Report No. 31737-UY Uruguay Sources of Growth Policies for the Development of Human Capital, Integration, Competition and Innovation June 14, 2005 Poverty Reduction and Economic Management Unit Latin America and the Caribbean Region Document of the World Bank ICT InformationandCommunicationsTechnology IDB Inter-AmericanDevelopmentBank IMF InternationalMonetaryFund IMM Municipality o fMontevideo INMvIE National Institutefor Minors INDA National FoodInstitute INE National StatisticalOffice INIA National Institute for AgriculturalResearch I" NationalInstituteforYouth IPR IntellectualPropertyRights LATU TechnologicalLaboratoryofUruguay MECAEP FullDay SchoolsProgram MERCOSUR SouthernCone CommonMarket MEVIR RuralHousingProgram MFN Most FavoredNation MPYMES Micro and Small and Medium-SizeCompanies MSP Ministry ofHealth MTOP Ministry ofTransport andPublic Works MTSS Ministry ofLabor and SocialSecurity MVOTMA MinistryofHousing, LandOrganizationandEnvironment NBC New CommercialBank NGOs Non-governmentOrganizations NPLS Non-performingLoans N I S National InnovationSystem NTBs Non-tariffBarriers OECD Organizationfor EconomicCo-operationand Development ORT ORT University PAE SchoolFeedingProgram PAYG Pay As You Go PISA InternationalProgramfor Student Evaluation PNCA National Programfor FoodSupplements PPP PurchasingPower Parity PSP PrivateSector Participation PROJOVEN Young Training Program R&D Researchand Development SAAC FoodAssistance Service for Collectives SEBRAE Brazilian Support Service for Micro and SMEs SCOT SupervisionSystem for Objective Work Conditions SICE IntegratedStatePurchasingandContracts System S M E Smalland Medium Enterprise NIS National InnovationSystem SR RemunerationSystem TCC ThermalCombinedCycle TFP TotalFactor Productivity UdelaR University ofthe Republic UI Inflation Unit UNESCO UnitedNationsEducational,Cultural and Scientific Organization UNIT UruguayanInstituteofTechnicalStandards URSEA Powerand Water Services RegulatoryUnit URSEC RegulatingUnit for CommunicationsServices UTE ElectricPlantsand Transmissions Company UTU UruguayanTechnicalUniversity ACKNOWLEDGEMENTS This report has been prepared by a team led by Daniel Oks (Task Manager, LCSPE) based on contributions fiom World Bank staff and consultants during October 2003 and June 2004. The team benefited fiom the cooperation of various government officials as well as from participants of the private sector, think tanks, NGOs, political parties and academia in various seminars and workshops organized between December 2003 and December 2004 in Montevideo; in particular it appreciates the comments receivedfrom the current Minister ofEconomy, Danilo Astori, andthe former ministerof Economy, Isaac Alfie, duringthe seminar heldinDecember 2004. The main contributors to the chapters of the main report were: Daniel Oks (Macroeconomics, LCSPE), Julio NoguCs (Trade, Consultant), Omar Chisari (Infiastructure, Consultant), Alvaro Clarke (Capital Markets, Consultant), Guillermo Rozenwurcel (Small and Medium Enterprises, Consultant), Jean Guinet (Innovation, OECD consultant), Raimundo Soto (Factor Productivity, Consultant), Lisa Bhansali (State Reforms, LCSPS), Truman Packard (Social Sectors, LCSHS), Alvaro Forteza (Pensions, Consultant), Carlos Winograd (Competition Policy, Consultant), Alejandro Guerson (Debt Management, LSCPE) and Luis de la Plaza(Banking, FIPSI), The report also benefited from contributions by: Alejandro Guerson (Macro Section and Data), Eduardo Siandra (Capital Markets, Consultant), Germin Lambardi (Infiastructure, Consultant), Carlos Casacuberta (Factor Productivity, Consultant), Nora Lusi (State Reforms, Consultant), Cristina Flood (Social Programs, Consultant), Carlos VClez (Infrastructure, LCSFW), Pablo de Silveira (Education, Consultant) and John Fiedler (Health, LSCHH). The report was enhanced by the valuable comments by peer reviewers responsible for the official review of the document- Luis ServCn and Marcel0 Bisogno, as well as by the following participants at discussion meetings and/or readers of the document at its various stages: Axel van Trotsenburg (Director, LCC7), Guillermo Perry (Chief Economist, LCRCE), JuanGaviria (Sector Leader, FPSI), Carlos Vdlez (LCSFW), Phillipe Durand (LCSFE), Carlos Winograd (Consultant), Jesko Hentschel (Sector Leader, LCSHD), Emiliana Vegas (LCSHE), and Mauricio Carrizosa (Sector Manager, LCSPE), who improvedthis report, as well as those who participatedinthe meetings to discuss the principal aspects of the report. Yanina Budkin (LCC7C) was in charge of communicationswith media and the logisticso f seminars and workshops. Jesica Zupnik and Mariela Alvarez (LCC7C) helped organize the seminars and workshops. In the concluding stages valuable comments and various editorial suggestions were received fiom James Parks (Sector Leader, LCC7A). Mariela Alvarez andFlorenciaLiporaciwere responsible for formatting andcompiling the final document. PREFACE Selected technical background papers prepared for this report were edited in a separate volume and are availableupon request fiom the task manager; they can also be foundonthe regionalwebsite (www.bancomundial.ora.ar). The following background papers were included: "Fiscal prudence and debt management - reducing macroeconomic volatility in Uruguay" by A. Guerson; "Long- run growth and productivity changes in Uruguay- Evidence fiom aggregate and plant level data" by R. Soto and C. Casacuberta; "Trade negotiations for growth and development" by J. Nogues; "Cost and price of infrastructure - A computable general equilibrium appraisal of gains for Uruguay" by 0. Chisari and G. Lambardi; "Infiastructure sectors - Suumary diagnostics" by 0. Chisari and G. Lambardi; "An anhlisis of the capital market in Uruguay" by A. Clarke; and "Options for pension reform" by A. Forteza. CONTENTS EXECUTIVE SUMMARY .......................................................................... i CHAPTERI:INTRODUCTION ..................................................................................... Structure ofthe Report................................................................................................... 1 2 CHAPTER11: SOURCESOFGROWTHAND EQUITY- 4 GROWTH STRATEGY .................................................................................................... ......................................... 4 2.1 GROWTH. CAPITALFLOWSAND REGIONALVOLATILITY ........................................... 4 2.2 FACTORS OFPRODUCTIONAND PRODUCTIVITYGROWTH .......................................... 5 2.3 GROWTH. ....................................................... 9 2.4 SOURCESOFGROWTH.STRUCTURALFACTORS ..................................................... EMPLOYMENT. POVERTYAND EQUITY 11 2.5 THE3-PILLAR GROWTHSTRATEGY......................................................................... 14 CHAPTER 111: FROM RECOVERY TO GROWTH-CONSOLIDATION OF MACROECONOMIC STABILITY AND SOCIAL PROTECTION. 1 19 ... 3.1 RECENTREFORMSAND MACROECONOMICDEVELOPMENTS.................................... PILLAR 19 3.2 REFORMSAND FISCALSUSTAINABILITY-MACROECONOMIC STRATEGY 3 3 DEBT . ...............22 .............................................................................................. ~9 3.4 DE-DOLLAFUZATIONMONETARYPOLICY ........................................................ MANAGEMENT AND 31 3.5 STRENGTHENING BANKS ......................................................................................... 33 3.6 DEVELOPING CAPITAL MARKETS ............................................................................ .................................................................................................... 35 3.8 REFORMINGSOCIAL SECURITY AND THE SOCIAL SAFETY NET................................. 3.7 LABOR MARKETS 39 44 CHAPTER IV: SUSTAINABLE GROWTH . INVESTMENT CLIMATE . PILLAR2 ......................................................................................................................... 4.1 TRADEPOLICY AND INTEGRATION.......................................................................... 51 51 4.2. FOSTEFUNG ..................56 4.3 COMPETITIONPOLICY ............................................................................................. EFFICIENCY THROUGHCOMPETITIONININFRASTRUCTURE 4.4 HUMAN CAPITALDEVELOPMENTAND EQUITY-HEALTH AND EDUCATION ..............67 69 CHAPTERV:INNOVATION-DRIVEN GROWTH.PILLAR3 ............................. 5.1 PRIVATESECTORDEVELOPMENT(PSD) ................................................................. 80 81 5.2 SMESAND INNOVATION ........................................................................................ 5.3 DEVELOPMENTSTRATEGYFORTHENATIONAL OFA ...........84 88 5.4 MODERNIZINGSTATE ...................................................................................... INNOVATION SYSTEM THE 94 CHAPTERVI: CONCLUSIONS ................................................................................................................... ............................................................................. 100 Bibliography 102 StatisticalAnnex . . ............................................................................................................. 105 Tables Table 1.Sources ofgrowth inUruguay............................................................................. 6 Table 2 - Decomposition o fchangesinproductivity o fmanufacturing plants-................8 Table 3 - Comparative Goveament Indicators, LatinAmerican Countries, in% 13 Table 4 - Selectedmacroeconomic indicators .................................................................. o f GDP for 2001................................................................................................. 20 Table 5 - Debt Sustainability - Deterministic Simulations ............................................... 24 27 Table 7 -Debt Sustainability - Stochastic Simulations.................................................... Table 6 - Impact onPrimary FiscalBalance 2005-12 - Reform Scenario........................ 29 Table 8 - The Uruguayan BankingSector ........................................................................ Table 9 - Uruguay's capital marketsininternationalperspective .................................... 33 36 Table 11- Payroll Taxes for Pensions andAll Social Insurance...................................... Table 10 - Investor protection ratings............................................................................... 36 43 Table 12 - Principal Risksto HumanCapital FormationandUruguay's Policy 46 Table 13 - Access to Public Services in2002 (% oftotal population) ............................. Interventions ................................................................................................... 57 Table 14 - Ex-refinery Prices (November 2004) .............................................................. 60 Table 15 - Uruguay: GeneratedandExchangedEnergy(Gwh), 1997 and2002 ............64 66 Table 17 - PISA Ratings ................................................................................................... Table 16 - Simulations of the computable general equilibrium model............................. 74 Table 18 - Science and Technology Indicators, Year 2000.............................................. 85 Figures Figure2 .Productivity........................................................................................................ Figure 1.Uruguay's per-capita GDP relative to U S per-capita GDP (PPP prices) ...........4 7 Figure 3 - GDP growth, unemployment andpoverty ....................................................... Figure4 -RealMultilateralExchangeRate .................................................... 10 21 Figure5 - Pensionfunds (fundsundermanagement) - millionpesos.............................. 37 37 Figure 7 - Macroeconomic Trends, LaborMarket Adjustments, and Sector Shifts in Figure6 - Fundsadministeredbyopen-endedh d s (thousands ofUS$)........................ Uruguay........................................................................................................... 42 Figure 8 - Spending on Social Protection (Social Insurance andWelfare) as a Figure9 - Trade flows....................................................................................................... percentageo f GDP, SelectedLCR andOECD Countries in 1998.................45 53 59 Figure 11- PublicEnterprise Efficiency .......................................................................... Figure 10- Intemationalcomparison ofelectricityprices, 2001...................................... 60 Figure12- Private Investment inInfrastructure............................................................... 60 Figure 14- Average Number ofYears ofEducation, Uruguayand SelectedCountries..73 Figure 13 - Nationalexpenditure inhealth-Selected Countries............................ 