- struments and monetary correction of loans - will go a long way in mobilizing private savings in the short- and medium-run. However, over the long-run the Government should make an effort to restructure the entire financial system in order to rationalize the existing maize of regulations and institutions. Working toward this objective, the authorities have sent to Congress a general law restructuring the official financial system. Also needed, however, is a restructuring and modernization of the commercial banking system and the estab- lishment of private medium-term financial intermediaries (financieras) with the authority to issue and lend instruments with monetary correction.  - 74 - 201. In short, the Government should recognize that under the present poli- tical social balance a drastic fiscal reform and a major turn around in expendi- ture policy is not possible at least in the near future. This means that Uruguay may have to continue to live with a certain degree of inflation. Under these circumstances, changes are required in monetary policy which are usually considered of a domestic nature but which also have a significant impact on the balance of payments. The main theme of these changes is 'treadjustability" of financial instruments. These changes are necessary: (a) to hedge against the possibility that the stabilization program might not work as well as tar- getted by the authorities; (b) to enhance the incentive to save and improve the capacity of the banking system to mobilize resources; and (c) last but not least because the flows in the capital account of the balance of payments are real interest sensitive funds, so that changes in the exchange rate by themselves will not bring about an overall improvement in international transactions.  - 75 - V. BALANCE OF PAYMENTS AND CREDITWORTHINESS A. Recent Trends 202. The behavior of the balance of payments of Uruguay on the receipts side has been mainly determined by the following factors: (a) world market prices for livestock products (wool, meat, hides); (b) official exchange rate policies; (c) tax policies on exports; (d) relative prices of meat in Brazil and in Uruguay. Moreover, the diverse movements in world prices for the sev- eral livestock products induced a drastic change in the structure of this cate- gory of exports -- low world prices for wool have led to a shift in production and exports away from wool and into beef. Failure of the authorities to adjust the exchange rate within reasonable time periods to realistic levels, adequately reflecting internal price and cost increases acted as a disincentive to exports of meat and fostered cattle smuggling. High export taxes have had the same detrimental effect as peso overvaluation and in periods in which both prevailed, smuggling attained critical levels. The effects of price differentials for meat in Uruguay and Brazil on Uruguay's balance of payments were discussed in detail in Chapter III. 203. The behavior of the balance of payments on the expenditures side has been in large measure influenced by the deeply entrenched and persistent im- port substitution policies of the past two decades. These policies managed to reduce imports of consumer goods and even to promote some exports of manu- factures, but they were also responsible for rapidly increasing imports of intermediate goods which have virtually mortgaged export earnings. Although difficult to measure with precision, it does not appear that import-substitu- tion policies have resulted in any substantial saving of foreign exchange. 204. The erratic behavior of export earnings and the built-in regities in the import bill have generated continuous weakness in the current account of the balance of payments. The resulting tight foreign exchange position was further accentuated by inappropriate fiscal, monetary and interest rate policies which were responsible for large remittances of private capital abroad with their adverse effects on the capital account of the balance of payments. 205. Uruguay's balance of payments experienced sharp fluctuations in the past decade. Both the trade balance and the current account registered small surpluses, while the overall balance of payments was in deficit. The periodic balance of payments crises drained foreign exchange reserves and re- sulted in the accumulation of short- and medium-term debt. Between 1965 and 1971, the net foreign exchange reserves of the banking system declined by about US$72 million. It is believed that the most important element in these de- clines was capital flight which reached about US$90 million in 1965, and US$70 million in 1971 and early 1972. In order to cover the import needs to sustain even the low levels of economic activity, the authorities were forced to resort to borrowing on unfavorable terms. This was particularly true in 1965 and 1971, when the monetary authorities accumulated substantial volumes of commer- cial arrears which had to be consolidated and repayments extended over five to seven years.  - 76 - Table 17: SUMMARY BALANCE OF PAYMENTS, 1965-1972 (US$ Millions) Average 1965/70 1970 1971 1972 Exports (incl. NFC) 249.7 280.5 252.6 257.0 Imports (incl. NFC) -214.3 -286.5 -302.9 -265.0 Resource Balance 35.4 -6.0 -50.3 -8.0 Net Factor Payments -21.6 -22.0 -21.6 -25.0 (Interest on M&LT Public Debt) (-10.1) (-13.4) (-12.6) (-13.2) Net Transfer 7.4 5.2 8.3 8.0 CURRENT ACOOUNT BALANCE 21.2 -22.8 -63.8 -25.0 Grants & Grant-Like 2.4 3.2 2.7 3.8 Public Loans, Medium & Long-Term 12.5 4.7 10.4 29.0 Disbursements 42.3 43.6 53.8 91.5/1 Amortization 29.8 -38.9 -43.4 -62.5 Short-Term Credit (net) 1.2 - 38.3 -1.3 Capital Transactions n.i.e. -47.2 -44.6 -20.3 -29.8 IMF Special Drawing Rights 1.5 9.2 7.4 7.3 Change in Resources (-3increase) 8.9 50.3 25.1 16.0 /1 Includes US$47 million rescheduled commercial arrears. p Preliminary Source: Table 3.1, Statistical Appendix. 206. Surpluses on trade account helped Uruguay repay rapidly the rescheduled commercial arrears and financial credits from private foreign banks accumulated during the mid-1960s as the result of accelerating inflation, delays in exchange rate adjustment, internal financial crises and substantial capital flight. The net outflow of private capital continued despite an intensification of controls over foreign exchange sales. 207. The more realistic exchange rate and appropriate export tax policies were the principal factors responsible for a reduction in the balance of payments deficit in 1972. However, the full year result for 1972 marks the progress made after the first quarter of the year. In the first quarter merchandise exports were 57 percent below those of the corresponding quarter of 1971, while for the year as a whole merchandise exports are estimated to have increased by about two percent. It should be noted, however, that a depressed import demand, an unexpected drastic increase in wool prices and the continuous rise in world meat prices were also factors which affected favorable balance of payments results in 1972.  - 77 - Exports 208. Exports have fluctuated widely over thie years as a result of climatic conditions and price variations. However, even at the recent peak level of US$224 million, they were still below the 1950-54 average of US$245 million. Moreover, the 1969-71 average of US$207 million, was just about equal the 1955-59 level of US$160 million if account is taken of the depreciation of the U.S. dollar. Some restructuring of the main export commodity categories has occurred over the past two decades, particularly in the case of wool and beef, as previously mentioned. 209. In 1971 and 1972 Uruguay suffered balance of payments deficits of US$25 and US$16 million, respectively. The worsening of the balance of payments started in 1970 despite a 12 percent rise in exports resulting largely from higher prices and greater volumes of beef exports. Merchandise imports in that year rose by 16 percent. This rise in imports, together with lower receipts from tourism which were mainly caused by terrorism in the major summer resorts, led to a sizeable increase in the deficit on current account. The outflow of capital became quite heavy in the second semester of 1970 when Uruguay failed to follow the devaluation of the Argentinian peso, and social unrest in the country increased. 210. In 1971 the trade balance worsened further, with the deficit on current account being the largest since 1965. Exports fell from US$224 million in 1970 to US$197 million, with no offsetting reduction in imports. Although the export shortfall affected all major categories, the sharpest decline was in meat, where volume fell by almost 40 percent and value by 21 percent. The decline in the volume of meat exports resulted mainly from the substantial rise in cattle smuggling to Brazil induced by the wide spread between Uruguayan and Brazilian cattle prices. Finally, a stagnation of imports in this period of high inflationary pressures and overvalued currency was achieved by the intensification of a number of measures aimed at discourag- ing imports. These measures included surcharges, outright prohibitions on imports, prescription of terms of import financing, and a reduction in the. import quotas not subject to special deposit requirements. The capital account strengthened somewhat in 1971, mainly due to the public sector's large drawings on loans from international agencies. Net outflow of private capital continued despites and intensification of controls over foreign ex- change sales.  - 78 - Table 18: EXPORrS BY MAJOR CATEGORY (in millions of U.S. dollars) Annual Average Annual (Percent) 1950- 1955- 1960- 1965- 1969 1970 1971 1950- 1967- 54 59 64 69 54 71 Wool 132.0 87.6 83.7 81.4 69.1 74.8 65.5 54.6 37.9 Meat 44.0 18.3 39.4 53.8 62.1 87.8 69.6 18.1 33.4 Hides 24.3 12.3 16.9 19.6 23.9 24.3 21.5 9.8 10.5 Crop Products 36.1 29.2 11.2 17.4 26.5 21.1 25.5 14.8 9.8 Other 6.2 12.3 9.1 10.8 18.7 24.7 23.6 2.7 8.4 Adjustment/1 -8.6 -9.1 Total 243.5 159.7 160.3 183.0 200.3 224.1 196.6 100.0 100.0 /1 To compensate for the fact that customs figures for wool were based on aforos or minimum export prices which were known to be in excess of average market prices. Source: Central Bank of Uruguay. Wool Exports 211. The substantial drop in wool export values since 1950-54 has been largely the result of the drop in price in international markets. Prices were considerably lower during 1964-71 than in the post World War II years and the Korean War period. However, internal price-cost relationships were also involved. The imposition in recent years