Uruguay - Economic memorandum

Report No. 2706-UR Economic Memorandum on Uruguay June 1980 Latin America and the Caribbean Region Country Programs Department II FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Exchange Rates Effective May 2, 1979 Buying US$1.00 = NUr$8.747 Selling US$1.00 = NUr$8.769  FOR OFFICIAL USE ONLY This report is based on the findings of an economic mission that visited Uruguay in April-May 1979, consisting of: Messrs. Manmohan Agarwal (Chief of Mission) Hugo Zea (Economist) Ms. Priscilla Urbano (Young Professional) Mr. Max Vildosola (Consultant) Ms. Maria Cristina Germany (Research Assistant) It was subsequently revised and updated by John Johnson (Economist) following a March 1980 mission to Uruguay. This document has a restricted distribution and maY be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   TABLE OF CONTENTS Page No. COUNTRY DATA MAP SUMMARY AND CONCLUSIONS ........................... i-vi I. MACROECONOMIC PERFORMANCE 1975-79 - Background ...............-.-.....,....... . 1 - Principal Reform Measures o ...........-........ 1-4 - Results of the Reforms: Overview ....-.......... 4-7 - The External Sector -- ......................... 7-12 - Fiscal and Monetary Developments ........ . 13-16 - The Price Stabilization Program ..o................ 16-22 II. MEDIUM- AND LONG-TERM ISSUES AND PROSPECTS - Exchange Rate Policies and Aggregate Demand Management ... .... ...-.... . ........... ...... 23-27 - The Exchange Rate, the Balance of Payments, and Problems of Economic Analysis ........ 24-26 - The Scope and Pace of Trade Liberalization.. 27 - Medium-term Economic Outlook ................... 28-35 - Public Sector Investment ..................... 28-31 - Energy Dependence .-- *o-**....... 32 - Growth, Investment, and the Balance of Payments ........................... 32-35   Page 1 of 2 pages COUITRY DAA. - URUGUAY AREA 2 POPULATION DENSITY 2 177.5 km 2.9 million (mid.1979) 16 per km2 Rate of Growth: 0.8 (from 1974 to 1976) 19 per km2 of arable land POPUIATION CHARACrERISTICS 1975 HEALTH 1975 Crude Birth Rate (per 1,000) 20.4 Population per physician 840 Crude Death Rate (per 1,000) 9.3 Population per hospital bed 150 Infant Mortality (per 1,000 live births)48.1 INCOME DISTRIBUTION 1476 DISTRIBUTION OF LAND OWNERSHIP % of national income, hibest quintile 46.7 % owned by top 10% of owners lowest quintile 5.5 % owned by smallest 10% of owners ACCESS TO PIPED WATER 1971 ACCESS TO ELECTRICITY 1975 % of population - urban 87.8 % of dwellings - urban 89.2 - rural 66.4 - rural 27.8 NUTRITION 1977 EDUCATION 1975 Calorie intake as % of requirements 114.0 Adult literacy rate % 94.0 Per capita protein intake 98.1 Primary school enrollment 7 95.0 1/ GNP PER CAPITA in 1979 : US $2,090 GROSS NATIONAL PRODUCT IN 1979 ANNUAL RATE OF GROWTH (7.. constant prices) UsS $i Mln. % 1965- 69 1970-74 197 -79 GNP at Market Pr'Ces 6,886.6 100.0 1.4 0.9 5.2 Gross Domestic Investment 1,169.7 17.0 3.8 -1.6 13.4 Grogs National Saving 834.7 12.1 2.3 -5.1 16.3 Current Account Balance -335.0 -4.9 Exports of Goode, NFS 1,172.8 17.0 0.6 -1.6 11.3 Imports of Goods, NFS 1,441.8 19.7 9.5 -0.6 11.3 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1975 Value Added Labor Force7 V. A. Per Worker US Mln. % Mln. % US $ % Agriculture 430 13.7 0.21 19.8 2,047 0.70 Industry 1,027 32.7 0.31 29.0 3,312 1.13 Services 1,684 53.6 0.55 51.2 3,061 1.04 Unallocated - Total/Average 3,141 100.0 1.07 100.0 2,936 100.0 GOVERNMENT FINANCE GOVERNMENT -FINANCE General Government 3/ Central Government ( NUrS Mln.) % of GDP (NUr $ Mln.) % of GDP 1978 1978 1975-77 1979 1979 1975-78 Current Receipts 11,438.7 37.7 37.2 8,424 15.4 13.5 Current Expenditure 10,943.7 36.1 35.8 7,055 12.9 13.9 Current Surplus 495.0 1.6 1.4 1,369 2.5 -0.4 Capital Expenditures 1,125.4 3.7 4.8 972 1.8 1.8 External Financing (net) 30.4 0.1 0.9 55 0.1 0.9 1/ The Per Capita GNP estimate is at 1977- 79 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. 3/ Total public sector. not available not applicable  Page 2 of 2 pages COUNTRY DATA - lRUGUAY MONEY, CREDIT and PRICES 1973 1974 1975 1976 1977 1978 1979 (Million pesos outstanding end period) Money and Quasi Money 757.4 1,552.4 2,683.6 5,201.2 8,480.8 14,300.1 24,510.6 Bank Credit to Public Sector (net) 106.8 197.0 388.7 492.6 668.1 797.8 -52.2 Bank Credit to Private Sector 417.7 851.4 1,587.3 2,912.7 4,698.2 8,522.4 18,558.1 (Percentages or Index Numbers) Money and Quasi Money as % of GDP 29.4 33.7 32.1 40.0 42.6 47.2 44.5 General Price Index (1966 - 100) /1 723.4 1,499.4 2,501.7 3,501.1 5,506.3 8,040.0 14,724 .4 Annual percentage changes in: General Price Index 77.5 107.3 66.8 39.9 57.3 46.0 83.1 Bank credit to Public Sector (net) 2/ 25.7 83.1 82.3 27.0 21.2 9.1 3/ Bank credit to Private Sector 2/ 41.3 89.6 57.9 51.1 61.3 59.0 99.0 BALANCE OF PAYMENTS MERCHANDISE EXPORTS (AVERAGE 1976-79) (Prel.) 1976 197 7 1978 1979 US $ Mln % (Millions US $) Beef 104.9 16.1 Wool 124.7 19.1 Exports of Goods, NFS 696.2 871.1 989.4 1,172.8 Rice 38.6 5.9 Imports of Goods, NFS 705.1 907.1 940.0 1,441.8 Fish 18.6 2.9 - - Hide and skins ~~~~~~31.5 4.8 Resource GaP (deficit - -) 8 2 -36.0 49.4 -269-0 Manufactured goods 266.6 40.9 Interest Payments 4/ -57.3 -57.8 -60.4 -68.9 All other commodities 67.6 10.3 Workers' Remittances .. .. .. .. Total 652.5 100.0 Other Factor Payments (net) -15.2 -11.6 -17.5 -3.1 Net Transfers 7.7 6.6 8.0 6.0 EXTERNAL DEBT. DECEMBER 31. 1979 Balance on Current Account -78.6 -97.3 -20.5 -335.u US $ Mn Direct Foreign Investment Net MLT Borrowing - - - - Public Debt, incl. guaranteed 913.7 Disbursement; 224.1 225.7 416.0 173.5 Non-Guaranteed Private Debt 136.0-/ Amortizatiou -148.3 -186.9 -365.8 -54.5 Total outstanding & Disbursed 1,049.7 Subtotal 75.8 38.8 50.2 119.0 6109 Capital Grants 5.4 - DEBT SERVICE RATIO for 1979- other Capital (net) 109.1 219.1 164.9 266.6 % Increase in Reserves (-) -111.7 -160.6 -194.6 -50.6 Public Debt, incl. guaranteed 10.5 Non-Guaranteed Private Debt 9.4- Gross Reserves (end year)?/ 1,234.2 1,379.8 1,379.0 1,522.8 Total outstanding & Disbursed 19.9- Net Reserves (end year) RATE OF EXCHANGE IBRD/IDA LENDING, DECEMBER 31.1979 (Million US$): End - 1971 and End - 1979 IBRD IDA US $ 1.00 = NUr$0.563 1.00 = US $1.78 . Outstanding & Disbursed 73.8 Undisbursed 68.0 Outstanding incl. Undisbursed 141.8 US $ 1.00 = NUr$8.464 1.00 = US S0.118 1/ December index. 2/ Foreign currency converted at the following rates for two-year periods ending in: Year Rate (NUR$ per U.S. Dollar) 1973 0.85 1974 1.20 1975 2.40 1976 3.50 1977 4.85 1978 6.50 1979 7.90 3/ Net banking system credit to the public sector was negative in 1979 as public sector deposits surpassed total gross borrowings outstanding from the banking system. 4/ Interest on public debt only not available 5/ Estimated not avaicable 6/ Ratio of debt service to exports of goods and non-factor services . not applicable 7/ Including gold valued at US$300 per ounce  URUGUAY, tt~~~~~~~~~~~~~~~~~~~~~~~~~~~~~mi R-0 ,I. R___ eL~ityroods seoir -y A WpTr s Portoearn A borts Department Bos U ries -\ - t RIIn-ernWtX Bjn*daries V,c1 . \ \4 hodero~ *, I( 2$ Sd - E5 dOILOMETE D !R n 3 Tg A C U AR I_ ar \~~~~~~~~~~~~~~~ *Fth>H < X fX~~~~~~~~~~~~~~~~~~~~~~~~ou G-h-~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~r'rc i~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~.   Summary and Conclusions Economic Overview 1. The economy currently presents a picture of steady recuperation from the economic woes of the sixties and early seventies when per capita incomes declined, capital was run down, balance-of-payments problems were chronic and inflation rose to unprecedented levels. In 1974, faced with a balance-of-payments crisis triggered by the oil price increase, closure of the EEC market to meat imports, a deteriorating fiscal situation, and accelerating inflation, the Government focussed on the need to restore economic stability, starting in the external sector. The high level of consumption in the pre- vious decade had been achieved at the expense of investment and exports, resulting in low growth punctuated by periodic crises. Thus, a basic shift in economic policy was indicated. 2. The control-oriented framework surrounding the private sector has been gradually dismantled, and measures to improve the direction and the efficiency of public sector operations have been adopted. Since 1975, the Government has deregulated the foreign exchange and capital markets, tightened controls over public sector expenditures, reformed the tax system, decontrolled many consumer prices, reduced its intervention in agriculture, started remov- ing import barriers and provided new incentives to non-traditional exports. 3. This reorientation of economic policy has stimulated steady growth in output and employment, an increase in investment, an improved balance-of- payments situation with reserve accumulation, and the elimination of the fiscal deficit. However, the rate of inflation, though lower than in the early seventies, continues to be a problem, averaging just over 50 percent per annum during 1975-78 and exceeding 80 percent in 1979. 4. Growth has been concentrated in industry and construction. Indus- trial performance was strongest in sectors oriented toward non-traditional, agriculturally-based exports like textiles, leather goods, and fish processing. Construction activity has been stimulated by a surge in Argentine demand for investment properties in the Punta del Este region and by the end of rent controls which has spurred new housing construction in the Montevideo region. Poor weather has hampered agricultural output in recent years, but rising international prices for beef and wool and the liberalization of government policies in the sector have encouraged the rebuilding of cattle herds and helped to inspire a modest recovery in 1979. 5. Real trade growth has outpaced overall economic growth by a wide margin in recent years, reflecting the impact of Government efforts to open the economy to international competition. Real import growth of 14 percent annually has been paced by non-oil intermediate goods, reflecting Uruguay's limited natural resources and the increased demands of an expanding indus- trial and agricultural base. Fuel imports rose 3 percent in real terms from 1975-78, but declined sharply in 1979 due to supply interruptions from abroad. Non-traditional exports, growing at nearly 22 percent annually in real terms, were clearly the dominant factor in the improved export performance. Traditional exports (mainly beef and wool) have suffered from the effects of past governmental controls and, since 1978, from the herd rebuilding efforts of cattle producers. Having declined in volume by 9 percent annually since 1975, traditional exports represented barely one-quarter of 1979 exports. Rising tourist expenditures have furnished a major additional source of service revenues.  - ii - 6. Large net foreign capital inflows have been sufficient to finance the current account deficit and generate an overall balance-of-payments surplus in every year but 1975. Net capital inflows rose 80 percent in 1979 alone to reach nearly US$400 million. The liberalization of financial and exchange markets, the resurgence of the economy, and the policy of pre-announcing the exchange rate devaluation are developments which have increased Uruguay's attractiveness to foreign lenders. Foreign exchange reserves quintupled from US$73 million at end-1975 to US$381 million by the end of 1979, not counting gold holdings valued at more than US$2 billion at market prices prevailing as of June 1980. 7. Public medium- and long-term indebtedness totalled US$913 million at the end of 1979, or slightly over half of the US$1.7 billion in total disbursed external indebtedness. Over the past five years, both overall and public external debt declined slightly as a share of GDP to 24 percent and 13 percent, respectively, in 1979. The public debt service ratio, after peaking in 1978 at the record level of 43.1 percent--principally due to heavy redemptions of foreign-held, long-term government bonds--fell to only 10.5 percent in 1979, reflecting significant improvement in the average term structure of the debt. 8. The sharp reduction in the public sector's domestic financing require- ments can be attributed to major improvements in fiscal management. Current expenditures of the central government declined as a share of GDP, chiefly because of cuts in the real public sector wage and salary bill, while the efficiency of the tax collection process improved. Total public sector investment is rising as a share of GDP and is concentrated mainly in the energy and transport areas. 