70 Figure 16- Comparison o fbusinessclimate..................................................................... Figure 15- Educational Attainment ofUruguay's EmployedLaborForce, 1986-2002 .75 82 Boxes Box 1.Pro-cyclical FiscalPolicyinUruguay ................................................................. 14 Box 2 - Pillarsofthe Growth Strategy.............................................................................. 18 Diagrams Diagram 1.Sources ofKnowledge andInnovation......................................................... 91 EXECUTIVE SUMMARY 1. Uruguay, with a prosperity built on beef and other meat exports, was amongst the fastest-growing economies in the world at the turn of the twentieth century. In parallel with economic successes driven by exports under a liberal trade regime, early in the 20th century Uruguay had already began developing a strong and efficient welfare state. Even following the growth decline experienced from the 1930s, Uruguay's per capita GDP in 1955 was higher than that o f Italy, slightly below France's and 44% of that in the United States. By contrast, the slowdown in per capita GDP growth has been more severe inthe past 40 years (over 1961-99 per capita GDP growth averaged 1.1% which is two-thirds of the rate achieved by Latin America) -except inthe nineties when Uruguay (temporarily) grew at a faster rate than the region. In the 1961- 1999 period, the rate o f growth has been less than half that o f industrial countries, and less than one-fourth of that o f East Asia. At this pace, it will take 70 years for per capita income to double. 2. Despite this slowdown in growth, public expenditure has been on a long-term upward trend -its share to GDP has risen from under 20% inthe 1960sto 36.8% in 2001 (this includes interest payments and capital expenditures by state-owned firms). The bulk of the increase inpublic expenditure inthe 1990s is accountedfor by the explosive trend insocial security expenses, andpensions inparticular. As a result o f the relative economic deterioration, the welfare state has become increasingly burdensome for the economy. 3. Uruguay must consolidate its incipient economic recovery following a prolonged and deep recession: the economy shrank 17% and household incomes dropped over 20% in real terms over 1999-2003. The number o f poor has doubled since 1999 to represent 31% o f the population in 2003. O f those that were employed, 25% were not registered under social security. Without sustained economic growth, the adverse trend inthese indicators is unlikely to be reversed. Inthe first half of the 1990s poverty and unemployment indicators improved, driven by growth. However, fast growth over 1996-98 did not have a similar effect in terms o f social improvements -poverty levels remained stagnant, unemployment increased and income distribution deteriorated, Uruguaystill has one o f the most equitable income distributions inthe region andthere is virtually universal access to education, health and all basic infrastructure services. However, changes inthe economic and social structures - growinginformalemployment, risingunemployment andpoverty-have revealedthe needto reformulate and strengthen Uruguay's social safety net. 4. The economy has bounced back strongly since mid-2003 and GDP growth in 2004 is estimated at 12.3%; the level of unemployment fell from almost 20% at the end of 2002 to 12.1% at the end of 2004. However, there i s a qualitative difference between economic recovery and sustained growth. The latter requires sustained investment in physical and human capital to drive growth beyond existing capacity constraints. This inturn requires improving the investment climate - the investment- i GDP ratio hovered around 15% inthe 1990s(low for sustained growth) and dropped to 13%in2000-03. Uruguay's relativelypoor growthperformance over the last half century can betraced to severalkey structural weaknesses: 0 Pro-cyclicalfiscal policy - intrinsically associatedwith lack o f flexibility insocial spending - which led to rising debt levels and sharp interruptions o f growth periods; 0 A high and growing dependency ratio (between retirees and the working age population) -worsened by emigration by young people- and increased levels of informal employment (giveninpart to hightaxes on labor) limitsthe possibilities o f financing contribution-based social benefits; 0 Financial fragility and costly bail-outs linked to inadequate and insufficient bank regulation, weak supervision, and a strong process o fdollarization; 0 Vulnerability to regional instability - worsened by the increased trade integration promoted byMERCOSURinthe 1990s; 0 Lack o f effective competition in infrastructure sectors dominated by the public sector and - in a related manner- the setting o f tariffs with a fiscal criterion that limitsincentives to increaseefficiency -and, inparticular- to passon such gains to consumers and companies, contributing respectively to welfare .and global competitiveness; 0 A less than enabling environment for private sector development; for example, lack o ftransparency limitsprotectionto retail investors, the highcost o f setting up companies, the difficulties o f courts in dealing with complex economic matters, and inefficient bankruptcy processes; 0 A widening gap between performance and investment in some sectors of social security, education and innovation in relation to the trends in more developed countries, and insuccessfuldeveloping countries. 5. The objective of this study is to help develop a "shared" vision of growth with equity in Uruguay. Unless shared, the policies and reforms discussed are unlikely to be implemented,maintainedor to be credible. Manyofthe policy options proposedhave already been discussedinseminars andworkshops with wide participation o f technical experts, govemment officials and private sector and civil society representatives. Speeding up reforms in support o f a broad-based growth agenda will require: (i) participationby key social stakeholders, as well as those inthe private active sector, to increase awareness o f the issues and help generate consensuses; and (ii) increased transparency and better social communication about the costs and benefits o f reforms andtheir counterfactuals. .. 11 Growth strutegy 6. The growth plan proposed contemplates three pillars which correspond broadly with policies and reforms for consolidation of macroeconomic stability (Pillar l), improvement in the investment climate (Pillar 2), and modernization of the state in support of growth driven by the private sector and innovation (Pillar 3). The timeframe over which benefits from policies basedon pillars 1,2 and3 are expected to consolidate their impact corresponds broadly with the short, medium and long term, respectively. Nevertheless, the correspondence is far from full. For example, macroeconomic and financial stability i s an essential requirement for the short, medium and long term. Policies aimed at improving the investment climate are relevant even in the short term, andmust be deepenedinthe longterm. Andpolicies regardinginnovation, which because of their institutional nature will no doubt require lengthy terms for implementation, should therefore be given priority over the short term. 7. The first pillar involves policies leading to fiscal and financial stability, the efficient operation of factor markets (capital and labor), and the strengthening of social protection. It i s expected that such policies will enable the consolidation of economic recovery and alleviate the social situation o f those more vulnerable by means of the use o f idle capacity and the reallocation o f factors towards more productive companies and sectors -the main drivers o f productivity in coming years- as well as a more efficient use o fthe resources assignedto social protection. 8. The second pillar of policies and reforms aims at the creation of an investment climate that is favorable to the accumulation of physical and human capital; it includes trade and integration policies, the development of a competitive framework -particularly in infrastructure sectors; and policies on education and health for the development of human capital. The commercial integration strategy plays aparticularlyimportant role inthe process o f expanding export markets, investment and growth. It must be matched by improvements in the efficiency of infrastructure services to contribute to Uruguay's global competitiveness. New investments will be linked to the incorporation of new technologies; the accumulation of factors and technology will bethe drivers o f growth inthe mediumterm. 9. The third pillar is formed by policies and reforms to promote growth driven by innovation; it will require a thorough transformation of institutional capabilities, entrepreneurial culture and the system of innovation. The benefits o f some reforms, such as deregulation to encourageprivate sector development, could beginto materialize inthe short term. Other benefits, requiringprofound institutionaltransformations, could probably be seen in the mid to long term, depending on the commitment and perseverancewith which the programo f reforms is implemented. Although it is assumed that innovation will lead to increased productivity in the short term, it is likely that the benefits from policies on innovation will only be able to be capitalized on in the long term; hence the priority that ought to be granted to the pursuit o f such policies. 111 ... 10. Broad-based growth is defined as growth with wide social participation in both the generation of transformations and in the scope of the benefits. The policy andreform options proposedinthis report highlight the importance of social participation inthe definition and implementation of the growth strategy. First, an attempt has been made to evaluate the impact of key policies and reforms on poverty and welfare. For example, increased competition ininfrastructure can lead to higher real wages; reducing bureaucratic obstacles and improving the incentive framework in the labor market can encourage business to createjobs; pension reform proposals may help to improve inter- generational equity. Second, health and education policies -impacting the development of human capital- constitute an integral part o f the growth agenda. Third, proposals to reformulate the social safety net take into account the important changes that have occurred in the productive structure including the rising share o f uncovered informal workers and self-employed. Macroeconomic stability and socialprotection -Pillar 1 11. The main policy goal in the first pillar is fiscal consolidationto finance social spending and service the debt. Highinitial levels o f sovereign debt (92.2% o f GDP in 2004) and high pension deficits will severely constrain fiscal options over the medium term. Uruguay has already performed a drastic fiscal adjustment, achieving a primary fiscal surplus o f 3.8% o f GDP in 2004. Nevertheless, sustaining the current level o f primarysurplus over time will require structural reforms. This is due to the pro-cyclical nature o f public expenditures, infrastructure investment requirements, and the need to simultaneously strengthen the social safety net to support the significant share of the population that has fallen below the poverty line. Key reform options that the government could consider include: revision of the retirement benefit formula (an increase in the retirement age, reduction in the replacement rate and a revision of the formula for pension indexation), a reduction inredundant public sector employment, the deepening o f ongoing procurement reforms, efficiency gains in infrastructure services, andincreasedtax andsocial contributions compliance. 12. Financial stability is a key ingredient of macroeconomic stabilization. Bankingcrises have been a source of both fiscally expensive bailouts and financial dis- intermediation with a negative impact on growth. The challenge is to simultaneously pursue policies and reforms which would foster efficient financial intermediation and reduce banking sector fragility. Financial stability requires: prudential regulations to induce financial institutions to better internalize currency, liquidity and country risk; autonomy o f the banking supervisor; completion o f the ongoing restructuring of public financial institutions; and cautious implementation (including fimding) of the recently approved deposit insurance scheme. Policies and reforms that the government may consider include the de-dollarization agenda, a gradual process parallelto the increase in confidence in the local currency, granting greater autonomy to the Central Bank, a monetary policy designed to ensure price stability (for example by means of inflation targeting) andthe promotionofinflation-indexed instruments. iv 13. In the short term, output growth is likely to stem from increased capacity utilization and from shifting existing factors of production to new or expanding firms. This is usually cheaper than new investment. A basic condition to facilitate the reallocation o f factors of production i s to ensure the efficiency o f factor markets (capital and labor). For example, flexible labor markets can facilitate the reallocation of existing factors o f production from non-competitive firmslsectors to competitive ones. Bank credit and capital markets can help mobilizeresources o fthe most productive sectors and companies. The role of capital markets is particularly important as they are less constrained than banks after the crisis (they do not suffer restrictions on currency and maturity mismatches, nor fiom the same degree o f risk aversion) and they are intrinsically flexible in adapting to market needs -as the emergence of instruments to finance farm and construction activity or to dispose non-performing loans o f banks have already shown. 