of varying rates of export taxes has had particularly negative effects on the profitability of wool production. Annual variations in wool exports 'have also reflected changes in stock- building policies of exporters based on their expectations regarding exchange rate adjustments. Beef Exports 212. Although the importance of beef in Uruguay's exports has been increasing, they have been subject to severe annual fluctuations. Because of a reduction in cattle herds and of especially favorable weather conditions for pasture output, the volume of beef exports attained very high levels in 1964 and 1965. The turn in the beef cycle resulted in a drop in the volume of beef exports in 1966-67. Rising world market prices and an exchange rate policy favorable to producers stimulated meat exports between 1968 and 1970. However, the Government's failure to adjust the exchange rate in 1971 had a  - 79 - disastrous impact on meat exports, with farmerB either retaining the cattle in anticipation of higher prices or smuggling it to Brazil where prices were considerably higher. Total exports of beef fell in volume terms by about 40 percent from the 1970 level and only a sharp rise in world beef prices limited the decline in value terms to 21 percent. Table 19: VOLUME INDICES FOR MAJOR EXPORTS (1963 = 100) 1965 1966 1967 1968 1969 1970 1971 Wool 120 103 109 126 100 112 115 Meat 89 63 68 101 116 150 79 Hides 160 143 113 128 166 161 146 Linseed 54 49 39 24 66 99 59 Wheat 167 266 42 - 142 - 202 Source: Table 3.2, Statistical Appendix. Other Exports 213. Exports of agricultural crops also registered a declining trend from the 1950s as the international market for grains and oilseed products deteriorated. The poor weather conditions in 1967-68 adversely affected exportable crop surpluses. Government incentives to wheat and rice growers resulted in increased exportable surpluses in 1969-70; export proceeds from oilseed products were also higher in these years mainly due to subbtantial increases in export volumes. 214. Exports of manufactured goods have only recently recovered to the levels of the late 1950s. The policy of encouraging non-traditional exports through "drawbacks", as well aa through favorable tax treatment by mid-1972 had not as yet produced significant results, except in the case of cement sales to Brazil stimulated by the Brazilian construction boom. Imaports 215. Given the dependence of the Uruguayan economy on imports of fuels, Intermediate and capital goods, the sharp decline in import capacity associated with stagnation of production for export and financial instability, had adverse effects on output and employment in manufacturing. Notwithstanding the generally low average level to which imports had fallen in 1965-68, there  - 80 - were wide annual fluctuations as a result of expectations of currency devalua- tions, variations in credit policies and changes in import restrictions. The drastic reduction of imports from 1964 to 1965 (27 percent) reflects the severe balance of payments difficulties of 1965 which culminated in a sharp decline in reserves in the latter part of the year. In 1967, on the other hand, short- ages of agricultural machinery and vehicles forced a liberalization of imports in these categories. And in 1971, the level of imports was the net result of a struggle between importers expecting a substantial devaluation and author- ities using a variety of measures to limit the importers' speculative gains, Table 20: AVERAGE ANNUAL INPORTS By Majlor Category (C.I.F.), 1950-1971 (In US$ millions) Percent Annual Averages Annual Composition 1950- 1955- 1960- 1965- 1968 1969 1970 1971 1950- 1968- 54 59 64 69 54 71 Consumer Goods 33 22 24 13 13 18 27 31 13.5 10.9 Intermediate Goods 149 105 101 91 91 98 114 123 47.9 51.9 Fuels 32 38 29 29 29 25 34 33 13.1 14.8 Capital Goods 63 38 53 36 26 55 56 47 25.5 22.4 Total 247 204 207 169 159 197 231 234 100.0 100.0 Source: Central Bank of Uruguay. Trade Balance 216. The trade balance (f.o.b. basis) in 1971 showed a deficit -- a situation unknown since 1962. For the 1965-71 period as a whole, Uruguay had a US$238 million surplus equivalent to an annual average surplus of US$34 million. Underinvoicing of exports, cattle smuggling to Brazil and overstate- ment of imports probably led to some underestimation of the surplus. Wide fluctuations from year to year have characterized Uruguay's trade balance and mainly reflected world price developments for Uruguay's major exports, meat and wool, and the country's own erratic exchange rate policy. Services Account 217. During 1965-71 the services account showed a substantial deteriora- tion. The 1965 deficit of US$6 million increased to US$43 million by 1971. Mainly responsible for the increases in the deficit were rising outflows in the form of interst payments on medium and long-term loans and profit remit- tances. Outflows for freight, insurance and travel also rose substantially,  - 81 - while earnings from tourism stagnated and actually declined in 1970-71 in the wake of internal political unrest and guerilla activity. Part of the recorded outflow for freight and travel probably reflects capital flight, the actual size of which is difficult to estimate. Current Account Balance 218. Substantial export short-falls and