Chapter 2. Economic Trends and Outlook

Major Trends and Outlook

Uruguay continues to suffer from its longest economic recession in recent history. Gross Domestic Product (GDP) has declined continuously since the last quarter of 1998. GDP fell 17% in real terms (46% when measured in dollar terms) from September 1998 through December 2002, and per capita GDP dropped from $6,800 to $3,500 in the same period.

The crisis was triggered in late 1998 by the devaluation of the Brazilian real, low commodity prices, a severe drought, and uncertainty in an electoral year. In 2001-2002, the upheaval in neighboring Argentina and an outbreak of foot-and-mouth disease deepened the slump. The situation deteriorated further in 2002 with a banking and debt crisis, leading GDP fall by 10.8%. The economy continued to contract in the first quarter of 2003, but as of mid-year, appears to be recovering slightly, fueled by exports and higher commodity prices.

After the "corralito" was imposed, most Argentine depositors in Uruguayan banks withdrew their funds and Uruguayans followed suit shortly thereafter. Since the Central Bank nearly exhausted its international reserves propping up the banks, the government was forced to abandon its decade-long exchange rate band regime and allow the peso to float freely. Since Uruguay's financial sector was over 90% dollarized, this led to the drying up of credit and severe hardship for dollar debtors. The government declared a four-day bank "holiday," froze time deposits, and eventually closed four banks. $3 billion in loans from the international financial institutions -- helped by a $1.5 billion bridge loan from the U.S. -- saved the financial system from total collapse.

As of July 2003, the situation in the banking sector has improved. The state-owned BROU was able to release the first tranche of frozen deposits, and deposits are gradually returning. A new state-owned bank, the Nuevo Banco Commercial, subsumed three of the four closed banks. (Refer to Chapter 8 for a more detailed description of banking sector developments.)

From 1997 through 2002, Moody’s, Standard & Poor’s and Fitch Ratings rated Uruguay’s long-term, foreign currency-denominated sovereign debt “investment grade.” However, lax budget discipline, falling tax revenues, and the 2002 peso devaluation increased the debt burden to such an extent that the rating agencies downgraded Uruguay several notches to near default levels. In April 2003, the government proposed exchanging the bonds of creditors for new ones with longer maturities to eliminate short and medium-term financing gaps and to create the conditions for economic growth. A vast majority of investors accepted the proposal, helping the GOU avoid a default. As a result, Standard and Poor’s and Fitch upgraded their ratings for Uruguay from CCC to B- and country risk dropped from 2,300 basis points (bp) in April 2003 to 740 bp in June. Under the IMF stand-by agreement Uruguay must exercise extremely tight budget discipline and generate a primary surplus of 3%. This goal will be difficult given increased demand for social services and the need to spur economic growth.

The devaluation of the peso drove inflation up from 3.6% in 2001 to 26% in 2002. Inflation is expected to decline to about 20% in 2003 and drop further to approximately 10% in 2004. Real salaries fell 10% in 2002 as inflation outpaced nominal wages. The number of unemployed grew from 124,000 in 1998 (10%) to 211,000 (17%) in 2002, and has continued to rise in 2003. (Please refer to the Investment Climate/Labor Market Section for a fuller description of the labor market.)

The economic crisis has impacted Uruguay’s traditionally strong social indicators and provoked substantial emigration, especially to the U.S., Spain and Italy. Although Uruguay’s social indicators are still good by Latin American standards, recent government statistics show that poverty has grown from 11% of households in 1998 to 15% in 2002.

Principal Growth Sectors

Uruguay’s economy is heavily based on services (which account for over 60% of GDP.) Industry and agriculture comprise 16% and 9%, respectively, of Uruguay’s GDP. The economic crunch has hit most sectors, except utilities and financial services. While total GDP dropped 17% from 1998 through 2002, the fall in three major sectors (industry, construction and commerce, restaurants and hotels) was as much as 30%.

Electricity, Gas and Water Utilities (EGW) and Banking and Insurance Services were the only two sectors to escape the economic crunch, growing 1.5 and 2.0%, respectively in 1998-2002. EGW should continue to grow due to rising natural gas imports from Argentina, reconversion of firms from fuels to gas usage, and the interconnection of MERCOSUR power grids.

Government Role in the Economy

Uruguay’s economy is based on free enterprise and private ownership, although investors are often faced with cumbersome bureaucratic procedures. In spite of some demonopolization and privatization over the past ten years, the state continues to play a major role in the economy, owning either fully or partially, companies in insurance, water supply, electricity, telephone service, petroleum refining, airlines, postal service, railways, and banking. These activities generate about 18% of GDP and employ about 17% of the labor force.

At roughly 4% of GDP, Uruguay’s budget deficit was high from 1999-2002. The Uruguayan Government passed two budget adjustment laws in 2002 in an effort to reduce the deficit. However, instead of cutting expenditures, the adjustments focused on raising taxes. The government finds it hard to slash expenditures since 63% of total spending is allotted to public sector salaries and pensions.

Privatization of state-owned companies and their association with private sector capital is widely opposed by large segments of the population. In December 1992, 72% of voters overturned substantial parts of a state-enterprise privatization law that had been previously approved by Congress. Although the GOU wants to foster economic efficiency through demonopolization and the elimination of red tape, little progress has been made. The 2001 budget law provided for the demonopolization of telecommunications and certain types of insurance, but basic telephony and workers’ compensation insurance remain a monopoly. The law also created the framework for the regulatory agencies for telecommunications (URSEC) and electricity (UREE), and theoretically levels the tax treatment of public and private firms. However, neither URSEC nor UREE has had much influence in enforcing regulations. In December 2001, the government passed a law to demonopolize oil refining activities as well as imports of crude and refined oil. However, as of July 2003, no advances have been made, and the law may be repealed through a public referendum. Previous administrations gave the private sector access to areas formerly reserved for the state, including insurance and mortgages, road construction and repair, piped-gas distribution, water sanitation and distribution, cellular telephony and airline transportation. A law on energy sector reform that allows for the private generation of energy was approved in 1997. Transmission and distribution rights (wheeling rights) nevertheless remain a state monopoly.