14. Efficientbanks and capital markets will also make it possibleto underwrite the required new investments in skills, capital and technology - these are the backbone of employment creation and growth. Among the policies and reforms that the government may consider to help develop capital markets are: strengthening linkages between stock markets; de-mutualization o f stock exchanges; improving rights o f minority shareholders; fill legal voids in security trading; increased autonomy of regulators and supervisors; allowing further diversification of pension fbnd's permitted portfolio o f investments; and correcting rather severe regulatory asymmetries in insurance. 15. Sustained and broad-based economic growth is the "best" social safety net. However, the sharp increase in poverty and social vulnerability both due to structural reasons and to the severity o f the recent crisis poses a more immediate challenge. One of the most urgentobjectives duringthe recovery phase i s reinforcingo fthe social safety net to protect the large proportion o f the populationthat has fallen below the poverty line. It will be important to avoid an irreversible process of exclusion with direct adverse implications for humancapital accumulation. The proposal to be considered is to increase non-contributory programs through conditional cashtransfers to be financed from savings to be generated in the social security sector. Programs like food assistance to the poor and full-time schools are well targeted but coverage is low; they could be scaled up, thereby directly benefiting the lower income quintiles. Other food and healthprograms may need to be refocused to benefit the most vulnerable. Recently launched workfare programs may also prove effective as long as they carry an explicit sunset clause. 16. The mismatch between instruments and risks in the social security system can be illustrated by Uruguay's public pension system. Savings systems are an efficient insurance mechanism when the risk i s predictable andor frequent. For example, predictable longevity gains and population ageing make saving an efficient mechanism under the PAYG public pension system - is economically unsuitable to mitigate lost for providing cover against job losses in old age. On the other hand, risk pooling - as earnings ability that arises inold age. Inthis regard, the 1996pensionreform represented a step inthe right directionby introducing a saving pillar. If defined-benefit type V pension systems are politically the only viable option, the govemment may consider re- defining"old age" through the introduction o f a mobileretiringage. 17. Despite a welcome downwardtrend inthe unemployment rate, it remained at relatively high levels at the end of 2004 (12.2%). Past performance inUruguay and in other countries suggests that even the resumption of growth may not suffice for rapid reductions in unemployment. Furthermore, the increase in.the informal sector -in part related to the highlevel o f taxation on labor- means that a highnumber o f newjobs will be of lower quality, and will not grant workers the benefits o f contributory social security. Inthis context, a review process of regulations and institutions inthe search of better growth and employment opportunities is due. This report examines several such regulations and institutions including job security regulation and public employment policies. A more extensive review o f labor legislation i s desirable to help design sector specific reforms which may also help to reduceunemployment faster as well as to redress informality and emigration trends. Climate of investmentand human development-Pillar 2 18. Addressing Uruguay's key structural weaknesses will be conducive to translating the strong economic recovery underway into sustained medium-term growth. Among the key weaknesses are: the high exposure to MERCOSUR volatility; limitedaccess to industrialcountry's agricultural markets; the highcost o f infrastructure services; anddifficulties for equitable access to highquality healthandeducation. 19. In a small country like Uruguay, the framework conditions imposed by global trade and integration links are a key factor determining market access and investment. Slow progress in the multilateral trade negotiations has prompted many countries to negotiate bilateral and regional trade agreements. In that context, the difficulties o f MERCOSUR to expand its regional outreach - only very recently have announcements been made o f FTAs with Peru and other Andean countries - has had negative effects on agricultural exports of member countries like Uruguay. Uruguay would need to carefully evaluatepros andcons o f alternative trade policy options. 20. Strengthening MERCOSUR's internal trade links and promoting greater MERCOSUR trade integration with the rest of the world should be considered a priority. This requires deepening intemal commercial l i d s -at present trade policy within MERCOSUR is limited to little more than the adoption o f a common external tariff-andmakingmore aggressiveprogressontrade agreementswithother countries and regions. This strategy could be complemented with bilateral initiatives to reach trade agreements with other countries or trading blocks in the context of Uruguay's commitments to MERCOSUR - e.g., as Uruguay has done recently with Mexico. Uruguay's most dynamic export markets are developing countries - even after excluding MERCOSUR. Uruguay's free trade agreement with Mexico led exports fiom Uruguayto increase more than fourfold. At an institutional level, the highly complex nature of the negotiationagenda also highlights the needto strengthen communications betweenpublic vi bodies and links with the private sector, as well as the development o f the institutional capacity to evaluate trade agreements - andinparticular their non-trade aspects. 21. The strengthening of competition in infrastructure services is a key element of the investment climate. Uruguay ranks high in the region in terms o f infrastructure coverage and overall efficiency, though less so interms o f cost. While coveragei s high, a gap may surface increasingly in terms of quality, delivery standards and prices as technological change and the sophistication o f demand continues to increase. Competition plays an important role in fostering efficiency and, at least as important, in ensuring that efficiency gains are passedon through lower prices to firms andhouseholds - thereby enhancing the economy's competitiveness and social welfare. Uruguay's large investment needs for sustained growth and the severe budgetary constraint imposed by highdebt is yet another important reason for increasing the role of the private sector in infrastructure. Uruguay has already moved - gradually - in that direction - as private sector participation in telecommunications, transport and gas shows. The opening o f infrastructure to private sector participation in other sectors has been slow compared to OECD andmany emerging market economies, includingthose within the region. 22. The lack of a competitive framework in various sub-sectors of infrastructure i s due, among other factors, to institutional and regulatory shortcomings: Uruguay should clearly segregate the three independent functions for the definition o f policies, regulations and operations. Although some recent reforms (such as the regulatory framework for energy and communications) have enabled certain progress to be made in the separation o f these functions, there is still a long way to go. In particular, significant conflicts in policy definition subsist. Although the Executive can and should set regulatory policies, the definition o f tariffs should be a function of an independent regulatory agency. In Uruguay, however, it is the Executive that inthe final instance sets tariffs, and it does so in pursuit of fiscal objectives instead o f seeking efficiency, competitiveness and welfare. The political and financial independence o f the leading regulatory bodies from the Executive needsto be increased. 0 The presence of the public sector in all vertical components o f the supply chain, as well as in regulation, could discourage private operators. Non-competitive practices and market foreclosure could stem from distortions due to cross subsidization and biased price and quality standards aimed at favoring competitive advantages o f public sector enterprises, The vertical separation o f public monopolies could contribute to the development o f competition, at least in those segments where economies o f scale do not operate as a restriction on the entry of new competitors. Inthose segments recording such restrictions, a system o f accounting regulation couldcontribute to transparency andbenchmarking, with abeneficial effect on company efficiency. vii 0 There i s an absence o f regulatory frameworks for gas distribution and ports. Regulatory rules are determined by previous concession contracts or general practices, more than by specific laws and regulations. Contract incompleteness could be a source o fcostly renegotiation andunfair competition. Regulators URSEA (energy and water) and URSEC (communications) have already developed a reputation of transparency by placing all major proposals, decrees and regulations under public consultation processes. Publication and broader dissemination o f performance and comparative efficiency indicators o f regulated public firms could make the management and boards o f these firms more accountable, Similarly, increased transparency on the cost o f access to networks - e.g., interconnection fees for telephone services, energy transmission prices, railway tolls -could pave the roadfor greater competition. 23. Sustainable growth requires human capital accumulation through better and more equal access to health and education. All Uruguayan youth should be able to exercise their right o f access to schooling and be prepared to enter the labor market to meet the demands o f a competitive economy. Progress toward this objective may be assessed by: (i) quickly the current alarming rates o f repetition and especially o f how desertion from secondary school - particularly among students from lower-income households-canbe lowered; (ii) improved andmore equitable (across income segments) learning performance inprimary and secondary schools basedboth on domestic tests and on international tests; and (iii) faster pace o f growth o f university graduations and a shorter average stay at the state university. Policy options which the government could consider include: up-dating the curricula, improving teachers' and schools' incentives to perform, demand side interventions (to lower school leaving and improve opportunities), and addressing more systematically cost effectiveness, efficiency and equity across all segments o f education. 24. The main obstacleto growth posedby current health policies and institutions lies inthe unsustainablehealth insurance and care-delivery system. Uruguayhas one o f the highest relative levels o f health expenditure in the world (in relation to GDP). While it also offers some of the best coverage andhealth-outcome indicators inthe region and among middle income countries, there is increasing evidence o f eroding quality o f care and eveninequity inthe system. The system i s a complex array o f often overlapping and fragmented institutions, some of which are noted for their inefficiency. Inaddition, the health care model i s increasingly unrelated to the country's epidemiological profile. Reform options to be evaluated include: (i) changes to the regulatory system, (ii) a greater focus on prevention, and (iii) limitingthe scopefor privateproviders to shift risky cases to the public system, Institutional developmentand innovation-drivengrowth Pillar 3 - 25. Sustained economic growth will require above total factor productivity growth. In fast-growing countries innovation has become the most important source of total factor productivity growth; and the bulk of innovation activity in these countries i s viii produced by the private sector. A strategy for innovation needs to be placed within the broader context of a strategy for private sector development and state reforms that would permit implementing a modem system of innovation. 