stagnating earnings from tourism, together with rising payments for freight, travel, and factor services account for Uruguay's small current account surplus of US$64 million for the entire 1965-71 period. The larger swings into negative balances (1966/67 and 1969/70) were clearly associated with Uruguay's exchange rate policy. They occurred at times when Uruguay refused to adjust the exchange rate assuming that the maintenance of the parity implied certain economic stability. Capital Account 219. Uruguay's capital account showed wide fluctuations during the 1960s which were basically caused by the country's own policies and their impact on the capital market. A large errors and omissions item reflects the volume of capital flight. The outflow of capital became especially large in the mid-1960s averaging about US$50 million annually during 1962-65 due to lags in exchange rate adjustments in relation to accelerating domestic inflation. During 1966-71, Uruguay's exchange rate policy continued to be erratic. Exchange rate adjustments were postponed in 1966-67 after a sharp devaluation in late 1965 and again in 1970-71, following reasonable policies and favor- able results in 1968-69. During the second half of 1970, Uruguay experienced a resurgence of capital flight. The authorities compensated this drain on liquid working balances by refinancing, on very short terms, payments due against compensatory debt. They also had to rely on new short-term credit. For political reasons -- presidential elections were held late in 1971 -- the Government did not move the exchange rate and during that year commercial arrears of some US$37 million accumulated, while a number of short-term suppliers' credits were rolled over and payments on some long-term debts were rescheduled. As a result of the 1966-71 developments, Uruguay's net foreign exchange reserves declined from US$100 million in 1965 to some US$28 million at the end of 1971 or to the equivalent of one month's imports. 220. Disbursements by international organizations (IDB and IBRD) averaged US$7.6 million during 1965-71, accounting for only 17 percent of total capital inflow of medium-and-long-term loans to the public sector. They increased towards the end of the period mainly as a result of renewed support for Uruguay's livestock and power sectors. Bilateral loans, commercial and short-term financial credits were the most important source of external financing. Because of this debt structure, amortization payments increased fourfold between 1965 and 1971, while interest payments on public loans rose by a factor of 2.5. The debt service ratio rose from 6.5 to 22 percent of exports of goods and non-factor services. However, the low 1965 ratio reflected payment rescheduling, while the 1971 debt service ratio included the combined effect of higher debt service obligations and the decline in exports in that year.  - 82 - Exchange Rate 221. Official exchange rates established on April 29, 1968 were maintained through 1971 and remained effective until March 2, 1972. However, the exchange rate system became increasingly complex during 1971 when commissions and premiums were introduced on the buying and selling of foreign exchange which resulted in a wide range of effective rates. Special import surcharges had raised the effective import rate to about Ur$370/US$1.00. The rate used for calculating the December index (see table below) was applicable to exports of beef, wool tops and non-traditional exports. 222. The foreign exchange reform carried out March 1972 allocated "permitted" transactions to two foreign exchange markets; the "official" and the "free market". In addition, there has long existed in Uruguay a "parallel" or clandestine exchange market through which prohibited transac- tions are conducted. The newly established "official" exchange market incorporates commercial transactions - imports and exports - and public sector operations. The official market rate was initially set at Ur$495/500 per U.S. dollar - a cut of 50 percent in the value of the peso in terms of the U.S. dollar for the official rate, and a cut of 26 percent for the effec- tive export. The official rate has been moved since March 1972 in accordance with the government's flexible exchange rate policy, which calls for frequent small adjustments in line with changes in the domestic price level. 223. The second newly established exchange market is the "free" market for all other permitted transactions, including tourism. A rate of Ur$750/ US$1.00 was established at the outset and has been allowed to fluctuate freely ever since. At the time this "free" rate was adopted the "parallel" market rate for unregistered capital transactions stood at Ur$780/US$1.00. This spread between the "parallel" and "free" rates has remained roughly constant since March, 1972.  Table 21: OIPARATIVE MOViMENUS Ill EXCHANGE RATES L!'D PRICE INDICE (June 1970 a 1ic) Epor t Rate Financial Rate Parallel Market Rate Cos t Ivin7 Value index Vaiue Inueax Value Index ut.1962=lx) Jjne 1970 1970 June 248 100 249.5 100 257 100 2753.2 100 December 248 100 249.5 100 280 109 303305 110 1971 June 248 100 249.5 100 550 214 3327.8 128 December 368 148 249.5 100 635 247 J1.&50 1I9 1972 February 368 148 2149.5 100 785 305 h530o9 l164 Harch 2 495 200