9. The private sector's willingness to hold financial assets increased steadily through the early years of the stabilization program, reflecting the more rapid rise in domestic incomes and the decontrol of interest rates. On the supply side, the elimination of the public sector domestic financing requirement helped reduce the growth of credit supplied by the Central Bank from 131 percent in 1975 to 22 percent in 1978. Overall banking system credit slowed comparably. 10. A reversal of basic price and monetary trends occurred in 1979, however, as money velocity increased for the first time in four years, the growth of total banking system credit credit substantially exceeded that of money and quasi-money, and the rate of inflation nearly doubled. Among the factors which contributed to this reversal were: (i) the greatly increased investment by residents in industry, construc- tion and agriculture, supplemented by a surge of Argentine expendi- tures on Uruguayan consumer goods and real estate. Although both domestic output and imports expanded substantially, capacity con- straints and the still high level of redundant tariff protection led to a situation of excess aggregate demand and accelerating domestic price inflation;  - iii - (ii) the large increase in the volume of foreign capital inflows, at- tracted by high nominal peso interest rates in Uruguay and a pre- announced schedule of small exchange devaluations. Dollar rates of return on peso-denominated assets rose to levels as much as 20 percent above comparable short-term rates available in the Euro-dollar market. Domestic credit resources were also greatly extended by the decision in May 1979 to eliminate all legal reserve requirements. Thus, emerging aggregate demand pressures were reinforced by monetary and financial developments; (iii) sharp increases in world prices for beef and petroleum, which are major items in the basket of Uruguayan domestic consumption goods; (iv) catch-up increases on a large number of products decontrolled during 1978 and 1979; and (v) drought-induced shortages of domestic food supplies. 11. The authorities have sought to curb inflation through a package of fiscal, incomes, exchange rate, and trade liberalization measures. Primary importance has been ascribed to two of these measures: (1) pre-announced small devaluations of the peso against the dollar at rates well under the difference between international and domestic inflation--thereby allowing the peso to appreciate in real terms--and (2) the gradual reduction of import barriers. These measures are aimed at promoting an eventual convergence between domestic and international inflation rates. Data through May 1980 indicate that the increase in consumer prices has decelerated relative to the first 5 months of 1979. Medium and Long-Term Issues and Prospects 12. The new stabilization strategy relies on supply-increasing, rather than demand-reducing, forces to lower the long-term rate of domestic inflation and induce a restructuring of the economy toward the most efficient sectors. The recent decline in inflation and the steady improvement in the balance- of-payments position have encouraged the authorities to continue the present policies. There is concern, however, about the adjustment burden these policies may impose upon the economy, particularly upon the traded-goods sector, and the long-range effects of real exchange rate appreciation and uneven tariff protection on resource allocation. 13. The upsurge in inflation during 1979 had important roots in devel- opments in the real sector. However, it was underwritten by the decisions to preannounce the rate of devaluation, remove all capital controls, and abolish domestic banking reserve requirements which, together, permitted a major growth of liquidity and aggregate demand.  - iv - 14. In the Government's view, the total quantity of money and credit is entirely demand-determined in a small, open economy with an administered exchange rate, as in Uruguay's case. Any measures taken to restrict the growth of domestic credit, therefore, would be quickly offset by capital in- flows from abroad. Capital controls are perceived as being either ineffective or distortional and counter to the objective of establishing Uruguay as an international financial center. Management of the level of international reserves and the growth of the monetary base of internal origin are regarded as the primary tasks of the monetary authorities, who have assumed a passive stance with regard to the aggregate supply of money and credit. Once tariff redundancy in Uruguay has been eliminated, the authorities believe domestic inflation will no longer exceed the sum of international inflation and the rate of devaluation, and aggregate demand will be regulated by a modern-day, specie-flow price mechanism. 15. The efficacy of this model for short-run economic management depends heavily on the speed of the assumed adjustment, the relative importance in the equilibration process of price and wage movements--as opposed to output and employment changes--and the stability of the function relating the supply of external capital to domestic economic variables. In order to better under- stand the limits to, and the role of conventional demand management in the present Uruguayan context, further empirical analysis of these factors is urged. 16. While the present exchange rate regime is likely to achieve domestic- international price convergence, more attention should be given to the possible effects of an appreciated exchange rate on trade, resource allocation, and growth. For example, the shift from a policy of real peso devaluation during the period of 1976-77 to one of real appreciation in 1978-79 has been paralleled by a marked deterioration in real export growth, including the growth of non-traditional exports, and a corresponding acceleration of imports. A major increase in the volume of short-term capital inflows, attracted by the large spread between foreign and domestic interest rates as translated by the appre- ciating peso, has financed the progressively larger current account deficits, permitting a steady accumulation of reserves. Nonetheless, were the present real exchange rate maintained indefinitely, it could have important implica- tions for both the size of future external financing requirements and foreign lender attitudes. Given Uruguay's very large international reserves, however, the likelihood of any near-term loss of lender confidence appears remote. 17. An appreciating real exchange rate accompanied by declining tariffs results in a shift in relative prices favoring the nontradeable-goods sectors at the expense of the export and import-competing sectors. The speed of this shift will affect the ability of existing enterprises to adjust. At the same time, uncertainty regarding the future course of the real exchange rate may inhibit desirable investments intended to facilitate that adjustment. Now that inflation appears to be following a downward course, a slight acceleration in the current rate of devaluation might be warranted to assure reasonable balance between the rate of export growth, the evolution of the current account deficit and the build-up of external debt and debt service.  18. Under the current tariff reduction program, the uniform tariff target has been set at a level of 35 percent, not taking into account the implicit tariff effect of the import reference price system or the added protection deriving from various non-tariff barriers. Thus, effective protec- tion may be high and variable even after the liberalization program is com- pleted in 1985. The level as well as the pattern of protection which prevails over the next 2-3 years is likely to have a significant impact on the invest- ment response of industry as it seeks to modernize and expand. The sub-optimal use of investment resources could be considerable if price signals from abroad continue to filter through a system of high and unbalanced protection. The twin aims of price stabilization and allocative efficiency might better be served in the future by deepening and accelerating the trade liberalization program, while easing the adjustment process by a calculated program of compensatory devaluations. Medium-Term Economic Outlook 19. The major changes in the direction of livestock and trade policies undertaken in 1978-79 and the private sector investment response to those changes augur well for the long-run development of the Uruguayan economy. The projections presented for the period 1980-83 assume that the Government will continue to foster an open economy with due regard for the maintenance of a sustainable external balance. 20. Under such a policy framework, GDP could grow by about 5 percent a year during 1980-83, with gross domestic investment at about 20 percent of GDP and a resource gap of about 1.7 percent of GDP. Because infrastructure investment is projected to absorb a higher-than-normal share of total invest- ment resources--and thereby reduce the amount available for directly-productive purposes--the capital-output ratio is assumed to be relatively high, i.e., on the order of 4.5. Based on the likely financial resource availabilities and the public sector's absorptive capacity, public sector investment is projected to increase from an average of 4.2 percent of GDP during 1976-78 to 6 percent in 1983. This appears to be adequate to address the most urgent physical and social infrastructure needs of Uruguay's growing economy. 21. In order to restrict public sector domestic borrowing so that resources for the private sector are not preempted, the public sector invest- ment program would be financed mainly from public sector savings and external borrowing. It is assumed that the public debt service ratio will rise gradually from the current level of 10-11 percent to 17-18 percent by 1983. Public sector savings are projected to increase from 2.6 percent of GDP in 1980 to 3.5 percent in 1983. Such an increase would require further reductions in redundant employment within the public sector. The manpower resources released thereby could be absorbed by an expanding private sector. Timely and adequate adjustments of the tariffs for public services would be needed to generate the requisite current surplusses, as would continued improvement in planning, budget procedures, project preparation and project execution. The skilled personnel needed to carry forward these reforms would be attracted in greater numbers to public service were salaries more competitive than at present with those in the private sector.  - vi - 22. As regards the structure of the public sector investment program, it is assumed that transport and energy would continue to be the two leading investment sectors. Energy is particularly important, given Uruguay's depen- dence on imported oil. However, the country's options in this area are limited. Oil exploration efforts need to be intensified. Nuclear energy is being studied more intensively and could become economically attractive, if real energy prices continue to rise rapidly and design advances on small-scale reactors result in lower fixed costs per unit of output. Proposals for a gas pipeline from Argentina and for long-term natural gas contracts with Argentina and Bolivia ought to be accorded high priority, as should the plans for expanding the distribution network to utilize the much higher power levels soon to be generated by the major hydroelectric projects now nearing completion. However, other priority needs are also emerging. Telecommunications and the social services sector deserve more attention than they have received in recent years. Telecommunications represents an area where additional resources are urgently needed to raise the quality of operations up to a level commen- surate with the needs of a rapidly-expanding economy. As for the social sector, while Uruguay has enjoyed a well-developed system for providing health and education services to its population, investment in social services was cut back considerably after 1974 under the pressure of resource constraints arising out of the economic difficulties of the sixties and early seventies and the competing claims from other priority sectors. It is now necessary to expand such investment in order to arrest the deterioration of buildings, improve equipment, and upgrade the training of personnel. This will require considerable strengthening of the project planning and implementation capabili- ties of the agencies active in these sectors. 