26. Uruguay has well establishedproperty rights, relatively low corruption and a well established Judiciary. These are all important elements o f an enabling environment for private sector development. However, there is still substantial scope for simplifgng regulations and reducing the number o f steps needed to start a business - to start a business inUruguay is far more expensive than inArgentina or Chile. Laws, regulations and the quality of public institutions that enforce them make up the investment climate impactingthe private sector. One o fthe problems i s a lack of efficient public institutions to deal with complex commercial disputes inthe enforcement o f contracts. Bankruptcy legislation must be updated, facilitating rehabilitation processes for economically viable companies. For example, passage o f the bankruptcy reform bill currently in Congress could help to establish a better legal framework for private sector development, especially ifaccompanied by adequatereinforcingo fthe BankruptcyCourts. 27. The new global environment for innovation is characterized by a growing globalization of R&D activities, rapid development of markets for knowledge, high mobility of highly qualified labor, and regional integration of innovation systems. A forward looking innovation system for Uruguay could entail targeting the following broad strategic objectives. A first priority is ensuring political and budgetary commitment to sustained and balanced - vis-&vis the private sector - investment in knowledge, A second priority is identifying under-exploited potential and associative gaps, identifying "role models" in areas with potential and encouraging industry-led collective initiatives to difhse the associated good practices, and promoting "clusters" andpublic-private partnershipsinappliedscience. 28. The experience of the successful innovator countries - many of which are developing countries -provides useful lessonsfor Uruguay: they are generally small in size, have sound macroeconomic fundamentals and are very open economies. In addition, such countries are noted for: (i) average improvement in innovation above performance linked to a high rate of investment in education, information and telecommunications technology, R&D, and a high share of business financing o f R&D; (ii) increasingly diversifiedbaseofinnovators, withagreaterrolefor Smalland an Medium Enterprises (SMEs), improved linkages between science and industry and ahigh level o f networking among innovators; and (iii) financial systems that are supportive of innovative activities. These are some of the most important challenges for the development of Uruguay's innovation system. 29. The capacity to design and implementpolicies inthe fields of innovation and private sector development is closely linkedto state reforms invarious areas such as the professionalism of the civil service, the ability to link the budget to strategic objectives, and the state's procurement system. Among the policies neededto increase the professionalism o f the civil service, the government could consider the linking of performance evaluations, bonuses and promotions to compliance with the targets ix o f the executing units. The capacity to decide strategically in the area o f innovation in turn depends on the integration of the budgetary process with strategic objectives and results. Important state reforms have streamlined budgetary procedures. However, Uruguay i s far from having results-based budgeting. Lastly, completion o f rules on government procurement i s not only necessary from the point o f view o f the significant fiscal saving that it generates, but also because o f its potential impact on the competitiveness, efficiency, quality andinnovative development ofthe SME sector. X CHAPTERI:INTRODUCTION 30. Uruguay, with a prosperity built on beef and other meat exports, was amongst the fastest-growing economies in the world at the turn of the twentieth century. In parallel with economic growth driven by exports under a liberal trade regime, early in the 20th century Uruguay had already begun developing a strong and efficient welfare state. The relative efficiency o f the state, limited corruption and egalitarian distribution o f income distinguished the country fiom most others in the region. Inturn, the benefits o fthe welfare state help to explain the strong identification o f both citizens and politicians with it. The significant economic development achieved explains how even following the growth decline experienced from the 1930s, Uruguay's per capita GDP in 1955 was higherthan that o fItaly, slightly below France's and44% o f that inthe United States. 31, The slowdown in per capita GDP growth has become severe in the past 40 years -per capita GDP growth has averaged 1.1%, less than half the growth rate of the 1900-30 period. This equals about halfthe growth rate o fbetter regional performers like Chile and Braziland is well below that o fmost industrialized countries. At this pace, it will take over 70 years for per capita income to double. As a result of the relative economic decline, maintenance o f the welfare state became increasingly burdensome. It should also be mentioned that growth has beenerratic, as in 1990-1998 Uruguay grew at an average rate o f 3.9%; the recession that took place in 1999-2002, with an annual averagedecline o f4.6% wiped out many o fthe gains o fthe previous decade. 32. Uruguay is facing the challenge to consolidate its recovery after a long and deep recession. The economy shrank by 17.5% andhousehold income dropped over 20% in real terms in 1999-2003. Since 1999 the number of poor has doubled -to 849,000 in 2003 (around 21% o fhouseholds and 31% o fthe population) -while indigence increased two and halftimes to 76,000.' After peaking at almost 20% in late 2002, unemployment fell to 16.9% in 2003 and 12.1% in the last quarter o f 2004. Of those that were employed, over 25% were not registered under social security. Without a return to a sustained growth path, the adverse trend insocial indicators is unlikely to be reversed. 33. The economy has recovered strongly since mid-2003, and GDP growth in 2004 reached 12.3%, after a recovery of 2.2% in 2003. Nevertheless, there is a qualitative difference between economic recovery and sustained growth. The latter requiring sustained investment in physical and human capital to drive growth beyond existing capacity constraints; this in turn requires an enabling investment climate. And there is also a qualitative difference between growth and broad-based growth - the latter 'Thedefinitionofpovertyfor Uruguaysuffers fiom certain difficulties -the deflator beingbasedon the priceoffood andbeverages- and inaddition it is substantially higherthan that usedininternational comparisons. For example, onthe basisofameanusedininternationalcomparisons ofUS$2per day, the percentageofthe populationbelowthe povertyline inUruguay was 3.9% in2000, comparedwith 15.1% in Argentinain2001, and26.3% inMexico in2000 (World Development Indicators, 2004). Accordingto the official definitionofpoverty, in2000 17.2% ofthe populationwas belowthe povertyline. 1 referring to participation inboththe productive transformation and the resulting benefits. As in the past, growth alone is unlikely to suffice to reverse adverse social trends. Policies and institutions that promote broad-basedgrowthtogether withthe reformulation of the social safety net will be criticalto reduceunemployment and poverty over the next decade.2 34. Thisstudy aims to help developinga "shared" vision ofgrowthwith equity in Uruguay. Unless shared, the policies and reform options discussed are unlikely to be implemented, maintained or to be credible. Many o f the policy options proposed have already been discussed ina series o f seminars and workshops3held in Montevideo with wide participation o ftechnical experts, governmentofficials, and representativesfromthe private sector, political parties and civil society; in some instances, these alternatives are a result o f the mentioned activities, The findings from this report were incorporated into Policy notes discussedwith the incoming administration inJanuary, 2005 and formed the core analytical basis for the new Country Assistance Strategy to be discussed by the Boardo fExecutive Directors inJune. The focus onwide participation acrossthe political spectrum duringthese seminars andworkshops was linkedto the objective o fraising the awareness o f key social and economic stakeholders inrelation to the rationale, costs and benefits o fthe reform options examined. 35. More specifically, the goalsofthis reportare to: a. Evaluate past growth and productivity performance inUruguay. b. Assess the role o f policy, institutional and structural factors constraining Uruguay's growth potential. c. Identify policy and reform options to consolidate macroeconomic and financial stability andreduce poverty. d. Identify policy and reform options to improve the investment climate for private sector development and sustainedgrowth. e. Identify options for sustaining growth through state reforms and development o f the national innovational system. Structureofthe Report 36, Chapter I1describes growth trends and identifies structural factors underlying low per capita income growth in Uruguay over the last half-century, It breaks down See for example, Aart Kray, "When IsGrowth Pro-Poor?Evidence fiom aPanel ofCountries", World Bank, 2003, memo. After launching a general seminar inDecember, 2003 atthe Central Bank,a series of5 workshopstook placebetweenApril and September, 2004 covering the following themes: social sectors, innovation, state reforms, capital marketsandtrade policy. 2 output growth into its sources: human capital, physical capital and total factor productivity (TFP). It concludeswith a summarydescription o fthe growth strategy. 37. Chapter 111discussespolicy and reformoptions for pillar 1o fthe growth plan: fiscal and banking sector policies to ensure macroeconomic and financial stability; policies to increasethe efficiency o f factor markets -capital and labor, as well as policies to adjust and strengthen social protection, The section evaluates the sustainability o f public debt under alternative scenarios, and proposesalternatives for reformwith a fiscal impact on the mediumterm -pensions, private sector participation in infiastructure, state reforms. Inaddition, options are identifiedfor the strengtheningo fthe banking sector, to promote the development o fcapital markets and increasethe flexibility o f labor markets. Lastly, it evaluates alternative strategies to strengthen social insurance mechanisms and social programs to better meet the needs o fthe most vulnerable sectors. 38. Chapter IV evaluates policy and reform options in relation to pillar 2 of the growth strategy; it envisagesthe improvement o fthe investment climate through policies and reforms for: trade integration, increased competition and efficiency in infiastructure services, and development o f human capital in the areas o f education and health. Trade policies in particular play a crucial role in ensuring conditions for sustained growth by making it possible to improve access to external markets, increase domestic competition and incorporate technology - all these factors could result in a significant increase in factor accumulation, In addition, it is argued that the opportunities for investment in infiastructure services in a competitive environment will make it possible to increase global competitiveness o fUruguayan fwms as well as social welfare. 39. Chapter V describes policy and reform options for pillar 3 o f the growth plan aimed at fostering growth through innovation. It focuses on the enabling environment for private sector development and possible strategies for catching up on innovation policy, It also discussesreform options to increasethe efficiency o fthe state and its civil service and the government procurement system -particularly effective in increasing competitiveness and innovation in the SlME segment. Increased State efficiency is essentialto be able to implementthe modernization o fthe national system for innovation. 40. ChapterVI summarizesthe conclusions. 