Balance of Payments Situation

The trade deficit for goods and services ($447 million in 2001) turned into a surplus of $195 million in 2002 as a result of a greater decrease in imports compared to exports -- 36 and 10%, respectively. In 2002, imports and exports of goods and services dropped to $2.5 billion and $2.7 billion, respectively.

In 2002, Uruguay’s principal trading partners (exports plus imports) were, in descending order, Brazil, Argentina, the European Union, and the U.S. The leading suppliers of Uruguayan imports in 2002 were Argentina ($541 million), Brazil ($390 million), the European Union ($345 million--mainly Germany and France), and the U.S. ($164 million). Uruguay's leading 2002 export markets were the European Union ($493 million--mainly Germany and Italy), Brazil ($435 million), the U.S. ($135 million) and Argentina ($113 million). Uruguay's exports are highly concentrated in a few products. Meat, rice, wool, dairy products, and leather account for roughly half of overall exports.

The U.S. purchased 7% of Uruguay's exports and provided 8% of its imports in 2002. U.S. sales to Uruguay fell 64% from 1998 through 2002 as a consequence of Uruguay’s prolonged and sharp economic contraction. The U.S. share of imports has, however, increased slightly over the last decade. The Batlle administration vigorously favors expanding trade with the U.S. and the rest of NAFTA. MERCOSUR's market share was 48% in 2002.

For most of the 1990s, Uruguay had current account deficits. However, in 2002, it experienced a $190 million surplus (about 1.5% of GDP.) The change was mostly due to a collapse in domestic demand, which drove imports down.

Infrastructure

Land Transportation: Located between two Latin American giants, Uruguay is the geographical center of MERCOSUR’s most densely populated zone. MERCOSUR integration has fostered trade among its partners, and transportation-related infrastructure is expected to continue growing once the present regional downturn is over. Uruguay is in the middle of a land corridor that connects the Pacific and the Atlantic Oceans through Santiago de Chile, Buenos Aires, and Sao Paulo. Investment in regional road systems is underway, with the active participation of the private sector. Except for approximately 200 miles of highway connecting the southern cities of Colonia to Punta del Este, all other roads are single lane. A study is underway on the rehabilitation of certain stretches of the railway network to transport lumber from the country’s interior to its seaports.

Water Transportation: Uruguay is the natural gateway to the 1.2 million sq. mile Paraná-Paraguay River transportation system used by 40 million people. The waterway goes north to Paraguay and Bolivia and deep into Argentina and Brazil. A major seaport is located in Montevideo. Small ports are located in the free zones of Nueva Palmira and Colonia and in the towns of Piriápolis, Punta del Este and La Paloma. The Nueva Palmira port is experiencing steady growth due to its status as the terminal port of the Paraná-Paraguay waterway and its usage as an alternative port for the embarkation of lumber and grains.

Air Transportation: Uruguay is connected to the rest of the world via an international airport located in Montevideo that is serviced by approximately eight regularly scheduled foreign airlines and one “national” airline. Privately operated air service to the interior has recently become a viable, yet little-used, alternative to land transport.

Telecommunications: Uruguay has one of the most advanced telecommunications infrastructures in Latin America. Its teledensity (main lines per 100 people) was 43 in 2001. In 1997, Uruguay became the first country in the Americas and the sixth country in the world to become fully digital. Internet penetration is estimated at 12% and growing rapidly. Approximately 20% of the population has access to cellular phones.

Energy: The basic source of primary energy in Uruguay is hydroelectric. The limitations of the country’s hydroelectric potential and increasing energy demands have led to the construction of a 250 km-long gas pipeline from Argentina. The pipeline will transport approximately 2-2.5 million cubic meters per day.

Water: A steady supply of potable water (which complies with the World Health Organization’s standards) is permanently available throughout the country. The state-owned water and sanitation company, OSE, is continually improving the system.

Regional Economic Integration

Uruguay is a founding member of MERCOSUR (the Southern Cone Common Market composed of Argentina, Brazil, Uruguay, and Paraguay with Chile and Bolivia as Associate Members) and the geographical center of the bloc’s most densely populated and richest area. Its capital, Montevideo, is the seat of the MERCOSUR Secretariat. MERCOSUR integration fostered regional trade in the 1990s, with Uruguayan exports to the bloc growing from 35% of overall exports in 1990 to 55% in 1998. However, MERCOSUR has faced serious problems since late 1998, and exports to the bloc currently account for only 33% of Uruguay’s overall exports. MERCOSUR’s problems stem mostly from the economic crisis in Argentina, the devaluation of Brazil's currency in early 1999, ineffective macroeconomic coordination, the lack of an effective dispute settlement mechanism, and the lack of supranational institutions. The recently elected presidents of Brazil and Argentina have demonstrated a strong interest in MERCOSUR's reinvigoration. In 2001, the U.S. and MERCOSUR began a dialogue on ways to address regional and global trade issues of mutual concern under the U.S.-MERCOSUR (“Four-Plus-One”) Council on Trade and Investment.