23. Corresponding to higher anticipated levels of investment, imports of capital goods are projected to grow rapidly. The expansion of imports of non-food consumer goods should also be above trend because of the growth in incomes and the greater access to foreign goods afforded by import liberaliza- tion. However, in view of an expected pause in the growth of real fuel imports from 1980 through 1983, as additional hydroelectric capacity replaces power now being generated by thermal plants, total imports in constant prices are expected to grow by only 4.8 percent per year during 1980-83. Real exports, on the other hand, could grow by around 6.6 percent annually, reflect- ing the continued rapid growth of non-traditional exports and large expected increases in meat exports after 1981 when the livestock investments undertaken in 1978-79 will have matured. 24. Assuming the maintenance of a foreign exchange rate consistent with the projected growth of exports and imports, the current account deficit would average about US$230 million a year during the period 1980-83. Gross capital requirements to finance this deficit, meet amortization payments and permit a modest increase in foreign exchange reserves are projected at around US$330 million a year. Public sector borrowing is expected to cover about 60 percent of this need--roughly US$200 million annually--and private capital inflows the rest. Due to a heavy backlog of existing loan commitments, disbursements of the US$200 million in public sector borrowing would require new commitments of only about US$180 million a year, of which roughly half is expected to come from international and bilateral agencies, the rest being provided by foreign private commercial banks and suppliers. Assuming a continuation of the structural changes already initiated by the Government, Uruguay should be poised for a period of steady growth.  Chapter 1 Macroeconomic Performance, 1975-79 Background 1. Uruguay is currently experiencing a period of steady recuperation from the economic woes of the sixties and early seventies when per capita incomes declined, capital was run down, balance-of-payments crises were chronic and inflation rose to unprecedented levels. To reverse these trends and lay the basis for sustained growth, the Government adopted policies favoring both investment and exports. The results were a gradual expansion of output and employment, an increase in investment, an improved balance-of- payments situation, and the attainment of a balanced public sector budget. However, the rate of inflation, though lower than in the early seventies, continues to pose difficulties, averaging 52 percent annually during the period 1975-78 and exceeding 80 percent in 1979. 2. Between 1955 and 1974, the Uruguayan economy was characterized by stagnation and periodic external crises involving large and growing current account deficits, abrupt and massive outflows of short-term capital, a rapid depletion of reserves, and forced devaluations. These difficulties must be attributed in large part to the policies being pursued during those years. Import substitution policies inspired a vast array of tariff and non-tariff barriers to trade, which not only protected inefficient domestic industries, but also imposed a heavy indirect tax on exports. Price controls were perva- sive. Tight controls on interest rates, the allocation of credit, and the degree of permissible banking competition stifled the domestic financial market. Exchange regulations established separate rates for commercial and official, versus private, capital transactions. Residents' rights to transact in foreign securities or otherwise to hold currency abroad were severely circumscribed and chronic fiscal deficits financed by the Central Bank led to inflationary surges in the growth of money and credit. 3. Since September 1974, the Government has initiated major reforms in each of these areas, although there is considerable disparity in the speed at which they are being implemented. For example, in the monetary, financial, and foreign exchange sectors, the liberalization process was con- siderably advanced by the measures announced in 1979 regarding legal reserve requirements, rediscounts and the decontrol of interest rates. Major steps have also been taken in the fiscal and consumer price control areas, although a few remaining measures have still to be implemented. By contrast, steps to open the economy to external trade were begun comparatively recently and have had only a limited effect to date. Principal Reform Measures 4. The principal reforms already introduced are as follows:  - 2 - a. Financial and monetary liberalization 1. Rules on exchange transactions, restricting the rights of private residents to own and trade foreign securities or to establish domestic contracts denominated in foreign currencies, were substantially liberalized in September 1974. This was intended as the first of several steps aimed at creating an international finan- cial center in Uruguay. 2. In October 1978, the dual exchange markets were unified on a de facto basis, rendering the peso fully convertible. (Legal ratification followed in November 1979.) An advance schedule of crawling-peg devaluations, initially decreed for nine months, has been periodically extended. In June 1980, rates were announced through the end of the calendar year. By pre-announcing devaluations at rates below the prevailing differential between domestic and international price increases, the authorities have sought to use exchange rate policy as a tool for bringing prices in the traded-goods sector in line with those prevailing in international markets, thereby reducing inflation. Also, as part of an April 1980 tax reform, most exchange taxes on exports and profit remittances were eliminated. 3. Central Bank reserve requirements and rediscount facilities were eliminated in May 1979. These conventional monetary policy instruments are believed to be ineffective in controlling the growth of the money supply, given the small size of the economy and its financial openness, as well as discriminatory against resident banks. 4. Improvements in fiscal management, the gradual reduction of subsidized credit and changes in the interest rate structure (see below) have enabled the Central Bank to exercise more effective control over the monetary base of domestic origin. 5. Interest rates on foreign exchange deposits and loans were freed in 1976. Peso interest rate ceilings were raised to 62 percent in 1976, 90 percent in 1978, and, finally, decontrolled -altogether in 1979, when a longstanding law on usury was repealed. Official credit controls were abolished as was most subsidized credit, an exception being subsidized export credits-- the so-called pre-antecipos-- which were suspended in early 1979, but recently restored in limited form. 6. The domestic financial market was opened to capital flows from abroad with a view toward promoting more efficient resource allocation and converting Uruguay into an international capital market. 7. A domestic market in precious metals (mainly gold and silver) was created in order to broaden the selection of assets available to investors.  -3- b. Fiscal reforms 1. The Treasury cash deficit was reduced from the equivalent of 4.4 percent of GDP in 1975 to 1.0 percent in 1978. An overall surplus equivalent to 0.7 percent of GDP was achieved in 1979. This improvement was the result of a strong rise in revenue collections and a policy of restraint on current expenditures. 2. The system of tax collections was reorganized with a view toward discouraging evasion and promoting higher levels of domestic saving. There has been a gradual shift away from individual income taxes toward value-added, property and company profits taxes. A major new tax reform, passed in April 1980, will better enable agricultural enterprises to match their tax liabilities to their net cash flow by shifting taxable farm income from a gross to a net income basis. It also empowers the executive branch to replace immediately one-half of the employer taxes which underwrite the social welfare system with a higher value-added tax rate, thereby helping to reduce direct labor costs. 3. Expenditure controls were tightened by centralizing prior authorizations for most expenditures in the General Accounting Office. Most central government transactions, whether budgetary or extrabudgetary, now accrue to a single account (caja unica). Decisionmaking regarding the level, allocation, and financing of public sector investment has also been centralized to a greater extent than before. c. Pricing reforms 1. By December 1979, prices had been decontrolled on 77 percent of all items included in the consumer price index (compared with 54 percent in March 1978). Although controls on public sector utility tariffs and service charges remain, the Government has stated its intention to adjust these prices so as to avoid the emergence of distortions, implying greater realism for the future in public sector pricing policy. Ultimately, the authorities plan to reduce further the application of official controls. 2. Agricultural reforms in August 1978 brought sweeping changes to a sector where Uruguay enjoys a strong, but latent, comparative advantage. To enhance export capacity and strengthen producer incentives, fixed livestock prices were eliminated, geographical barriers to the marketing of beef were removed, the state-owned meat-processing plants were sold to the private sector, govern- mental control of their finances was abolished, the surcharge  - 4 - on imports of farm machinery was reduced to a maximum of 10 percent, and surcharges on other agricultural imports were eliminated. More recently, the land tax was redefined from a gross to a net income basis (see above). d. Trade liberalization 1. An initial step toward opening the trade sector was taken in April 1975 with the abolition of all import quotas. 2. In December 1978, the Government announced a framework for gradually consolidating all import surcharges, taxes, and tariffs into a single global rate of 35 percent by 1985. This compares with a maximum consolidated rate of 116 percent as of January 1980. 3. In the latter half of 1978 and in 1979, the Government announced a series of selective tariff cuts covering over 500 items, notably tractors, agricultural machinery and spare parts, wool, and selected foodstuffs. These cuts were intended to: (1) combat inflation by increasing competition in those sectors where prices were rising faster than justified by cost increases, and (2) reduce existing tariffs immediately to the 35-percent minimum rate on all goods not currently being produced in Uruguay as provided for in the December 1978 framework decree. 4. Also in line with that decree, the maximum surcharges on imports were reduced from 150 percent and 110 percent to 110 percent and 90 percent respectively, as of January 1979 and cut to 90 percent across-the-board in August 1979. 5. A January 1980 decree abolished the system of aforos (import reference prices), while delegating to the Ministry of Economy and Finance the discretionary power to establish new reference prices. In practice, much of the aforo system has been preserved by a new set of official reference prices. However, the authorities have indicated their intention to reduce gradually most of the prevailing import reference prices to c.i.f. import price levels. Reference prices raise total assessed duties as much as four times higher than nominal tariffs by increasing the base price on which duties are calculated. Results of The Reforms Growth and Resource Mobilization 5. Government reforms have been highly successful in dynamizing growth, substantially easing the balance-of-payments constraint, improving resource allocation, boosting productive efficiency, and shifting resources from con- sumption to investment and exports. The control-oriented policy framework  - 5 - inherited from the past has been gradually dismantled, while non-traditional exports have been encouraged via the adoption of a "crawling peg" exchange rate and fiscal incentives. The economy attained an average real annual growth rate of 4.5 percent during the period 1975-79, compared with -0.2 percent annually from 1971-74 (see Tables 1 and 2). The real economic growth rate of 8.4 percent in 1979 was higher than in any year since 1946. 6. Investment and savings increased rapidly in response to the expansion of exports, the improved domestic growth prospects, changes in the tax system, the decontrol of financial markets, the partial deregulation of agriculture, and the drive to modernize industry before introducing greater foreign competition. In 1977, investment grew by 7 percent in real terms, then declined by 5.5 percent in 1978, as uncertainty developed regarding the Government's beef and industrial policies, but rebounded in 1979 to a 28 percent annual rate once this uncertainty had been removed by the announce- ment of agricultural reforms. Argentine and other foreign investment also became much more significant in 1979 relative to 1977-78. Overall, gross domestic investment rose from 13.2 percent of GNP in 1975 to 15.4 percent in 1977 and 17.0 percent in 1979. 