3 CHAPTER11: SOURCES OF GROWTHAND EQUITY - GROWTHSTRATEGY 41. The slow growth by Uruguay in the last half-century -with the transitory exception of the 1990s- can be traced to a series of structural and institutional determinants,aswell as to adverseconditions at the internationaland regionallevel. The growth strategy proposedinthisdocument arises from analysis ofthose determinants andconditions and their potential impact on the growth factors ofthe economy -physical capital, humancapitalandtotal factor productivity (TFP). 42. This chapter addresses these matters in the following sections. First, it describes growth trends and possible linkages with past capital flows and regional volatility. Second, it decomposes output growth into its aggregate sources: humancapital, physical capital and total factor productivity (TPF). Third, it discusses the relationship between growth, employment, poverty and equity. Fourth, it summarizes the principal hypotheses on the impact of structural, institutionaland external factors on the factors of growth. And fifth, it providesa summary ofthe 3-pillar growth strategy, 2.1 Growth,capitalflows and regionalvolatility 43. The economic performance of Uruguay in the last 50 years has been disappointing. Per capita GDP in 1955-2003 grew on average close to 1% per year - well below the more dynamic countries inLatin America or inEast Asia. Relativeto the US per capita GDP, adjusted for PPP prices, Uruguay's per capita GDP has declined steadilyexcept for atransitory recoveryinthe 1990s(Figure 1). Figure 1 Uruguay'sper-capita GDPrelativeto US per-capita GDP(PPP prices) - I 60% 20% 1 , ,, 195;' a1466 '' 1980'' ldw' 2000' 1955 1965 1975 1985 1995 Source: World Bank staffestimates. 4 44. Uruguay suffered sharp fluctuations in growth rates across decades: average per capita GDP growth was 0.4% inthe 1960s, 2.6% in the 1970s, -0.7% inthe 1980s and 2.7% in the 1990s. Growth was strongly correlated with trends in capital flows in andout o fthe region-strongcapitalinflows inthe late 1970s-early 1980swere followed by the sharp contraction in flows and growth for most of the 1980s-the so-called"lost decade" associated with Latin America's debt crisis, Strong private capital flows and growth inthe 1990swere interruptedabruptlyafter 1998-as happened inmost emerging markets - and this was associated, together with other factors, including the sharp devaluation of various regional currencies, with a prolonged recession over 1999-2001 followed by crisis in2002. 45. between both countries - around 90%. However, what distinguishes Uruguay fi-om Close integration with Argentina explains the very high output correlation high performers in the region - specially Chile over the last 20 years - is that under favorable circumstances (1990s) growth has been at best moderate and under less favorable external circumstances (1999-2002) economic contractions have been prolongedand severe. Poor average growth performance inUruguay is explained inpart by regional shocks and contagionepisodes but inpart also by its own structuralfeatures. 2.2 Factorsof productionand productivitygrowth4 46. The factors of economic growth are human capital (skilled labor), physical capital, and the "technology" used to combine these factors. "Technology" includes technological processes, such as management and organization, and the innovation system that permitsthe development, transfer and adoption of such processes. Growth in output by worker, which reflects household income and welfare, averaged 0.9% during the period 1955-2003 (Table 1, Soto and Casacuberta, 2004). The contribution by factors of production to worker's productivity growth was: human capital (0.2%), physical capital(0.3%) andtechnology (0.4%). 47. At a level of approximately 15% of GDP in the 1990s and 13% at the beginning of the 21" century, the level of investment in Uruguay is too low to support high rates of sustained growth. Hence the importance of developing a favorable investment climate, including: a predictable and stable macroeconomic environment, fluid access to international markets, efficient labor and capital markets, and in general, laws, regulations and institutions that enforce property rights and are compatiblewith the market economy. 48. Physical capital includes infrastructure assets; there is evidence that infrastructure is an important growth factor. Uruguay has a well-developed infi-astructure base, with a broadcoverage. Insome sub-sectors the private sector plays a dynamic role -for example, in transport and telecommunications; in the remaining sub- sectors, infrastructure services are still dominated by public monopolies. An adequate Estimatesby Soto andCasacuberta(2004) as backgroundfor this report, 5 competitive fiamework is ingeneral desirable to induce efficiency gains and at the same time ensure that such gains result inbenefits -through lower prices and improvementsin quality- for both producers and the consuming population in general. Modernization of infiastructure through the strengthening and development of the competitive fkamework represents one of the main challenges to consolidate improvements in the investment climate inUruguay. Table 1 Sources of Growth inUruguay - IAverage annual Average I annual Contribution by I growth in labor in TFP growth Physicalcapita; productivity(YO) (YO) Humancapital ( Y O ) ( Y O ) 1955-2002 0.9 0.4 0.3 0.2 1955-1981 0.6 0.0 0.3 0.3 1955-70 0.0 -1.0 0.4 0.6 1971-81 1.4 1.1 0.2 0.1 1982-2002 1.3 0.9 0.3 0.1 1982-91 0.1 -1.1 0.3 0.9 1992-03 12.1 10.6 1-0.5 Latin America 1.3 I12.2 10.0 10.7 10.6 (1960-85) USA. 1.3 0.5 0.3 1.o 1960-85 OECD 2.4 1.4 0.3 0.7 1960-85 EastAsia 4.7 2.9 0.8 1.o 1960-85 49. The deveiopmentof humancapitalis not only desirable in itself, but is also a critical component of sustained economic growth. Loayza, Fajnzylber and Calderh (2002) estimate that 90% of the economic growth in Latin America and the Caribbean during 1961-2000 can be attributed to humancapital. Inthe case o f Uruguay, different estimates come up with different results, inpart because of the difficulties inmeasuring humancapital. According to Soto and Casacuberta (2004), human capital explains close to one quarter of the growth in labor productivity inUruguay inthe period 1955-2002; according to de Brun (2000), this contribution is significantly higher. Government intervention through policies on education, health and risk management can assist households to form, update, maintain and protect their investment in human capital. Links between socialpolicy and growth have beenwell established on an empirical basis. Such interventions could lead to both growth and greater equity. For example, Ardente andothers (2004) discoveredthat inUruguaybroadeducationalcoverage hada favorable impact onthe long-termdistribution o f income. 6 Factors of productivity: 1955-03 50. As Figure 2 shows, total factor productivity (TFP) has been an important explanatory factor of labor productivity in Uruguay. Labor productivity growth depends on TFP growth, the accumulation of physical capital and the accumulation of human capital (Table 1). Out ofthe 0.9% of annual growth inproductivity in Uruguay, TFP growth accounted for around 45%. Other studies have identified human capital as the main source of output growth inUruguay, e.g. de Brun(2000)'. Insuccessful East Asian and Europeaneconomies the rate of TFP growth accounts for approximately60% ofproductivity growth. 1959 1967 1975 1983 1991 1999 Per working-age personGDP -Total Factor Productivity Source: Soto and Casacuberta(2004). 5 1. In the 1955-1981period, labor Productivity grew very slowly (0.6%). At this rate, it would take over 100 years to double productivity levels. When breaking down this period into decades, it becomes clear that the 1960sand 1970swere different. Inthe 1960s, the effort in accumulating physical and human capital was undone by declining TFP levels. Negative growth in TFP may have stemmed fiom cyclical factors and microeconomic policies (e.g., trade protection) that ledto an inefficient use ofresources. The 1 9 7 0 ~on ~ the other hand, marked an important reversal in policies and saw the resumptionof growth. Physical and human capital expanded pari passu with GDP, but economic growth was largely driven by TFP which recovered at 1.1% per year. The economy expanded untilthe debt crisis o f 1982. 'Measurementof the contributionby the various factors ofproduction varies accordingto the methodologiesadoptedto buildthe humancapital andphysicalcapital series. 7 52. The 1982-2003 period reproduces the pattern of the previous period, the first decade (1982-1991) characterizedby a significant use of physicaland human capital and declining TFP and the second decade (1992-2003) marked by a substantial recovery in fixed capital formation and TFP levels (Table 1). Also, like inthe 1970s, the 1990s were characterized by structural reforms which may account for faster TFP growth, particularly trade liberalization, Also, significant differences were recorded between decades. First, the declining contribution o f human capital to GDP in the 1990s was itself the direct result o f lower employment levels. The second difference with previous periods is the significant rate o f growth in TFP observed in this period (2.2%). This was the only time TFP grew faster that the benchmark economy (the UnitedStates), at rates closer to those o fEast Asian economies (Table 1). Productivityfactors in themanufacturing sector 53. Examination of a pane1of Uruguayan firms in the manufacturingsector over 1985-1999 shows fast productivity growth until 1994.6 The methodology employed allows to break up manufacturing TFP growth into: the utilization effect (intensity with which existing endowments o f factors are used); the reallocation effect (ability o f producers to reallocate factors o f production fiom low- to high productivity frms); the markup effect (the increase o f input utilization across sectors stemming fiom differential market power) and-residually obtained - technical change, 54. During the 1985-94 period, the increase in TFP levels arising from data on manufacturing companies can be ascribed primarily to reallocation of factors and technical change (Table 2). This coincides with the period o ffast trade liberalization and stabilization. Productivity gains fiom factor reallocation may reflect the fact that manufacturing frms substituted capital for labor during the 1990s - in response to the risingrelative price o flabor (inturnassociatedwith the real appreciation o fthe peso), The 1995-99 period presents a very different situation: productivity increased by a mere 0.8% per year and this is entirely accounted for by a substantial use o f capital and labor. Reallocation continues to be significant as a productivity factor, but at a lower pace. On the other hand, there has been a strong impact fiom increased competition (lower market strength) on TFP growth, i.e., as competition strengthens, firms are induced to increase their productivityto maintaintheir margins. Table2 Decompositionofchanges in productivityof manufacturingplants- - averageannualgrowth rates Change in Period observed Change in Change in labor effort and capital Reallocation of Residual productivity markups utilization inputs technicalchange 1985-89 8.3% -0.4% 0.1% 3.1% 5.6% 1990-94 7.2% 0.2% -0.1% 4.1% 3.0% 1995-99 0.8% 0.9% 0.9% 1.3% -2.3% Soto andCasacuberta(2004). 8 55. As a benchmark for comparison, data from manufacturing plants in Chile over the 1979-97 period show that productivitygrew around 5% per year. In the Chilean case, factor reallocation derived largely from market liberalization and trade opening, a process that was largely completed by the mid-1980s. The Chilean experience shows how over 1979-85, factor reallocation was the main driver o f productivity growth whereas over 1986-97 technological change became the key driver. As in the case o f Uruguay over 1988-96, the figures illustrate the importance o f allocative efficiency gains following a period o ftrade liberalization. 56. The implication in Chile is that initially -in response to trade reforms- companies concentrated on the reallocation of factors, and that only as these gains were exhausted did technological change (associated to new investments) become a more significantfactor for productivityincreases. InUruguay, boththe reallocation o f factors and technological change played an important role in 1985-94 -the period o f greatest increases in productivity; in the period 1995-99, competitive pressure began to play a more important role. 2.3 Growth, employment, povertyand equity 57. Growth per se cannot be assumed to result in poverty reduction, particularly when inequality increases.' The experience o f Uruguay during the second half o f the 1990s helps to illustrate this (Figure 3). Poverty initially declined fiom around 29.7% in 1990to 15.3% in 1994; however, thereafter it rose during the 1995 and remained at around with the deterioration o f income distribution - the Ginicoefficient increased fiom 41.1% in 17% over 1996-98 while the economy was growing strongly. The latter may be related 1991 to 43.8% in 2001. While Uruguay still has one o f the most equitable income distributions inthe region, the increaseininequality may account for the reduced impact of growthon poverty. 58, As a result of the prolonged and deep recession in 2002, both unemployment and povertyshot up. Unemployment rose sharply to 15% in2001 peaking at nearly 20% in late 2002. This, and the strong depreciation o fthe currency that was associatedwith a sharp increase in the cost o f the basic basket o f goods consumed by the lower-income sectors, helps to explain the rapid increase inpoverty, from around 18.8% in2001 to 24% in2002 and 31% in2003. 59. Social policies play a crucial role in the equalization of opportunities. The providing of adequate health, education and social protection for all promotes social mobility and ensures that during economic liberalization processes andlor at times o f increased competition, all segments o f the population can benefit fiom reforms, In particular, policies or reforms that increase the relative price o f labor -as took place in 'De Ferranti, David, Guillermo Perry, FranciscoFerreiray Michael Walton"IneguaZity in LatinAmerica and the Caribbean:BreakingwithHistory?", World Bank Latin AmericanandCaribbeanStudies, Washington, DC, 2003. 9 - Uruguay during the 1990s -could benefit relatively more skilled workers, accentuatingthe inequality existing inrelation to less qualified workers.' This reinforces the importance o f developing an inclusive education system and providing egalitarian access to higher education and high quality education for those less privileged. This may require in some instances specific interventions and programs such as conditional cash transfers targeted to those attributes o fthe poor which tend to perpetuatepoverty. Figure 3 GDP growth, unemploymentandpoverty - 1 3 5 . ,10 -I----: -6 10 ................................................................ t Q- v 5 ........................................................................ , 0 -15 -Poverty% +Unenpbyment% -m-GDParowth %. riahtscab Source: INE. 60. One distinctive feature of growth during the 1990s in Uruguay is its low- employment intensity, particularly during the second half of the decade. Despite relatively fast growth in the 1990s, unemployment rose fiom under 9% inthe early 1990s to 11% inthe late 1990s. However, these figures need to be analyzed with caution since the 1990s were also characterized by a sizable increase in the employment index - fiom 57% in 1990 to around 60% in the late 1990s; this was mainly due to the rising participation o fwomen inthe labor force -up from 47.4% to 52.5% in2000. 61. Unemploymentmay stem from regulatorybarriers, abrupt appreciationof the exchange rate or high labor taxes. Casacubertaet al. (2003) found that in responseto trade liberalization in the 1990s there was fast job destruction and job creation in manufacturing; however, there was on balance net job destruction driven by downsizing and firm exit. Consideration must thus be given to how and how fast reforms, laws and regulations may impact on job destruction and job creation, as these processes will drive unemployment. In general, policies that remove barriers to the setting up of new businesses or expansion o fexisting ones, as well as the hiringo f labor inthe forma4 sector, in addition to macroeconomic policies that help prevent strong fluctuations in competitiveness conditions, will foster job creation and social protection (the benefits o f which are strongly biased infavor o fthe formal sector). For example, trade liberalization hasbenefited skilledworkers inLatin America-e.g., deFerranti, Perry, Walton andFerreira(2004), World Bank-andinUruguay - e.g., J. deBrun(2000). 10 Growth and emigration 62. During its golden years, Uruguay relied heavily on immigration. In contrast with the past, emigration becamemore common during the second half o fthe 20fhcentury -between1964and1981,netemi rationwasestimatedat317,000peopleorabout12%of the population. Recent estimates show a small negative outflow o f people inthe 1990s !F followed by a sharp rise in 2000-2002 o f around 70,000 people - this is above the annual increase in population o f between 20,000 and 22,000. Uruguayan emigrants are mainly male and young adults and their educational attainment is middle and high compared to a similar age group. This shows that the challenge is not just to encourage investment in human capital but also to create conditions to retainandlor attract skilled labor. Apart fiom the obvious growth implications, reversal o f this process o f emigration could help to remedy the country's chronic fiscal imbalances originating in the high ratio between beneficiaries (mainly the elderly) and contributors (mainly those in work) in the public health and pensionregimes. 2.4 Sourcesofgrowth Structuralfactors - 63. The importanceof structural reformsto growth is widely documented; in the case of Uruguay in particular there is econometric evidence for this relationship. Applying an econometric fiamework to various countries, Loayza et al. (2002) found that fast growth in Uruguay during the 1990s can be ascribed to macroeconomic stabilization and structural policies in education, trade and infiastructure. Deeper financial intermediation contributed to explaining the per capita GDP increase between the 1980s and the 1990s. Using a similar model Loayza and Soto (2002) showed that average per capita GDP growth could rise 0.5% due to education catch-up, 0.6% due to infiastructure catch-up, and 0.7% due to catch-up incredit deepeningand trade openness. 64. The quality of institutionsis an importantdeterminant of long-term growth"; structural reforms aimed at strengthening institutions contribute to the design and implementationof sectoral policies. Uruguay enjoys a good reputation within the Latin American and Caribbean region in terms o f institutional achievement. Continued institutional progress will be key to growth performance. As laws and regulations change rapidly with technology, globalization and social demands, there is an increasing need for rapid adjustment and reform of existing institutions to support the goal o fgrowth driven by improvement inthe investmentclimate, development o fhuman capital and innovation. 65. Uruguay has two types of structuralweaknesseswhich could impair long-term growth: macroeconomic, financial and commercial factors which have exposed Uruguay to regional and internationalvolatility (factors i)to iii)described below); and institutional restrictions and regulatory framework deficiencies that limit the development potentialofthe privatesector and innovation(factors iv) to vi)). Pellegriniand Vigorito (May 2003). loWorld Development Report, World Bank, 2003. 11 i. Weakfiscalfunda~entals. Growthspellsinthe1970sand1990swereassociated with pro-cyclical fiscal policies (Box 1) and rising sovereigndebt levels, processes of real exchange rate appreciation, and low domestic savings which ultimately provedunsustainable inthe face ofexternal shocks and contagionepisodes. Lower public debt ratios could have dampened sharp exchange rate fluctuations, thus limiting costly bailouts ofthe financialsystemand sharp contraction inreal income. The increasingly high cost of the pension system -which accounts for half of all public spending (or approximately 15% of GDP), the high cost of intervention in banks (an accumulated cost ofapproximately 20% ofGDP in2002-03) and interest on the debt (close to 6% of GDP) represent a heavy fiscal burdenthat cannot be sustained, particularly in the absence of steady growth. In addition, there is a negative fiscal impact fiom an ageing population, and a rising level of informal employment affecting vast sectors of the population (implying lower contributions and less social protection). As a result of all this, Uruguay has one of the highest public spending to GDP andtax to GDP ratios inthe region, representingapossible barrier to investmentand sustained growth (Table 3). ii. Failures in banking regulation and supervision. Sharp fluctuations in credit associated with fmancial crises have amplified macroeconomic volatility and represent a heavy fiscal burden. The mainregulatory failures during the last crisis (2002) were the inadequate protection against foreign exchange rate risk, particularly in view o fthe high level of dollarization of savings, as well as against country risk (especially as regards investments by Uruguayanbanks in Argentina). Structural problems include lack of autonomy (including financial autonomy) for supervisory authorities, failure to implement a deposit guarantee system, and the dominant role heldby public banks (60% ofthe system), which limit the potential for the development and stability ofthe fmancialsystem. iii. Highexposuretoregional volatilig. Uruguayisasmallcountrythat isheavily integrated with two large and historically volatile economies - the GDPs of Argentina and Brazil are respectively 10 and 40 times larger than that of Uruguay. During the 1990s, the mRCOSUR increasinglyfosteredtrade and financial links, further increasing Uruguay's exposure to exchange rate, financial and output volatility in the region. The GDP growth correlation coefficient between the Uruguayan economy and that of Argentina is inthe order of 90%. MERCOSUR's path of trade liberalization has been weakened by exchange rate asymmetries and unilateralprotective actions by its larger members. Largely as aresult ofBrazil and Argentina's recent crises, the share of Uruguay's exports accounted for by MERCOSUR dropped from over half in 1998 to less than a quarter in 2004, Although this indicatesthat currentlyUruguayis less exposedto regionalvolatility, it is also an indication of the size of the historical vulnerability to crises within MERCOSUR. The vulnerability of Uruguay to regional volatility has been exacerbated inrecent decades by strong agriculturalprotectionism in industrialized nations that has had the effect of limiting the potential for commercial integration with the rest ofthe world. 12 iv. Weaknesses in the regulatory envir~nmentin relation to the business climate. These include the high cost o f business creation, high taxes on labor, complex licensing and certification procedures, lack o ftransparencythat limitsthe protection provided to small investors, lack o f a judiciary qualified to handle complex economic cases, inefficient bankruptcy procedures resulting in costly contract enforcement, weak anti-trust and consumer protection bodies, and limited coordination betweencompaniesand government inthe area o finnovation." v. Lack of a competitive regulatory framework for infra~~uctureservices hamper private sector ~ a r t i c ~ u t i oand development. While infrastructure coverage is n among the highest in developing countries, its relatively high cost (for fuel, water and electricity) and in some cases its high inefficiency (e.g., water) hampers competitiveness o f the private sector and consumer welfare. Vertically integrated state monopolies also constrain private opportunities for business in several infrastructure sectors. vi. Relative inefficiency of the State in areas of social security, education and innovation. While Uruguay still ranks among the top performers in Latin America interms o f health coverage, life expectancy, literacy and education ingeneral the high costlfiscal burden (Table 3) and the relative inefficiency with which some these services are being delivered as well as growing concerns on coverage and quality risk compromising the maintenance o f such leadership inthe future. Taxes on labor are the highest inthe region, and are even higher thanthe OECD average. The rapid surge in unemployment over recent years suggest that institutional rigidities may have become more bindingduringperiods o f severe stress. There is a widening gap in performance and investment in education and innovation systems compared with the trend in the more developed countries, and in successful developing countries. IArgentina1\ Brazil2\ Chile3\ Colombia4\I CostaRica5\ Ecuador6\ Uruguay7\ Non-interest ~UDIIC 1 1 1 Expenditures 25.0 20.9 23.0 28.3 12.0 19.6 34.0 Tax Revenue 23.1 11.6 15.3 17.2 1 19.2 12.5 12.3 12.3 I 21.8 Total Revenue 22.7 22.6 1 29.6 II24.7 I 32.7 Notes: 1\ Consolidated Public Sector, 2\ Federal govemment; 3\ Central government; 4\ Combined Public Sector; 5\ Central government, 6\Non-financial public sector; 7\ ConsolidatedPublic Sector. Source: IMF, World Bank, DoingBusiness, 2004. 