1/ Gross national savings climbed from 6.7 percent to 12.5 percent of GDP between 1975-77 before declining slightly to 12.1 percent in 1979. 7. Growth has been concentrated in industry and construction. Industrial growth has stemmed chiefly from the strong performance of non-traditional, agri- culturally-based exports such as textiles, leather goods, and fish processing. The impetus for construction growth has derived, in part, from investment activity in the resort area of Punta del Este, underwritten to a large extent by inflows of Argentine capital. During the past year, the construction boom has spread to the urban areas, particularly Montevideo, in response to the abolition of rent controls on commercial buildings in July 1978 and on resi- dences in July 1979. The growth performance of the agricultural sector was favorable in 1975-76, but poor weather in 1977-78 resulted in a severe decline of nearly 7 percent in real output, cancelling virtually all of the gains of the prior period. Wheat production was particularly affected, declining by over 30 percent and making it necessary to import substantial quantities of cereal grains in 1978. Rising international prices for beef and wool and the new incentives afforded by the agricultural liberalization program contributed to a 2.7 percent real rate of growth in 1979. 1/ These figures were derived from national accounts in 1961 prices. The weights used to derive these accounts may not reflect the current economic structure. However, the changes depicted in direction and magnitude are valid.  TABLE 1: SECTORAL GROWTH OF REAL GDP AND COMPOSITION, 1965-79 (Annual percentage change) Average Average Average Composition % 1965-70 1971-74 1975 1976 1977 1978 1979 1975-79 1974 1979 Agriculture 2.8 -1.9 3.3 3.5 -1.4 -5.1 2.7 1.2 15.3 13.0 Industry 2.4 0.3 6.7 3.9 6.2 6.0 10.1 6.6 23.4 25.9 Construction 4.3 -1.0 31.6 -6.6 14.5 6.2 19.9 13.4 4.1 6.3 Services 1.9 0.2 1.8 2.6 2.3 2.1 7.6 3.7 57.2 54.8 Gross Domestic Product 2.3 -0.2 4.4 2.6 3.3 2.3 8.4 4.5 100.0 100.0 GDP in millions of 1961 Ur. pesos 19,594-a 19,456-b 20,320 20,848 21,557 22,398 24,279 Per capita GDP in 1961 Ur. pesos 7,240 7,000 7,305 7,435 7,625 7,740 8,425 a/ For 1970 b/ For 1974 Source: Central Bank - Economic Indicators  Table 2: Use of Resources (as percent of GDP) 1960-64 1970-74 1977-79 average average average Consumption 86.4 89.2 87.9 Private 75.2 74.8 Government 11.1 14.4 Investment 15.2 11.8 15.8 Private 12.3 8.2 Government 2.9 3.6 Resource Gap -1.8 -1.1 -3.7 Export 12.9 13.5 17.6 Import 14.7 14.6 21.3 Domestic Savings /a 13.4 10.7 12.1 Terms of Trade Effect (with respect to 1961) 1.2 /b -7.0 /a including the terms of trade effect. /b despite a terms of trade loss in 1974. Source: Central Bank Statistics and Mission Estimates The External Sector 8. Real growth in trade substantially outpaced the overall growth of the economy in recent years, reflecting the impact of efforts to open the economy to international competition. Import growth over the 1975-79 period of 14 percent per annum exceeded annual export growth by about 5 percent annually (see Tables 3 and 4). In 1979, imports rose by more than 30 percent, paced by intermediate inputs excluding oil (up 46 percent), capital goods (up 35 percent) and consumer goods (up 86 percent). Fuel imports grew by approxi- mately 3 percent annually between 1975 and 1978, but, due to disruptions in Uruguay's normal supply channels at the time of the crisis in Iran, declined by 9 percent in 1979, so that there was no growth in oil imports for the period as a whole. The exceptional expansion of overall imports in 1979 can be explained by a number of factors, including the high rate of economic growth, accelerated orders of foreign cars prior to a 1980 deadline for instituting new foreign car import regulations, significant reductions in the average level of tariffs and a substantial real appreciation of the peso over the past two years. Intermediate goods, the largest sub-group, now account for more than half of imports, reflecting Uruguay's limited natural resources and the increased demands of an expanding agricultural and industrial base.  TABLE 3: IMPORTS, C.I.F., AT CURRENT AND CONSTANT PRICES, 1975-79 (in millions of US dollars) 1975 = 100 (Prel.) % Change Average Annual 1975 1976 1977 1978 1979 1979 % Change,1975-79 1. Total (current prices) 556.5 587.2 729.9 774.3 1,230.9 59.0 22.0 (a) Import price index 100.0 97.3 106.2 107.5 130.7 21.6 6.9 (b) Total (constant price) 556.5 603.5 687.6 720.0 941.6 30.8 14.1 2. Intermediate inputs (current prices) 274.4 273.0 345.6 420.3 715.3 70.2 27.0 (a) Price index 100.0 92.1 100.8 103.5 120.6 16.5 4.8 (b) Sub-total (constant prices) 274.4 296.4 342.9 406.1 593.1 46.0 21.3 3. Fuels (current prices) 183.1 181.2 208.0 216.8 291.4 34.4 12.3 (a) Price index 100.0 103.0 111.8 107.9 159.0 47.4 12.3 (b) Sub-total (constant prices) 183.1 175.9 186.0 200.9 183.2 -9.0 0.0 4. Capital goods (current prices) 72.8 108.1 147.7 104.6 157.2 50.3 21.2 (a) Price index 100.0 106.4 113.8 124.4 135.8 9.2 7.9 (b) Sub-total (constant prices) 72.8 101.6 129.7 84.1 113.4 34.8 11.7 5. Consumer Goods (current prices) 26.2 24.9 28.7 32.6 72.9 123.6 29.2 (a) Price index 100.0 84.1 98.9 112.7 135.4 20.1 7.8 (b) Sub-total (constant prices) 26.2 29.6 29.0 28.9 53.9 86.5 19.8 Memorandum Item: Import/GDP Ratio (%) 15.3 15.3 17.4 15.6 17.7 Source: Central Bank - Economic Indicators.  TABLE 4: EXPORTS, F.O.B., AT CURRENT AND CONSTANT PRICES, 1975-79 (in millions of US dollars) 1975 - 100 % Change, Average Annual 1975 1976 1977 1978 1979 1979 % Change, 1975-79 1. Total (current prices) 383.8 546.5 607.5 686.1 788.1 14.9 19.7 (a) Export price index 100.0 106.3 111.9 119.5 144.8 21.2 9.7 (b) Total (constant prices) 383.8 514.1 543.0 573.9 544.3 -5.2 9.1 2. Traditional Exports 194.5 252.8 261.2 248.6 222.7 -10.4 3.4 (a) Price index 100.0 112.9 130.9 130.7 172.0 31.6 14.5 (b) Sub-total (constant prices) 194.5 223.9 199.5 190.2 129.1 -32.1 -8.9 2(a). Meat (current prices) 82.8 121.1 110.7 93.5 102.4 9.5 5.5 (a) Price index 100.0 104.3 136.4 126.7 197.1 55.6 18.5 (b) Sub-total (constant prices) 82.8 116.1 81.2 73.8 52.0 -29.5 -10.9 2(b). Wool (current prices) 96.0 115.5 120.7 132.0 101.4 -23.2 1.4 (a) Price index 100.0 130.9 149.5 151.5 173.0 14.2 14.7 (b) Sub-total (constant prices) 96.0 88.2 80.7 87.1 58.6 -32.7 -11.6 3(c) Other traditional exports 15.7 16.2 29.8 23.1 18.9 -18.2 4.7 (a) Price index 100.0 82.8 79.4 78.9 98.2 24.5 -0.5 (b) Sub-total (constant prices) 15.7 19.5 37.6 29.3 19.2 -34.5 5.2 3. Non-traditional Exports (current prices) 189.3 293.7 346.3 437.4 565.5 29.3 31.5 (a) Price index 100.0 101.2 100.8 114.0 136.3 19.6 8.1 (b) Sub-total (constant prices) 189.3 290.2 343.6 383.7 414.9 8.1 21.7 Memorandum Item: Export/GDP Ratio (%) 10.5 14.3 14.5 13.9 11.3 Source: Central Bank - Economic Indicators.  - 10 - 9. Growth of non-traditional exports (21.7 percent annually) was clearly the dominant factor in the improved export record. Rice, fish, leather goods, and textiles were among the most dynamic performers in this group, which accounted for nearly three-quarters of 1979 exports, compared with approximately half of 1975 exports. Traditional exports (mainly beef and wool), on the other hand, have suffered from lagging production in the agricultural sector. Until 1978, longstanding administrative controls virtually eliminated profits in cattle raising and discouraged new investment. In late 1978 and most of 1979, after the controls were relaxed, producer efforts to rebuild domestic herds resulted in a temporary reduction of export availabili- ties. As a consequence, over the five-year period, traditional exports con- tracted by nearly 9 percent per annum, constituting little more than one-quarter of total 1979 exports. 10. The services account improved steadily. Deficits averaging US$80 million annually over the 1975-77 period gave way to surplusses in 1978-79 averaging US$50 million annually. The key development was the growth of tourism into a major domestic industry. The number of foreign visitors passed the million mark in 1979, an increase of nearly 50 percent in only one year. Roughly four-fifths of these visits came from neighboring Argentina, reflecting a wide differential between the two countries' rates of inflation which was not fully offset by changes in the relative exchange rate. 11. Although the current account has been in deficit throughout this period--the deficits having ranged in size from 0.4 percent to 5.1 percent of GDP--financing from the capital account has been sufficient to permit reserve accumulation in every year but 1975 (see Table 5). The liberalization of the capital and exchange markets, the resurgence of the economy, and more recently the policy of pre-announcing the exchange rate (see below) have increased Uruguay's attractiveness to non-resident investors and brought in over US$1.1 billion in net foreign private capital inflows, most of this in the 1976-79 period. Net capital inflows totalled US$385 million in 1979, about 80 percent higher than in 1978, of which suppliers' credits to the private sector accounted for US$120 million; public sector external borrowing, mainly by state enter- prises, added another US$119 million; and the remaining US$146 million consti- tuted other capital movements, mainly interest-sensitive short-term flows and real estate financing imported by Argentine investors. Only net export credits declined significantly--by US$105 million. The overall balance of payments was in surplus by about US$50 million (excluding SDR allocations) in 1979, which was slightly smaller than the average balance of US$89 million for the entire period. 12. Total reserves, excluding gold, rose from US$73 million as of end-1975 (equivalent to less than two months' imports) to US$381 million as of end-1979 (equivalent to nearly 4 months' imports). Added to these reserves are substantial gold holdings (3.8 million ounces), which, at market prices of mid-June 1980, were valued at around US$2.3 billion. 13. Public medium and long-term indebtedness totalled US$913 million as of the end of 1979, or slightly more than half of the US$1,673 millions in total external indebtedness disbursed and outstanding. Both totals have grown by roughly 12 percent annually since the beginning of 1975, i.e., more slowly than US dollar-denominated GDP. As a consequence, the global debt-to-GDP ratio fell slightly from 25.2 percent to 24.1 percent; similarly, the GDP share of public and publicly-guaranteed debt declined from 13.6 percent to 13.1 percent (see Table 6A).  - 11 - Table 5: Balance of Payments (millions of US$) 1975 1976 1977 1978 1979 (Preliminary) Trade Balance -109.2 28.4 -68.1 -73.9 -399.3 Exports, f.o.b. 384.9 565.0 611.6 686.1 790.0 Imports, f.o.b. 494.1 536.6 679.7 760.0 1,189.3 Net Service Payments -16.0 -42.3 32.1 122.5 130.3 Net Factor Income -71.2 -72.4 -67.9 -77.1 -72.0 Net Transfers 6.9 7.7 6.6 8.0 6.0 Current Account Balance -189.5 -78.6 -97.3 -20.5 -335.0 (percent of GDP) (5.1) (1.9) (2.3) (0-4) (4.8) Public Medium and Long Terms Loans (Net) 102.7 75.8 38.8 50.2 119.0 Gross Disbursements (284.6) (224.1) (225.7) (416.0) (173.5) Amortization (-181.9) (-148.3) (-186.9) (-365.8) (-54.5) Other Net Capital Movements (including errors and omissions) 14.0 114.5 219.1 164.9 266.6 Change in Reserves 1/ (- = increase) 72.8 -111.7 -160.6 -194.6 -50.6 1/ Before valuation adjustments and SDR allocations. Sources: Central Bank statistics and Mission estimates 14. The public debt service ratio 1/ peaked in 1978, reflecting mainly an eight-fold increase over 1977 in the level of bond redemptions. 2/ Most of these bonds were rolled over in 1978 at substantially longer maturities (10-11 years compared to 4-5 years on the bonds redeemed, most of which had been issued before 1974). 3/ As a result, service on public debt, including amortizations and interest, fell from US$426 million in 1978 to US$123 million in 1979 and the corresponding debt service ratio from 43.1 percent to 10.5 percent. 1/ As a share of goods and non-factor service exports. 2/ These are mostly fixed-yield, dollar-denominated, ten-year bearer bonds sold by the government to the private sector. Existing data do not disclose the proportions of these bonds held by residents and foreigners, but it is generally believed that a major portion are in the hands of foreign, mainly Argentine, citizens. 