13 Box 1 PrecyclicaiFiscalPolicyin Uruguay - Fiscalpolicy inUruguayhas been strongly pro-cyclical.The first graph showsthat the cyclical componentof primary expenditures and of GDP" follow the same cyclicalpastern, with public spending cycles havingthe same lengthand durationas that of GDP. The second graph shows that the same pattern holds true when the cyclicalcomponentoftotalrevenues is comparedto the behaviorofprimaryexpenditures. CyclicalBehaviorof Primary Expenditures(1980-2003) - . 2 0 4 , , , . , , , I , . , ~, , , . , , , ,, , ,, ,1 - . 3 ~ , , , , , , , , , , , , , , , , , , , ~ 1980 1985 1990 1995 2000 1980 1985 1990 1995 2000 1 -Primaw Exoenditures ---- GDP 1 1 -Primary Expenditures ---- Revenues1 The graphs belowshowthat the responseofprimary expendituresto apositivecyclical shock onreal output andrevenuesis contemporaneous and statisticallysignificant(as can be inferred fiom the two standard deviation intervals inthe figures), andtends to have a persistenceof about three years (generalized impulse responsefunctions). GeneralizedImpulseResponseFunctions(1965-2003) Responseof CyclicalPrimaryEqenditurestoGeneralizedOne ResponseofcyclicalPrimarywnditurasto GeneralizedOne S.D. CyclicalRevenuesInnovation S.D. CyclicalGDPInnovation 1 2 3 4 1 2 3 4 Source: Guerson(2004) 2.5 The3-pillar growthstrategy 66. The proposed growth plan is based on three pillars that correspond to policy and reform optionsfor the consolidationof macroeconomic and financialstabilityand attentionto the socialemergency (pillar l), the development of a favorableinvestment climate and the accumulationof human capital (pillar 2), and the strengthening of '*Cyclical componentswere calculatedusingthe Hodrick-Prescottfilter on the logarithmofrealrevenues, primaryexpenditures andGDP. 14 institutionsin support of the development of the privatesector and innovation(pillar 3). Sequentialimpact of policies and reforms 67. Policies includedunderthe first pillar include fiscal management, the financial sector, capital and labor markets, and social security. These policies can enable consolidation o f the economic recovery by means o f using idle capacity and reassigning factors to more productive companies and sectors -the main factors for increased productivity inthe short term. The maintaining o f fiscal discipline and financial stability is a necessary condition for sustained growth, and therefore such policies should be maintained inthe short, medium and long term. 68. The second pillar of policies and reforms is intended to create a favorable investment climate for the accumulation of physical and human capital. It includes policiesfor trade and integration,the developmentof a framework for competition to ensure the efficiency of infrastructureservices, and policies on education and health for the development of humancapital.Although second pillar policies and reforms need to be considered inthe short term, and some o f their benefits may also materialize in the short term, the most significant benefits will probably only become evident inthe mid to long term. The accumulation o f physical and human capital that can encourage an improvement in the investment climate is associated with the incorporation o f new technology and an increase in competition -all o f which are drivers o f growth in the mediumand longterm. 69. The third pillar is basedon policiesand reformsfor innovation-drivengrowth. It includes policies for the development of a national system for innovation, and policies for the modernization o f the State and the development o f the private sector. Some o f the policies for the development o fthe private sector, such as the simplification o fregulations and increased efficiency o f the legal system, are an inseparable component o f the investment climate and could have an economic impact even inthe short and medium term. In addition, the benefits o f the profound transformations that are needed in institutional capability, the development o f an entrepreneurial culture and a system o f innovation will materialize on the basis o f the commitment and constancy with which the program o f reforms will be implemented. Although innovation can generate an increase inproductivity inthe short term, it is only in the long term that knowledge and innovation are likely to becomethe maindrivers o feconomic growth. 70. In short, the plan advocates the simultaneous pursuit of the various policies and reformsunderthe three pillars. The timeframe over which benefits fiom policies are expected to consolidate their impact in the short, medium and long term correspond broadly with pillars 1, 2 and 3 respectively. However, there is no full correspondence between the pillars and the short, medium and long term. For example, as already ' mentioned policies and reforms described under pillar 1 (fiscal consolidation, financial stability, social security) are expected to have a strong impact over the short term but will remain important over the mediumand longterm. Policies and reforms aimed at improving the investment climate can be important even inthe short term, and must bedeepened 15 in the long term. Capital and labor market reforms, although having a certain short-term priority, will be crucial elements indefiningthe investment climate inthe mediumand long term. Innovationpolicies, preciselybecausethey will take longer to mature, for this reason needalso to be givenpriority inthe short term. Consolidationof macroeconomic stability and socialprotection Pillar 1 - 71. The structural weaknesses described have hindered the creation of a stable macroeconomic framework Fiscal imbalances have beenthe most significant obstacle. For this reason, Pillar 1 assigns priority to fiscal strengtheningas the principal instrument for achievingmacroeconomicstability. Maintaining the fiscal gains fkom 2002-04 over the medium and long term will require undertaking significant structural reforms with fiscal impact incritical areas such as pensions, reformofthe state andparticipationby the private sector ininfkastructure.A second source ofmacroeconomic instability has been &agility of the financial sector and the fiscally costly recapitalizationsthat it has been subject to inthe past, For this reason, the strengthening ofthe financialsector also constitutesapriority area for macroeconomic stability. A third priority is the strengtheningthe social safety net to protect the most vulnerable sectors of society. Reformulating the social safety net can provide cost-effective protection to the vast segments of the society that have fallen throughthe formal security net. 72. Initially, continued growth is more likely to stem from increased capacity utilizationand from shiftingexisting factors of productionto new or expandingfirms than from (more expensive) new investment-except in the case of the more dynamic exporting sectors. This raises the significance of improving the efficiency of factor markets. Flexible labor markets can facilitate the reallocation of existing factors of production fkom non-competitive firmslsectors to competitive ones; this will be a fundamentalcontribution to reductioninunemployment. Bankcredit andthe appearanceof new products on capital marketscan help to reallocateresourcesto sectors and companies with the greatest potential. Possibly in the short term, capital markets and the internal sources of financing of companies -their profits- will play a more important role than banks, given the high aversionto risk shown by banks and borrowers following the crisis. Capital markets have already demonstrated - during the recent crisis - considerable versatility inthe development of new products for the dairy industry, constructionand the disposalo f non-performingbank loans. Over the medium and long term, both bank credit and capital markets can play a fbndamental role in the financing o f the new investments required in terms o f human competencies, capital and technology -the backbone of employmentand growth. Investment climate and developmentof human capital Pillar 2- 73. Sustaining growth requires creating a favorable investment climate that will help to raise the levelof investment from 15% of GDP to approximately20% of GDP over time. The investment climate has been defined by the 2005 World Development Report as "government policies and behaviors by relevant players influencing the 16 opportunities and incentives for fums to inve~t".'~ Incentives and opportunities for private investment are strongly influenced by global trade and investment links, the ftamework for competition and the efficiency o f infrastructure. The investment climate also encompasses incentives and opportunities for households to invest in human capital; in this context, social policies can play a critical role in creating equal opportunities to access health and education. 74. Some of the factors conspiring against the creation of a favorable investment climate in Uruguay are: high exposure to regional volatility, difficulty in gaining access to agricultural marketsin industrializedcountries, the high cost of the service infrastructure,and unequalaccess to high-qualityeducation. The second pillar o f the growth strategy centers precisely o f policies aimed at dealing with such aspects: trade and integration policies, a competitive framework to encourage efficiency and low costs in infrastructure services, and health and education policies. These constitute the basic policies with an impact onthe investment climate, although a good investment climate also incorporates pillar 1policies -such as macroeconomic and financial stability- and pillar 3 policies -such as institutional development and the regulatory ftamework for the development o fthe private sector, Institutional develo~~entandgrowth driven by innovation -Pillar 3 75. Evidencefrom fast growing emerging markets and industrial countries shows that innovationis the most important factor behind long-term productivitygrowth; the bulk of innovation activity is produced primarily by the private sector and is backed by significant institutional developments in the State (Guinet, 2004). The implication is that a strategy for innovation should thus be placed within the broader context o f a strategy for private sector development and reforms o fthe State that facilitate institutional developments. Inthe field o f innovation, the role o fthe state is to design and implement innovation policies and provide an enabling environment for private sector development. Pillar 3 thus focuses on state modernization, development o f an enabling environment for private sector development and catch-up on innovation policies to close the wide gap that separates Uruguay ftom successfulinnovators. 76. To sum up, the plan contemplates three pillars which correspond broadly with: consolidationof economic recovery, continuityof sustained growth by means of a more appropriate social and investment climate, and long-term innovation-driven growth. The "vision" o f growth under the 3-pillar growth plan is encapsulated inBox 2, which illustrates the key objectives, sources o f growth, agents o f growth and policies for the short, mediumand longterm. Designingand i~lementingreforms in Uruguay 77. Gradualism-and sometimesslow progress- in reformin Uruguaycan belinked to multiple factors. These include: the consensus approach deeply rooted in Uruguay's institutions (which is in itself desirable); the generous benefits o f the welfare state l3World DevelopmentReport, 2005, Chapter 1. 17 including job security at public enterprises and the central administration; non- programmatic political parties -which couldgenerate problems with representation; lack of cohesion and leadership in the private sector, and -more generally- the lack of a shared vision of growth and welfare. A number of factors may help to accelerate the pace of reform during the next years. Governments are usually empowered to introduce reforms during their frst year in office. High levels of public debt will impose fiscal discipline, which can inturn can create pressure for undergoingcertain reforms. Access to power for the first time in more than a century by a third political party brings with it an air of renewal, and possiblyan increasedcommitment with the restrictions imposedby economic and social reality. These factors can be leveraged ifgovernment and society place greater stress on ensuring transparency and improving communications to generate participatory processes to help foster consensus; as well as on greater policy coordination and policy reviewsat high levels o fgovernment to ensurethe internalconsistencyofthe strategyto be fo110wed. Box 2 Pillars of the GrowthStrategy - Short term 1Mediumterm Longterm Pillar 1 Implementation High High High Impact High High Medium Pillar2 Implementation High High High Impact LowlMedium High High Pillar3 Implementation Medium Medium High Impact Lowhledium MediudHigh High Investmentclimate Objectives Macro stability Socialprotection (15% GDP to 20% GDP) Innovation-drivengrowth Developmentofhumancapital Sourcesof Use ofidle capacity Accumulationfactors Processesfor innovation growth Absorptionof (physical andhumancapital), andthe development of (productivity) unemployment Reassigningoffactors Competitionandtechnology humancapital Agro-industrial activitieswith Innovativeentrepreneurs in Agricultural, forestry, increasedaddedvalue. varioussectors with access fishingsectors, Agro- Biotechnology to regionalandglobal markets. Joint public-private Agents of industry.Export services Exportofservices(data associationsfor R&D. growth (tourism, software) processing,software, tourism, Backwardand forward banks) Knowledgeindustries linkageswith exporting Foreigninvestmentinwood (biotechnology, software, sectors pulp, transport, medicine, agricultural telecommunications. technology, transport, tourism, banking). 