3/ See Table 6B for a summary of the average terms on new commitments undertaken during the 1974-79 period.  TABLE 6A: URUGUAY - DEBT STRUCTURE AND SERVICING CAPACITY OF EXTERNAL PUBLIC DEBT, 1974-79" (in millions of US dollars) 1974 1975 1976 1977 1978 1979 Debt outstanding and disbursed 516.0 616.5 692.3 735.1 792.7 913.7 Debt service 156.1 228.1 205.6 244.7 426.2 123.4 Composition of debt outstanding (%) 100.0 100.0 100.0 100.0 100.0 100.0 Multilateral agencies 17.7 16.1 17.1 16.8 18.3 18.3 Governments 34.9 26.7 20.9 16.7 13.9 14.2 Financial institutions 19.4 15.0 19.8 23.2 28.4 34.2 Suppliers 3.8 4.2 3.8 4.2 4.2 3.9 2/ Bonds- 24.2 38.0 38.4 39.1 35.2 29.4 Composition of debt service (%) 100.0 100.0 100.0 100.0 100.0 100.0 Multilateral agencies 9.6 6.7 8.2 8.4 5.3 19.5 Governments 15.4 12.8 19.1 16.4 7.8 13.6 Financial institutions 13.9 59.1 40.9 48.5 26.9 20.0 Suppliers 4.6 3.8 4.5 3.1 1.6 6.5 Bonds-/ 56.5 17.6 27.3 23.6 58.4 40.4 Debt Outstanding and disbursed as a % of GDP 17.0 18.0 17.7 16.0 13.1 Public debt service ratio 31.2 41.4 29.5 28.1 43.1 10.5 1/ Repayable in foreign currency 2/ Mainly ten-year,dollar-denominated government bearer bonds sold to the private sector. No breakdown of holdings by the nationality of the bearer exists but it is generally believed that a major portion are in the hands of foreign, primarily Argentine, citizens. Source: IBRD Debt Reporting System  Table SB: Uruguay - Average Terms of Public External Debt Contracted During 1974-79 (repayable in foreign currency) 1974 1975 1976 1977 1978 1979 Maturity Grace Maturity Grace Maturity Grace Maturity Grace Maturitv Grace Maturity Grace (years) (years) (years) (years) (years) (years) (years) (years) (years) (years) (years) (years) Interest Grant Element Interest Grant Element Interest Grant Element Interest Grant Element Interest Grant Element Interest Grant Element (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) Suppliers' credits 3.0 0.2 10.8 2.4 3.8 0.4 5.5 0.8 9.2 2.5 8.7 0.7 3.9 7.0 8.3 7.7 9.4 0.7 8.7 3.4 8.1 7.3 8.8 3.2 Financial Institutions 4.8 0.3 7.5 2.2 14.7 3.6 5.9 1.5 9.3 3.4 13.0 4.3 10.5 -1.6 9.7 1.9 8.8 7.3 8.9 3.0 10.6 -3.7 7.9 11.5 Bonds 8.8 1.3 10.1 1.1 10.0 1.0 10.3 5.9 11.0 6.0 - - 12.2 -8.9 11.2 -4.7 10.0 - 11.4 -9.0 10.7 -5.1 - - Multilateral loans 32.0 7.5 19.3 55 - 15.0 4.5 22.0 4.7 17.0 4.3 3.5 53.4 8.0 12.8 - - 8.6 7.0 7.9 13.0 7.7 12.7 Bilateral loans 7.9 2.1 27.6 6.0 17.8 4.9 2.7 0.2 2.3 0.4 - - 8.3 6.6 4.5 41.5 7.4 13.1 8.5 1.8 7.5 2.8 - - TOTAL 9.1 1.7 11.5 2.8 8.8 3.4 8.6 3.9 11.1 4.4 15.4 4.3 10.0 0.5 9.3 4.7 14.2 6.8 10.1 -2.8 10.3 -2.3 7.8 12.1 Source: IBRD Debt Reporting System Memorandum Items: Total External Public Debt as of end-1979, disbursed and undisbursed (in millions of US dollars): $2,412.0 Average Terms: Interest Maturity Grace Grant Element (percent) (years) (years) (percent) 9.4 10.8 3.1 3.2  - 14 - Fiscal and Monetary Developments 15. The sharp reduction in the public sector's domestic financing requirements reculted from significant improvements in fiscal management. Current expenditures of the central government declined as a share of GDP to 12.9 percent in 1979 from 14.4 percent in 1975 (see Table 7), attributable mainly to a contraction in real public sector wages and salaries of 23 percent. Revenues, on the other hand rose from 11.7 percent to 15.4 percent of GDP, reflecting the improved efficiency of the tax collection system and a shift toward more price-elastic imposts, such as value-added and property taxes. The balance of the current budget account shifted from a deficit equivalent to 2.7 percent of 1975 GDP to a surplus of 2.5 percent of 1979 GDP. Similarly, the deficit of the overall budget, taking into account both capital and current outlays, contracted steadily from 4.4 percent of GDP in 1975 to 0.8 percent of GDP in 1978, and actually shifted in 1979 into a surplus equivalent to 0.7 percent of GDP, the first such surplus in 20 years. Public sector investment has been very concentrated in recent years in two main areas--energy and transport--which jointly absorbed approximately 70 percent of expenditures over the five-year period. Table 7: SUMMARY OF CENTRAL GOVERNMENT OPERATIONS, 1975-79 (as percentage of GDP) 1975 1976 1977 1978 1979 Revenues 11.7 13.2 14.7 14.3 15.4 Current expenditures 14.4 13.9 14.0 13.3 12.9 (of which transfers to rest of public sector) (1.8) (1.3) (1.4) (1.1) (1.9) Current account surplus or deficit (-) -2.7 -0.7 0.7 1.0 2.5 Capital expenditures 1.7 1.8 1.9 1.8 1.8 Overall deficit -4.4 -2.5 -1.2 -0.8 0.7 Financing 4.4 2.5 1.3 0.8 -0.7 External (net) (2.0) (1.3) (0.2) (0.2) (0.1) Domestic (net) (2.4) (1.2) (1.0) (0.6) (-0.8) Sources: Ministry of Economy and Finance, Central Bank and Mission estimates.  - 15 - 16. The private sector's willingness to hold financial assets increased steadily through the early years of the Government's stabilization program. Real money and quasi-money increased by 14 percent annually from end-1974 to end-1978, velocity declined 10 percent per year, and prices followed a gradual downward course from 67 percent (cost-of-living index) in 1975 to 46 percent in 1978. Key factors behind the growth in money demand were the more rapid rise in incomes (3.0 percent real annual per capita growth in the 1975-78 period compared with -0.9 percent in the 1970-74 period) and the decontrol of interest rates, permitting savers to earn real positive rates of interest. On the supply side, the elimination of the public sector domestic financing requirement helped reduce the growth of credit (net domestic assets) supplied by the Central Bank to the public sector from 131 percent in 1975 to 22 percent in 1978. This was paralleled by a slowdown in the growth of total Central Bank credit from 98 percent to 40 percent annually over the same period. Success in slowing monetary credit expansion was accompanied by a decline in the growth of total banking system credit; the ratio of net domestic banking assets to the broad money aggregate dropped from 1.18 as of end-1974 to 0.76 as of end-1978 (see Table 8). 17. A reversal of these trends emerged in 1979, as money velocity in- creased for the first time in four years, the growth of total banking system credit substantially exceeded that of broad money (106 percent compared to 76 percent), and inflation surged from 46 percent in 1978 to 83 percent in 1979, the highest rate since 1974. In retrospect, it is apparent that a number of factors were at work: (i) A rise in investment demand associated with Uruguay's improved economic growth prospects coincided with a sharp increase in local expendi- tures by foreign tourists and investors, particularly from neighboring Argentina. This led to a situation of excess aggregate demand which could not be satisfied locally because of limited supply response capabilities, nor via imports given the still high and redundant levels of domestic protection. These excess demand pressures in the real sector of the economy intensified the demand for credit, which was validated in turn by increased foreign capital inflows and by the extension of domestic banking assets made possible by the elimination of reserve requirements. 1/ 1/ The argument above suggests that inflation in 1979 was the result of excess aggregate demand for goods, which was necessarily associated with an excess supply of money. One of the factors leading to this excess supply of money, it is argued, was the decision to eliminate all domestic reserve requirements. Banks were left with additional free reserves which contributed to the excess liquidity in financial markets. In contrast, the monetary authorities believe that the growth of the global supply of money and credit is exclusively demand-determined in Uruguay because of the openness of domestic financial markets and the administered exchange rate. The elimination of domestic reserve requirements did not accelerate the growth of money and credit, in their opinion; rather, it merely reduced the share supplied by foreign, as opposed to domestic, sources.  TABLE 8: Accounts of the Banking System (In mi.lions of new Uruguayan pesos) 1977 19E 8 Dec. 1/ Dee. 2jr Dec. 2/ Dec. 3/ Dec- 3/ Dec. 4/ De-c. 4 Net international reserves 199.2 2'6.6 781.1 1,046.6 . ,05& -4 3,711.5 4,024.5 F'oreign assets 1,328.-5 1,8=1.2 2,642.5 3,541.2 4,304.1 5,231.5 6,5tS.5 Foreign liabilities -1,129.3 -1,564.6 -1,861.4 -2,494.6 -1,250.7 -1,520.0 -2,558.o Net domestic assets 3,269.8 L . 2 5,276.6 5.928.o 8,209. 8,58 17,630.4 Public sector (net) ' 92 55J 1 731.5 797.8 56. 3 -52.2 .(ntral Government (net) 718.5 785.6 1,158.5 1,266-3 1,261.4 1,3i. 0 718.9 ,i"A cl' public vector (net) .9 -Lj4. -14 i)o.4 ->&.8 _ -!0 i. -4 [.I -( (I.1. Credit to official banks 67.5 67.5 69.7 69.7 224.4 224.2 464.0 Credit to banks in liquidation 67.7 74.1 76.5 85.6 93.5 110.6 94.9 Credit to prtvate sector 2,598.5 2,912.7 4,698.2 5,358-9 8,522.4 9,327.9 18,558.1 l7onmonetary international organizations -83.1 -73.3 -129.9 -117.5 51.6 65.3 427.6 Valuation adjustment 56.7 -109.6 136.9 -273.4 369.5 -562.9 758.1 Other accounts 98.9 253.1 -85.1 234.0 -1,726.0 -1,348.0 -2,492.6 Interbank float -29.0 -33.7 -157.8 -160.8 -126.7 -124.5 -127.5 14edium- and long-term foreign liabilities 124.4 160.4 176.1 220.9 228.4 261.7 340.1 Liabilities to official banks 98.1 X 126.0 126.0 494.3 494.3 1,194.0 Allocation of SDRs 93 L34.9 141.0 189.0 202.7 246.4 328.4 Liabilities to private sector 3,149.2 3,525.4 5,614.6 6,438.7 10,337-5 11 258.0 19 702 4 Moncy 1,324.6 1,32'. 5 1,o60.0 1,8'5.0 3,078.1 3,078.1 ~5 ,; Currency in circulation 782.1 782.1 1,114.8 1,114.8 1,811.7 1,311.7 3,186.5 Sight deposits 542.5 542.4 745.2 745.2 1,266.4 1,266.4 2,614.1 Quasi-money 1,824.6 2,20).9 3,754.6 4,578.7 7,259.4 8,179.9 13,991.8 Time and savings deposits in L/C 673.5 673.4 1,017.4 1,017.4 2,733.5 2,733.5 6,294.6 Foreign currency deposits 931.5 1,291.0 2,258.8 3,027.3 4,182.8 5,083.9 7,198.7 Import deposits 9.5 13.2 2.2 2.9 0.2 0.2 -- Bills 0.1 0.1 75.0 75.0 48.8 48.8 __ Other liabilities in L/C 175.9 -7j-9 240.0 240.0 203.8 203.8 363.6 Cther liabilities in F/C 34.2 47.3 161.2 216.1 90.3 109.7 134.9 Soarces: Central Bank of Uruguay; and IMF s-aff estimates. 1/ Foreign currency converted at NUJr$3.5 per USD1. / Foreign currency converted at 'NJr$4.85 pir US.S1. Foreign currency converted at 'Jr$6.5 pe: JSl. ' Foreign currency converted at .;-r$7.9 pe; US$l.  - 17 - (ii) As the economy became more open financially, foreign capital inflows, as noted above, reached record levels in 1979 (about 5.8 percent of GDP) and played a growing role in the determination of nominal interest rates and the availability of credit (see Chart 1). Foreign lenders were attracted by high nominal peso lending rates, ranging from 47 percent on certain preferen- tial short-term credit lines extended by the Banco de la Republica in mid-1979 to 70 percent for standard commercial credits, and a low, pre-announced rate of peso devaluation (23 percent in terms of the average dollar-peso exchange rate in 1979). Exchange-adjusted dollar rates of return on peso- denominated assets rose as high as 20 percent above comparable short-term rates available in the LIBOR market. The resulting inflows financed a 42 percent real growth in total credit in 1979, despite a 14 percent real contraction in the credit supplied by the Central Bank. These inflows tended to depress real peso interest rates, inducing shifts by residents from financial into real assets and adding to inflationary pressures. Although the monetary authorities took several measures to lower nominal peso rates and stem foreign capital inflows --such as eliminating legal reserve requirements in May 1979 and reducing substantially the tax on bank credit--interest rate spreads remained high owing to expectations of continued inflation and to lags in the competitive response of resident banks to the influx of lower-cost foreign funds. (iii) External forces exerted strong upward pressures on the domestic prices for key items in the Uruguayan basket of consumer goods, chiefly beef and petroleum, adding an important component of imported inflation; (iv) Domestic price decontrol resulted in some once-and-for-all increases in the level of recorded inflation; and (v) Drought in early 1979 curtailed supplies and pushed up food prices. The Price Stabilization Program 18. The authorities have sought to curb inflation through a package of fiscal, incomes, exchange rate, and trade liberalization measures. The sub- stantial progress achieved in the fiscal and trade areas was described above. In addition, in October 1978, as part of an effort to align expectations about producer costs, the Government began to pre-announce the rates of exchange, the minimum wage rate, the wage rate for public sector employees and the tariffs for public services. For the whole of 1979, minimum wage rates were raised 53.6 percent and public sector salaries 61.2 percent, i.e., well below the prevailing rate of consumer inflation. 1/ For the future, the Government has stated that it plans to determine official wage adjustments on the basis of expected, rather than past, inflation, apparently ruling out any allowance for past reductions in real wages. Guidelines for adjusting state enterprise and other public tariffs have been defined flexibly; the Government has stated only that tariffs will be set so as to preclude the emergence of distortions. 1/ For all workers, the official real wage index declined by 8.0 percent. The impact on family incomes of an apparent decline in hourly real wages and benefits in recent years may have been mitigated by the apparent growth of total employment and hours worked (see Tables 9-10).  CHART 1 URUGUAY NOMINAL AND REAL INTEREST RATES1 80 NOMINAL INTEREST RATES REAL INTEREST RATES Zv 30 70- Loans in L/C 20 (Prime rate) Loans in L/C j_ /. '.. /F (Prime rate) 60~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~U 50 | XX I < , X \ in A * Lns m F/C / 10 50 20 ... Loans in F/C {Prim rateJ , De(Prime rate) 40 r 0 Deposits in LIC \ - 30 (31-180 days) 5'. \V.' V\ 'I... -10 20 Loans in F/C (Prime rate) Deposits in L/C .- l.......... (31-80) days) o20 10 I Deposits in F/C Deposits in F/C (Time deposits) . (Time deposits) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __11 1 1 1 -3 0 1977 1978 1979 1977 1978 1979 Source: Central Bank of Uruguay, 11E1 j/Average annual interest rates. 2/ Taking into consideration the domestic rates of inflation and currency depreciation. L/C= Local currency. F/C= Foreign currency.  TABLE 9: URUGUAY - WAGE AND BENEFIT INDICES-' 1970-79/-2 (1968 = 100) Nationwide Wage Index,3 Private Sector Public Sector /3 Nominal Real - Nominal Real/3 Nominal Real - (1) (2) (3) (4) (5) (6) 1970 140.2 99.6 150.4 106.9 127.2 90.4 1971 192.0 110.0 197.6 113.3 184.8 106.0 1972 287.6 93.4 295.4 96.0 277.6 90.2 1973 593.1 97.8 585.6 96.6 602.0 99.3 1974 1,049.0 97.7 1,035.0 96.4 1,066.8 99.3 1975 1,773.8 91.0 1,734.1 89.0 1,822.9 93.5 1976 2,344.8 79.9 2,397.8 81.7 2,506.7 85.4 1977 3,532.2 76.1 3,273.0 70.5 3,857.5 83.1 1978 4,942.7 73.6 4,526.0 67.4 5,472.8 81.5 1979 7,586.3 67.7 6,843.7 61.1 8,529.8 76.2 Sources: Central Bank and Direccion General de Estad'stica y Censo. 1/ Includes salaries and social benefits,except for paid holiday and bonusses, earned by workers in industry construction, retail, trade, transport, and services. Excludes the meat packing, sugar and fruit-retailing sectors. 2/ Annual Average 3/ Deflated by General Consumer Price Index of Montevideo.  TABLE 10: URUGUAY - INDICES OF TOTAL REAL WAGES AND BENEFITS1/, 1975-79 (1975 = 100.0) Real Nationwide Wage Index of Total Index of Total Index of Total Index of Total Wage Index Hours Worked Employment/2 Wages I/3 Wages II /3 (1) (2) (3) (1) x (2) (1) x (3) 100 100 1975 100.0 100.0 100.0 100.0 100.0 1976 87.8 97.0 104.7 85.2 91.9 1977 83.6 101.0 111.2 84.4 93.0 1978 80.9 98.7 117.5 79.8 95.1 o 1979 74.4 98.7 128.9 73.4 95.9 Sources: Central Bank and the Direccion General de Estad-stica y Censo. 1/ Includes salaries and social benefits, except for paid holidays and bonusses, earned nationwide by workers in industry, construction, retail trade, transport, and services. 2/ Including part-time workers. 3/ Because information on the coverage of the total hours index is at present unavailable, this index and the total employment index were used to calculate alternative total wage indices. Although the employment index used in the second calculation does cover most sectors of the economy, it is also a less-than-ideal measure of total remunerated work because it is not adjusted for part-time work and includes certain non-wage employment within its definition of work.  - 21 - 19. At present, only the exchange rate is being pre-announced. In its most recent extension, the exchange rate for the peso was pre-announced through December 1980, when the buy rate will be fixed at NUR$10/US$1. This would imply a year-on-year nominal devaluation in 1980 of about 18 percent compared with 20 percent in 1979. Of all its anti-inflationary measures, the authorities ascribe major importance to the combined impact of exchange rate appreciation and of trade liberalization. They believe that, by reducing the downward crawl of the peso in relation to the dollar -- thereby allowing it to appreciate in real terms -- and gradually lowering tariff and non-tariff barriers to trade, domestic inflation can gradually be brought down to the international inflation rate, i.e., the trade-weighted average of increases in overseas prices on goods presently, or potentially, traded in Uruguay. This is the essential rationale for the roughly 16 percent apprecia- tion of the peso which occurred during the period of 1978-79 (see Table 11). The ability of domestic producers to raise prices at rates substantially above international inflation -- which, based on Uruguayan trade patterns, did not exceed 40 percent in 1979 -- suggests that a condition of substantial redundant tariff protection persisted throughout most of last year. Since the Government anticipates little change in the current real exchange rate and continuing reductions in the level of tariffs over the next several years, domestic producers may soon exhaust the remaining margins of redundant protec- tion available to them. If this happens, wage and price levels in the traded- goods sector would converge rapidly to international levels -- assuming nominal exchange rate devaluations are gradually slowed -- disciplined by ample potential supplies of foreign imports at competitive prices. These deflationary forces would be transmitted to the nontraded-goods sector via factor and product substitution. 20. Data through May 1980 reveal that consumer price inflation did, indeed, decline relative to the trend during the first five months of 1979. 1/ It is not yet certain whether the slowdown in inflation is a sign that price convergence is occurring in response to competitive pressures from rising imports or is the result of a contraction in aggregate demand induced by a shift in the pattern of Argentine investment and consumer expenditures toward other markets and a deterioration in the world markets for Uruguay's key beef, leather, and textile exports. However, there are some indications that nominal wage increases in the industrial traded-goods group have begun to slow relative to increases in nontraded sectors, such as construction, transport, and services, suggesting that the supply-increasing stabilization strategy may be working. 1/ From January-May 1980, the cost-of-living index went up 17.4 percent compared to 27.2 percent during the same period of 1979, 15.4 percent in 1978, and 23.4 percent in 1977. On this basis, the trend in prices appears to be closest to that of 1978, when year-on-year inflation was 46.1 percent (see Table 12). Projecting 1980 inflation on the basis of the results for the first 5 months also yields an annual inflation rate near this level--on the order of 48-49 percent.  TABLE 11: URUGUAY - INDICES OF TRADE-WEIGHTED REAL PESO EXCHANGE RATE,-/ 1973-79 Nominal Exchange Export-Weighted Real Import-Weighted Real Year Rate Exchange Rate 2/ Exchange Rate 2/ (NUJr$/US$) Index Annual Percentage Change Index Annual Percentage Change (+ = appreciation) = appreciation) 1973 0.875 91.1 - 100.9 1974 1.216 88.8 2.9 91.4 9.5 1975 2.299 100.0 -12.6 100.0 -9.4 1976 3.395 104.5 -4.5 113.0 -13.0 1977 4.750 104.9 -0.3 113.0 0.0 1978 6.125 102.9 1.9 101.7 10.0 1979 7.918 88.5 14.0 95.2 6.5 Sources: International Financial Statistics and Direction of Trade; IMF 1/ Annual Averages 2/ Derived by the following formula: XRU X . N. x WPI. U (or -) u u WPI u where U = Uruguay i = Trading partners of Uruguay XR = Exchange rate WPI = Whoesale price index X (or M )= Total exports (or total imports) of Uruguay. Xi = Exports of Uruguay to country i M = Imports of Uruguay from country i  - 23 - TABLE 12: URUGUAY - MONTHLY PERCENTAGE CHANGES IN MONTEVIDEO CONSUMER PRICE INDEX Year Month General Food Clothing Housing Other 1977 January 4.7 4.0 2.0 5.8 6.4 February 6.4 8.5 2.5 2.0 8.3 March 3.2 3.3 5.1 2.4 3.0 April 3.5 5.1 5.3 2.4 1.1 May 3.7 1.9 2.0 5.7 3.2 June 4.5 7.6 3.1 4.8 2.0 July 5.1 4.2 2.9 8.4 4.8 August 3.3 4.4 1.9 3.8 1.3 September 5.4 3.5 4.3 10.4 4.9 October 3.4 3.6 3.5 2.0 4.6 November 1.4 1.2 4.2 1.6 0.6 December 1.5 0.6 2.0 3.1 1.3 1978 January 1.2 0.2 2.0 1.5 2.4 February 2.7 1.0 1.5 6.9 2.5 March 2.7 2.6 3.1 2.1 3.3 April 5.2 8.3 4.1 3.6 2.0 May 2.8 3.5 2.4 2.7 1.6 June 2.9 3.2 2.3 2.8 2.8 July 3.4 4.2 0.5 4.3 2.0 August 3.5 4.3 1.6 1.6 4.7 September 4.1 3.0 3.4 6.1 4.4 October 3.7 5.6 4.4 1.3 2.4 November 1.7 0.2 5.7 1.8 1.8 December 4.7 4.4 2.8 3.7 8.1 1979 January 5.6 8.9 3.0 2.7 3.2 February 4.7 4.5 3.2 7.3 3.3 March 2.6 1.6 6.5 2.4 3.2 April 4.6 4.8 8.5 2.8 4.2 May 7.2 5.4 9.0 6.4 10.7 June 4.2 5.2 7.8 2.3 2.4 July 3.4 3.7 4.2 3.3 2.5 August 9.6 10.1 4.0 9.7 11.1 September 4.6 4.3 5.4 6.1 3.5 October 3.4 3.0 6.2 3.4 2.9 November 7.0 6.6 6.2 8.6 6.8 December 5.4 5.9 5.0 4.7 5.1 1980 January 3.6 0.7 1.0 8.9 5.6 February 4.4 3.6 1.6 6.0 5.4 March 2.0 1.5 1.1 1.8 3.4 April 2.6 3.0 2.6 3.6 0.8 May 3.7 Memorandum Item: (Projected) % Annual Inflation (General Index) 1977 1978 1979 1980 (a) Average 58.2 44.5 66.8 63.3 (b) End of Period 57.3 46.1 83.1 47.5 Source: Central Bank - Economic Indicators 1/ Based on January-May data.  - 24 - Chapter II Medium- and Long-term Issues and Prospects 21. The new stabilization strategy introduced in late 1978 attempts simultaneously to reduce the rate of inflation and to induce the modernization and restructuring of the economy by relying on supply-increasing, rather than demand-reducing, forces. The recent decline in the annual inflation rate and the steady improvement in the overall balance of payments have encouraged the authorities to continue with the present trade and exchange rate policies. There is concern, however, about (a) the adjustment burden imposed upon the economy, particularly upon export and import-competing industries, as conver- gence rapidly approaches, and (b) the long-range effects of a policy combining liberalization of trade with an appreciating real exchange rate. Exchange Rate Policies and Aggregate Demand Management 22. As noted in Chapter I, the upsurge in inflation during 1979 had important roots in developments in the real sector. Shortfalls in agricultural supplies, an increase in investment demand reflecting the improved domestic growth prospects, large increases in international prices for important traded goods like beef and petroleum, catch-up increases following the decontrol of many domestic prices, and a large increase in the Argentine demand for Uruguayan consumer and investment goods all contributed to inflationary pressures. At the same time, however, the decisions to pre-announce the rate of devaluation, remove all capital controls, and abolish domestic banking reserve requirements permitted a major growth of liquidity and aggregate demand. 23. In the Government's view, the total quantity of money and credit is entirely demand-determined in a small, open economy with an administered exchange rate, as in the Uruguayan case. Any measures it might take to restrict the growth of domestic credit, therefore, would be quickly offset by higher levels of capital inflow from abroad. Capital controls, moreover, are perceived as being either ineffective or distortional and counter to the objective of establishing Uruguay as an international financial center. Management of the level of international reserves and the growth of the monetary base of internal origin are regarded as the primary tasks of the monetary authorities, who have assumed a passive stance with regard to the aggregate supply of money and credit. Once tariff redundancy is eliminated, the authorities believe domestic inflation will no longer exceed the sum of international inflation and the rate of devaluation, and aggregate demand will be regulated automatically by a modern-day, specie-flow price mechanism. 24. Some concerns regarding the implications of this policy for long-term resource allocation are expressed below. The efficacy of the model for short- run economic management depends heavily on the speed of the assumed adjustments, the relative importance of price and wage movements--as opposed to output and empioyment changes--in the equilibration process, and the stability of the function relating the supply of external capital to domestic economic variables.  - 25 - In regard to this latter function, for example, the supply of external capital may not be independent of, or stably related to, the pattern of changes in domestic prices, interest rates, and the size of the current account deficit needed to eliminate excess demand and restore equilibrium. 1/ 25. To better understand the limits to, and the role of, conventional demand management policies under the present approach, the impact of the exchange rate and of trade liberalization on international-domestic price convergence needs to be closely monitored. For this purpose, detailed infor- mation about the evolution of domestic and c.i.f. import prices, wages and other production costs, profits, employment and income distribution are essential. There is also a need to analyze in greater depth the behavior and evolution of the demand for money, the impact of the current passive monetary policy on the formation of inflationary expectations, the inflow of foreign capital, including its composition and its elasticity in relation to interest rate differentials, and barriers posed by market imperfections to the unifica- tion of foreign and domestic interest rates. The Exchange Rate, the Balance of Payments and Problems of Economic Analysis 26. While the present exchange rate regime is likely to achieve even- tually the convergence of international and domestic inflation rates, more attention should be given to the possible effects of an appreciated exchange rate on trade, resource allocation and growth. Although the period of expe- rience is still too short to be conclusive, some preliminary evidence is available regarding the impact of the exchange rate on trade during the past four years. During 1976-77, the peso was devalued in real terms by nearly 1/ The current account deficit cannot, of course, exceed the sum of the capital account surplus and the expenditure of international reserves. The monetary authorities believe that it is the domestic demand for money, on the one hand, and the Central Bank's decisions regarding the expansion of credit of domestic origin, on the other, which determine the level and direction of international reserve changes and foreign capital flows. The current account balance is passively determined by reserves and capital flows. If reserves are held unchanged, then shifts in the supply curve of foreign capital--e.g., raising the risk premium implicitly assessed by foreign lenders--would, by forcing up domestic interest rates, lead to a reduction of the current account deficit to the level "approved" by foreign lenders. So long as such supply shifts were small or gradual, the adjustment process would be relatively smooth and painless. The concern expressed above pertains to the possibility of a quantum shift of the foreign capital supply curve which, in the absence of offsetting Central Bank credit expansion (contraction) and ample inter- national reserves, could force a substantial economic recession (infla- tion). It should be emphasized that Uruguay's very large reserves make the possibility of any near-term loss of lender confidence and capital flight remote.  - 26 - 13 percent on an import-weighted basis. 1/ Real exports went up by 41 percent, real non-oil imports by 34 percent, and the trade deficit averaged roughly 2 percent of GDP. In the more recent two-year period 1978-79, the exchange rate, both on an export- and on an import-weighted basis, appreciated by nearly 16 perce-t. Real exports rose by only 0.2 percent, real non-oil imports by 51 percent, and the trade deficit averaged 4.6 percent of GDP (see Tables 3-5 and 11). 2/ Particularly striking was the fall-off in non- traditional exports, which have played such a key role in the Government's export-diversification strategy. Here, real growth declined from 35 percent annually during the earlier period to 10 percent annually in the latter period. 27. An appreciating real exchange rate and declining tariff protection cause a shift in relative prices inside Uruguay in favor of the nontradeable- goods sectors and against export and import-competing sectors. The speed with which this shift occurs will affect the ability of existing enterprises to adjust their cost structures or adapt their product mixes so as to minimize the social costs of unemployment and capital obsolescence. 3/ At the same time, uncertainty with regard to the future real exchange rate may inhibit desirable investments in plant modernization and expansion, with associated losses of employment and output. The analysis recommended above (para. 25) would throw useful light on the present adjustment process. Now that inflation appears to be following a downward course, reconsideration of the current exchange rate policy might be appropriate. Rather than maintaining the present rate of devaluation, a slight acceleration might be warranted to assure the desired balance between the rate of growth of exports, the current account deficit, and the growth of the external debt and debt service. More rapid devaluation could also serve to compensate, in part, for the accelerated reduc- tion of trade barriers recommended below. 1/ Five percent on an export-weighted basis. 2/ The trend appears to have continued through early 1980. Although data on real changes were unavailable, a cumulative trade deficit of US$126.0 million was recorded for the first two months compared to US$6.6 million during the same period of 1979. Exports were up 13 percent in nominal terms, while non-oil imports increased by around 90 percent. 3/ The adjustment process will be eased to the extent that factor prices are flexible. An analysis of recent data for exporters indicates that wage costs over the 1978-79 period have evolved closely in line with changes in U.S. dollar prices for Uruguayan exports adjusted for peso devaluations against the dollar, as can be seen in Table 13. There is evidence, however, that wage hikes began to outdistance export price increases by a wide margin in the latter half of 1979. The April 1980 tax reform proved timely for exporters in this regard (see discussion of Chap. I, para. 4.b.2), because it essentially brought wage trends back into line with prices. Clearly, if the underlying wage trend continues to outpace export prices in pesos, however, exporters could be subject to growing cost pressures and significantly reduced profitability.  TABLE 13: URUGUAY--Evolution of Exchange-Adjusted International Prices for Uruguayan Exports and Nominal Domestic Wages (December 1977 = 100) Index of Inter- Index of Nominal Index of Exchange- Nationwide Index Ratio of Export Prices Year & Month national Prices for Peso/Dollar Adjusted Prices for of Salaries to Domestic Wages Uruguayan Exports Exchange Rate Uruguay Exports and Benefits(e) - d x 100 (a) (b) (c) ( x (b) (d) [(c) d 1977 Dec. 100.0 100.0 100.0 100.0 100.0 1978 Jan. 101.5 101.1 102.6 100.0 102.6 Feb. 102.9 100.6 103.5 100.0 103.5 Mar. 104.6 100.6 105.2 108.4 97.0 Apr. 105.4 102.6 108.1 108.4 99.7 May 105.0 105.4 110.7 108.4 102.1 June 106.5 108.4 115.4 117.1 98.5 July 107.8 113.6 122.5 117.2 104.5 Aug. 109.6 117.1 128.3 117.5 109.2 Sept. 110.7 120.6 133.5 128.6 103.8 Oct. 114.6 123.2 141.2 128.7 109.7 Nov. 114.0 126.2 143.9 128.7 111.8 Dec. 115.2 129.6 149.3 141.8 105.3 1979 Jan. 117.6 132.2 155.5 141.8 109.7 Feb. 118.6 134.9 160.0 155.5 102.9 Mar. 119.5 137.7 164.6 155.5 105.9 Apr. 119.8 140.5 168.3 155.5 108.2 June 122.5 146.5 179.5 170.3 105.4 Sept. 128.6 151.3 194.6 194.9 99.8 Dec. 134.7 154.8 208.5 223.8 93.2 1/ In US Dollars Sources: Central Bank and the Direcci6n General de Estadistica y Censo.  - 28 - The Scope and Pace of Trade Liberalization 28. The level and pattern of protection which prevail over the next 2-3 years are likely to play a significant role in shaping the efforts of industry, which has been the most highly protected sector of the economy, to modernize and expand its operations. 1/ Under the current tariff reduction program , the uniform tariff target has been set at a level of 35 percent, not taking into account the implicit tariff effects of the import reference price system or the added protection deriving from various non-tariff barriers. 2/ Thus, even after the completion of the tariff reduction program in 1985, effective protection may be high and uneven. The costs of having international price signals filtered through such a skewed system of protection could be consider- able in terms of the sub-optimal use of investment resources. In the future, the twin aims of price stabilization and allocative efficiency might better be served by a policy of more rapid exchange devaluation combined with an accelerated implementation of the tariff reduction program. Serious consid- eration should be given to deepening and accelerating the liberalization process by: (a) advancing the deadline for completion of the tariff reduction program; (b) lowering the final global tariff rate to well under 35 percent; (c) abolishing the import reference price system and converting rapidly to a c.i.f. price basis; (d) intensifying the review of non-tariff measures affecting imports, such as safety and sanitary regulations, to determine whether the same public welfare benefits might be achieved in ways which would minimize any distor- tional effects on trade; and (e) instituting new programs, such as infant industry credits and retraining grants for workers in older industries, to facilitate the domestic adjustment process. Finally, as noted previously, the adjustment process could be further eased by a calculated program of compensatory devaluations. 1/ In a recent year (1978), industry accounted for 30 percent of GDP, 28 percent of total employment, and 82 percent of total exports. On the basis of recent trends in gross domestic investment, an assumed GDP growth rate of 4.5 percent, and industry's relative size in the economy, over US$1 billion will be needed to improve industrial capacity over the next 3 years. 2/ Reference prices alone can result in final duty assessments more than four times higher than the nominal tariff.  - 29 - MeO_ium-term Economic Outlook Public Sector Investment 29. A basic choice facing the economy in the immediate years ahead is the rate of investment - i.e., the rate at which the country's infrastructure shculd be rehabilitated and its industrial sector modernized and expanded. There is need for improvement in the planning and execution of investment programs and for the development of a project mix which includes a higher proportion of projects with an early payout. Despite the large infrastructural needs of the country, only the most urgent projects should be undertaken. Implementation of all the projects currently under consideration by public sector agencies (see Table 14) would result in public sector investment equal to about 10-15 percent of GDP during the period 1980-83. Such a level of investment is neither financially nor administratively feasible. 30. The composition of public investment should reflect both the long- standing needs which have accumulated over the last decade and the goal of early payouts. These objectives can best be reconciled by careful selection and prompt execution of a small number of high-yielding projects. Appropriate project selection procedures would stand a greater chance of being followed if the project preparation and evaluation units in the decentralized agencies, the various ministries and the Planning Department (SEPLACODI) were strengthened and required to observe standardized evaluation practices. Project implementa- tion also needs strengthening. In this connection, improved monitoring of project execution is needed to ensure that resources are being fully utilized and that any problems which arise are promptly corrected. 31. Improved project planning and implementation will require the strengthening of technical staffs in the public sector agencies, which, in turn, implies salary levels competitive with those in the private sector. In general, public sector salaries presently fall well short of that objective. Furthermore, the flow of information within the different agencies and minis- tries, as well as to the Ministry of Economy and Finance and SEPLACODI, needs to be improved and regularized, so that decisions can be taken expeditiously based on timely information. Faster project implementation could also be achieved by permitting greater operating decentralization. 32. Sufficient information is not available to choose optimally from the long lists of projects compiled by the various public agencies. In recent years, public sector investment has been concentrated mainly in power and transport where the need for new resources has been great, revenues from earmarked taxes readily available, and institutional support for project preparation and implementation relatively strong. But needs in other sectors are increasing. Therefore, while transport and energy can be expected to retain the largest shares of future public sector investment, it might be possible to reduce somewhat the emphasis on transport investment and allocate the funds released to the telecommunications and the social sectors. The telecommunications sector urgently needs additional resources in order to raise the quality and speed of transmissions, both within the country and to other countries, up to a level commensurate  a/ TABLE 14: IRUGUAY - PUBLIC SECTOR IN\'ESTMENT PROGRAM, 1980-83 (1977 ,NUr$) 1980 7. 1981 . 1982 % 1983 % A. Infrastructure 2,781 71.1 2,239 85.1 2.370 89.6 1.684 62.4 1. Transport 885 22.6 870 33.1 992 37.5 738 27.3 a) MTOP 601 628 675 556 Road Reconstruction and Maintenance 353 371 315 363 Route 8 84 84 84 - Routes 1, 2 and 24 - - 135 135 Others b) AFE 157 104 96 103 Rail Reaonditioning 142 96 94 102 Other c) PLUNA 11 7 127 1 d) ANP 115 131 94 78 2. Communications - ANTEL 303 7.8 364 13.8 358 13.5 293 10.9 Telephone Improvement and Expansion 179 141 96 85 Telecommunications 103 134 168 98 Others 21 89 94 110 3. Energy 1,440 36.8 823 31.3 882 31.1 440 16.3 a) UTE 563 14.4 625 23.8 820 31.0 440 16.3 Generation 66.8 151.5 375.0 81.5 1 Transmission 102.4 93.7 39.2 10.1 w Distribution 273.1 252.2 250.3 255.3 0 - For the Interior 38.9 30.0 21.3 21.1 - Montevideo 234.2 222.2 229.0 234.2 Other 120.7 127.6 155.5 93.1 b) Salto Grande and El Palmar 877 22.4 198 7.5 2 - - - 4. Water Supply - OSE 153.8 3.9 182.7 6.9 198.4 7.5 213.8 7.9 Potable Water Connection - Montevideo 13.8 16.4 17.9 19.3 Tnterior 70.7 84.1 91.3 93.3 Sewerage 34.5 42.0 45.6 49.2 Other 33.9 40.2 43.6 93.9 B. Productive Sector 59.2 1.5 41.5 1.6 37.8 1.4 23.4 0.1 a) Agriculture 15.5 16.8 18.1 18.5 b) Industry - ANCAP 43.7 24.7 19.7 4.9 La Tablada Distribution Plant - - _ Bunker - - Others 43.7 24.7 19.7 4.9 C. Social Sector 123.4 3.1 118.2 4.5 80.8 3.0 82.0 3.0 a) Health and Sanitation 43.6 29.4 38.3 38.0 b) Education 79.8 88.8 42.5 44.0 CONAE 14.0 14.4 13.3 14.0 University 65.8 74.4 29.2 30.0 c) Housing _ _ _ D. Other 948 24.2 232 8.8 158 5.9 911 Municipalities (164.2) (154.6) (161.2) (165.0) TOTAL 3,911 100.0 2,630 100.0 2,645 100.0 2,700 100.0 a/ This program represents the ideas of the various agencies and is likely to be much larger than they can implement.  - 31 - with the requirements of Uruguay's expanding system of trade and financial intermediation. Investment in education and health should also be expanded in order to arrest the physical deterioration of plant and equipment, expand the existing capacity of the educational system, particularly at the secondary school level, and better adapt training output to the needs of a changing economy. 33. It is assumed that the projected public sector investment program will be financed through higher public sector savings and increased inflows of external capital (see Table 15). This will be necessary in order to elimi- nate public sector borrowing from the Central Bank and limit the government's claims on private savings. Projections of the likely current budget surplusses of the central government and the decentralized agencies suggest that public sector savings could be expected to increase from about 2.6 percent of GDP in 1980 to about 3.5 percent by 1983. The increased savings will have to come from the control of current expenditures, including a reduction of redundant employment, and further progress in coordinating, planning, and executing public sector budgets. More timely rate changes for the decentralized agencies would also raise public savings (in 1977-78, their savings amounted to only 0.1-0.2 percent of GDP). In addition, it is assumed that the level of external borrowing would result in the public debt service ratio rising gradually from its current 10-11 percent to roughly 17-18 percent by 1983 and that domestic borrowing would be negligible in order not to restrict the availability of funds to the private sector. Under these assumptions, the feasible level of public sector investment would increase from about 4.9 percent of GDP in 1980 to about 6 percent by 1983 (see Table 15). Table 15: Public Sector Investment and Financing (millions of 1978 Uruguayan pesos) 1980 1981 1982 1983 Total Public Sector Investment /a 1680 1920 2140 2370 as % of GDP 4.9 5.4 5.8 6.0 Central Government 845 895 980 1170 Public Enterprises 705 865 970 985 Rest 130 170 190 215 Financing 1680 1920 2140 2370 A. Public Sector Savings 885 1090 1230 1390 Central Government 601 708 787 847 Rest 284 382 443 543 B. Borrowings (net) 795 830 910 980 External 580 710 710 810 Net Domestic 115 120 150 170 /a Includes financial investment.  TABLE 16: Projected National Accounts, 1980-83 (Millions of 1978 Uruguayan Pesos) Average Annual Growth Share of GDY Rate 1980 1981 1982 1983 1980 1983 1980-83 __ Gross domestic product 32,626.2 .34,142.1 35,731.3 37,397.5 100.1 104.2 4.6 from terms of trade ~-30.3 -121.7 -187.7 -155.0 0.1 0.4 21.1 Gross domestic income 32,595.9- 34,020.4 35,543.5 37,242.5 100.0 100.0 4.6 Imports of goods and NFS 6,781.1. 7,081.4 7,393.6 7,722.5 20.8 20.7 4.8 Exports of goods andI NES 6,132.4 6,499.0 8,899.0 7,506.2 18.8 20.2 6.6 Exports (import cap- acity) 6,102.1 6,377.8 6,801.2 7,351.2 18.7 19.7 6.3 Resource gap 679.2 703.6 592.4 371.3 2.1 1.0 13.0 Consumption 26,530.7' 27,902.4 28,984.5 30,116.0 81.4 80.9 4.0 Investment 6,744.4 .6,821.6 7,151.4 7,497.8 20.7 20.1 5.4 Domestic savings 60O65.2 6,118.0 6,559.0 7,126.5 18.6 19.1 7. 1 National savings 5,601.3 5,638.2 6,052.8 6,604.8 17.2 17.7 7.4  - 33 - Energy Dependence 34. On the energy front, the lack of indigenous resources, other than the potential for the exploitation of hydro-electric power which already is being fully developed, limits Uruguay's future supply options. Off-shore exploration efforts have encountered no commercial deposits to date. Nuclear energy, once considered impractically expensive given the small dimensions of Uruguay's market, is now being studied more intensively and could become economically attractive if real energy prices continue to rise rapidly and progress in designing small-scale (under 600 MW) reactors results in somewhat lower fixed costs per unit of output than at present. A gas pipeline project, intended to facilitate imports of Argentinian or Bolivian natural gas, offers an attractive, alternative source of imported energy, located much closer to Uruguay than current imported oil sources, with potential gains in the relia- bility of supply and in the reduced transport costs. Negotiations are being actively conducted with Argentina. To utilize the electricity generated by the'two large hydroelectric projects at Palmar and Salto Grande, plans for rehabilitating and extending the distribution network need to be speedily implemented. Recently, the Government signed an agreement with Brazil for two additional hydroelectric projects in the Northeast. Growth, Investment, and the Balance of Payments 35. The projections of the balance of payments and of the national accounts in Tables 16 and 17 are based on the assumption that the Government will continue to follow an export-oriented, high-growth strategy. This implies that: (i) investment will continue to receive top priority (however, it is assumed that per capita private consumption will have recovered to the 1974 level by 1981-82); (ii) the import liberalization program will be implemented according to the schedule announced by the Government; (iii) the Government will continue to pass through fully any future price increases for imported crude and petroleum products to consumers. With the completion of the Palmar and Salto hydroelectric dam projects by 1983 and rising real domestic fuel prices, the antici- pated increase in energy production should be fully adequate to meet the anticipated growth in demand. 1/ Finally, (iv) policies providing sufficient incentives for continued export expansion would be followed. 1/ Over the 1975-79 period, total domestic fuel consumption rose at an average 3.6 percent annual rate (see Table 18).  - 34 - Table 17: EXTERNAL CAPITAL REQUIREMENTS AND FINANCING, 1980-83 (IN 1978 PRICES) (US$ millions) 1980 1981 1982 1983 Exports of goods and NFS 1216.5 1353.9 1538.7 1762.2 Imports of goods and NFS 1351.9 1503.3 1672.7 1851.2 Resource balance -135.4 -149.4 -134.0 -89.0 Net factor payments -96.6 -105.9 -118.2 -129.3 O-W Net Interest -72.4 -79.3 -89.0 -97.1 Net transfers 8.5 9.3 10.2 11.3 Current Account Balance -223.5 -246.0 -242.0 -207.0 Private Capital Inflows 146.8 145.0 129.4 110.2 Public M&LT loans (net) 101.0 126.2 140.9 126.6 Gross Disbursements 155.9 192.8 213.7 233.8 Amortization /a -55.0 -66.6 -72.8 -107.2 Change in Reserves (- = increase) -24.3 -25.2 -28.3 -29.8 Public debt service ratio 12.7 13.4 15.4 17.5 /a Amortization in 1977 and 1978 had been high because of prepayment of loans. 36. Under these assumptions, GDP could grow by about 5 percent a year during 1980-83, implying a per capita growth of over 4 percent per year. Gross domestic investment would be equivalent to 20 percent of gross domestic income (GDY) and the resource gap would average about 1.7 percent of GDY. Because of the expected high proportion of infrastructure investment, which would leave a somewhat lower-than-normal share available for investment in directly-productive facilities, the incremental capital-output ratio is assumed to be relatively high -- around 4.5. The growth path is consistent with the maintenance of a sustainable balance-of-payments position, assuming capital inflows continue to be significant for the next couple of years.  TABLE 18: URUGUAY - FUEL CONSUMPTION BY TYPE OF PRODUCT, 1975-79 (000s of metric tons) Annual Growth Growth in 1975 1976 1977 1978 1979 1975-79 (%) 1979 (%) Gasoline 253.0 239.5 252.5 278.3 308.2 5.1 10.7 Naptha 14.6 11.7 5.4 16.5 16.0 2.3 -3.0 Gas Oil 408.7 439.3 445.5 482.8 523.1 6.4 8.3 Diesel Oil 41.5 46.1 46.0 51.9 48.2 3.8 -7.1 Heating Oil 64.2 68.2 67.5 68.3 73.8 3.5 8.1 LPG 66.3 68.7 68.0 73.2 77.1 3.8 5.3 Fuel Oil 754.6 754.7 716.4 717.1 826.0 2.3 15.2 Kerosene 198.2 204.5 176.3 179.4 168.6 -4.0 -6.0 Aviation Fuels 9.1 8.1 9.1 7.7 8.0 -3.6 3.9 Solvents 7.1 8.0 8.6 7.7 9.5 7.6 23.4 Asphalts and Tars 33.0 40.3 37.9 56.8 73.1 22.0 28.7 Total 1,850.3 1,889.2 1,833.2 1,939.6 2,131.6 3.6 9.9 Source: ANCAP  - 36 - 37. Despite expectations of a rapid growth in imports of capital goods, in line with the needs of the investment program, and in imports of non-food consumer goods as import barriers fall, overall imports should grow by only 4.8 percent annually over the 1980-83 period, assuming fuels, representing roughly one-quarter of total imports, show little or no growth, as explained above. Exports, on the other hand, are projected to grow by 6.6 percent annually, owing to a large expected increase in meat exports after 1981--when the livestock investments made during the 1978-79 period will have matured-- and to the continued rapid growth of non-traditional exports. 38. The current account deficit is projected to average about US$230 million a year during 1980-83. 1/ Gross capital requirements to finance this deficit, meet amortization payments and maintain a reasonable level of reserves are projected to be about US$330 million a year. Public sector borrowing is expected to cover about 60 percent of this and private capital inflows the rest. Due to a heavy backlog of existing loan commitments, disbursement of the roughly US$200 million in projected annual public sector borrowing could be maintained by new commitments of only US$180 million a year, of which about half would come from international and bilateral agencies and the remainder from commercial bank and supplier credits. 39. Domestic inflation could continue at rates somewhat above interna- tional levels over the next year or two, reflecting a temporary acceleration in the schedule of exchange rate devaluations and rising aggregate demand pressures deriving from the higher anticipated levels of domestic investment. Full convergence with foreign price levels is more likely to occur toward the latter part of the 1980-83 period, after the most urgent investment needs have been satisfied, productive capacity has been enlarged, access to foreign imports eased through further trade liberalization, and the exchange rate adjustment completed. Thus, assuming a continuation of the structural reforms and overall liberalization of the economy, Uruguay's prospects for a period of sustained growth at higher-than-trend rates are encouraging. 1/ The balance of payments and capital requirements projections are expressed in dollars of 1978.