18 CHAPTER111:FROMRECOVERYTO GROWTH- CONSOLIDATION OF MACROECONOMICSTABILITY AND SOCIAL PROTECTION-PILLAR 1 78. The first pillar of the growth strategy includes policies leading to fiscal and financialstability,the efficientoperationof factor markets(capitaland labor) and the strengthening of social protection. It is expected that such policies will enable consolidation o fthe economic recovery and an improvement inthe social situation o fthose most vulnerable through the use o f idle capacity and the reassigning o f factors to more productive businesses and sectors -the main drivers o f productivity in coming years- as well as a more efficient use o fthe resourcesallocatedto social protection. 79. This chapter putsforward and analyzes policy and reform options for Pillar 1 of the growth strategy.First, the macroeconomic context and the status o fthe reforms is described. Second, the sources o f macroeconomic instability are analyzed, and alternatives are provided for reform to ensure fiscal sustainability in the mid to long term. Third, aspects o f the monetary, fiscal and de-dollarization strategy are analyzed to ensure macroeconomic consistency. Fourth, evaluations are made o f the alternatives for strengthening and promoting the efficiency o f the banking sector. F@h, reforms are identified to promote the development o f capital markets. Sixth, the behavior of the labor market is analyzed, and options are considered for an improvement in its efficiency. Seventh, alternative strategies are evaluated for strengthening the social security mechanismsandthe social programsto meet the needs o fthe most vulnerable sectors. 3.1 Recentreformsand macroeconomicdevelopments 80. Growth in the 1990s. The relatively fast economic growth averaging 4.4% over 1990-98 was associated with a process o f reforms and macroeconomic stability in conjunction with significant flows o f capital to the region -Uruguay received US$550 million o f capital flows annually on average in the period from 1993 to 2001- favorable terms o f trade, and a regional environment characterized by economic growth (Table 4). Moderate fiscal deficits (between 1% and 1.5% o f GDP during 1995-98) and a gradualist monetary policy helped reduce the rate o f inflation fiom over 40% in 1994 to single digits at the end of the 1990s, in a context o f macroeconomic stability -the public debt-to-GDP ratio hovered around 40% o f GDP during the decade, and Uruguay was able to achieve investment grade for its sovereign debt issues-the risk premium standing at approximately 200 basis points prior to the 2002 crisis. 81. Growth was favored by trade, financial and state reforms.Even beforejoining MERCOSUR in 1994, Uruguay had unilaterally liberalized much o f its trade regime, with an average external tariff that declined from 17% in 1986 to below 5% in 2002, Under MERCOSUR, Uruguay freed inter-regional trade and adopted the common external tariff. Uruguay passed an important social security reform in 1995- strengthening contribution requirements for benefit eligibility o f the PAYG system, increasing the retirement age 19 for women, and introducing a defined-contribution funded pillar covering approximately one quarter of all pensioncontributions. State reforms helpedto reduce public employment by around 10% andto improve financial management. Despitethe passage of legislationto introduce competition in electricity, there were no private entrants in the sector. On the other hand, it was possible to introduce participation by the .private sector in the gas, transport and telecommunications sectors -although this was not always linked to the introduction of aregulatory fiameworkto promote competition. 82. Despitesignificant reformsand moderatedeficits, weaknessesin the regulatory framework of the financial sector and the pro-cyclical nature of public pending persisted. In the financial sector, regulation and supervision were strengthened and intervened banks were privatized. On the basis of open financial markets, strict bank secrecy laws, and relative macroeconomic stability, off-shore banking flourished, mostly serving Argentine clients. Since the mid-1990s, legislationhas been introducedsupporting capital market development. However, weaknesses persisted in prudential regulation and supervision of banks -for example, country risks and currency risks were not duly internalized by regulation, and supervision tended to be biased in favor of public institutions- and o f capital markets. Such weaknesses and high levels of dollarization exposed bank vulnerability duringthe 2002 crisis, when the flight of 50% ofdeposits inthe system left the CentralBank virtually without reserves and led many banks into technical insolvency. Furthermore, despite maintainingmoderate deficits, the pro-cyclical nature of fiscal policy meant that inabsolute terms sovereigndebt grew fiom approximatelyUS$4,4 billionin 1990to aroundUS$9billioninthe early ~OOOS.'~ Table 4 Selected macroeconomic indicators - 1990-1998 1999-2003 2004 Est. Real GDP Growth 3.9 -3.2 12.3 GrossDomestic InvestmentlGDP 15.1 13.5 13.3 CPI inflation 53.7 9.6 9.2 Exports of Goods & Services (%GDP) 19.5 20.3 30.4 Imports of Goods & Services (%GDP) 19.1 20.9 27.8 Current Account Balance(% GDP) -0.8 -0.9 -0.8 Primary Expenditure (% GDP) 29.2 32.0 26.2 Primary Balance(% GDP) 1.o -0.4 3.8 Overall Balance(% GDP) -1.4 -4.0 -2.2 Public DebtI GDP (%) 39.4 68.3 92.2 GDP (billion USD)' ' 16.6 16.6 13.2 83. The prolonged recession over 1999-2001 ended in an economic collapsein 2002 with GDP contracting nearly 20% over 1999-2002. The recession can be partially attributedto a sharp contractionincapital inflows to the region and a strong real currency appreciationfollowing the Brazil devaluation in 1999 andthat ofArgentina in2002 (Figure 4). Fiscaland financial indicatorsdeterioratedduring the recession and particularly during l4The share to GDP declined fiom 70%in 1990to 36%in 1996dueto the Brady Plan, fast growth andreal pesoappreciation; thereafter itroseto 54% in2001 dueto real peso depreciation andthe recession. 20 the 2002 crisis, Fiscal deficits rose above 4% of GDP and, following the floating of the peso in mid 2002, the public debt-to-GDP ratio doubled to 101.5% in 2003. Non- performing loans (NPLs) inpublic institutionsrose fiom 41% in 1999to 54% in2001 -and provisions covered less than.40%ofthe amounts involved.The high level of dollarization- deposits in foreign currency accounted for 89% oftotal deposits- represented a significant source of vulnerability: althoughloans inforeign currencyamountedto 81% oftotal loans, very few were granted to individuals or companies with genuine income in foreign currency, or to exporters. The country risk premium skyrocketedto over 2000 basis points at the end of2002 and into early 2003. Figure 4 RealMultilateral ExchangeRate- 1995=100 - I 160.00 140.00 100.00 80.00 60.00 40.00 20.00 0 00 Source: BCU. 84. The government confronted the crisis decisively. It promptly intervened to restructure andlor liquidate troubled institutions and committed to a program of fiscal adjustment and enhanced social protection. The primary fiscal balance was turned fiom a deficit of 1.2% of GDP in 2001 into a 3.8% surplus in 2004. In spite of an almost 100% peso devaluation, the pass-throughto inflationwas only 25.8% in2002 and 10.2% in2003, falling below 8% in 2004. A US$3.7 billion multilateral support package was tied to structuralreforms in fiscal, financial and socialareas, and includedthe creation of a Fund for the Stabilization o f the Banking System with sufficient funding to back fully all US dollar sight and savings deposits at public and intervened banks. Time deposits of state- owned banks were re-programmedand their maturities stretched over a three-year period, maintaining the currency in which the deposits were denominated. A radical restructuring of the National Mortgage Bank (BHU) -the second largest and deeply insolvent public bank-was initiated (with almost all its assets denominatedinlocal currency -or adjustedon the basis ofthe performanceofwages- the devaluationhad a devastating impact onthe net worth of this institution). BROU, the largest public bank, started a process of portfolio clean-up, organizational rationalization and modernization o f its credit and risk management functions. Four deeply insolventdomestic privatebanks were suspendedon a permanent basis, and work began on their orderly liquidation -although this ended up taking longer thanexpected. 21 85. Following a successful debt exchange with private bondholders for around US$5.4 billion -extendingmaturitiesfor an average of five years without raisingthe interest rate- country risk dropped to around 600 basis points and an incipient economic recoveryensuedas from the second halfof2003. Onthe demand side, growth was driven by a strong rise in dollar exports -around 30% in 2004- and a significant recovery ininvestment and consumption. On the side of supply, a rapid process of import substitutiontook place with a particular impact onthe industrialsector. Gross international reserves have quadrupled since early 2003 to close to US$2.5 billion at the end of 2004, and aroundhalf ofresident's deposits inforeigncurrency that had left the system returned. Country risk fell further (below 400 basis points), and immediately after the successhl exchange Uruguay regained access to international capital markets, placing a 3-year inflation-indexed peso-denominated US$ 150 million bond. The unemployment rate droppedfrom 19.8% inNovember2002 to 12.1% at the endof2004. 3.2 Reformsand fiscalsustainability-Macroeconomicstrategy 86. Macroeconomic instability is the single most important factor limiting the development of a favorable climate in Uruguay; high debt - in turn - is the consequence of past fiscal imbalances and is one of the main sources of fiscal vulnerability and potential future macroeconomic instability. Although the debt fell from 101.5% of GDP in 2003 to 92.2% in 2004, this level is still high. Uruguay, in addition, must face sizable amortization on its debt with internationalmultilateral lending agencies inthe 2005-07 period. 87, The benefits of maintaining a strict fiscal policy and gradually reducing the debt go well beyond the objectiveof ensuring debt sustainability.The fiscal breathing- space gainedprovides freedom for the BCUto manage monetarypolicy without sacrificing inflation objectives or burdeningthe private sector with excessively high interest rates or episodes of abrupt exchange rate appreciation. A good example of this combination of policies is provided by Chile during the 1990swhen strict fiscal policies ledto a reduction inthe debt and were conduciveto achieve competitive interest and exchange rates. Instead, when in 1998 Chile tightened monetary policy to target the exchange rate while fiscal policy was (temporarily) relaxed, interest rates rose to unsustainably high levels and the country fell into a recession. In the medium term, as debt servicing declines, the fiscal surplus generated will make it possible for Uruguay to increase on a sustainable basis social spending, investment inhumancapitaland inresearchanddevelopment. 88. In the absence of structural reforms, it will be difficult to reach and sustain primary fiscal surpluses consistent with debt sustainability. Inthe absence ofreforms, the primary fiscal surplus is highly likely to decline over time. Pro-cyclical public spending (pensions in particular), the need for public investment to make up for limited private sector participation in infrastructure, possible future bank interventions and the impact of an aging population on spending and income relatedto the healthand pension system are some of the factors indicative of this trend. In this scenario -without structural reforms- assuming (i) the primary surplus declines to 3% of GDP and stabilizes around that 22 (historically high) level, (ii) growth falls to its long term average of 2% (after 2008), GDP and (iii) averagereal rate o fexchange appreciatesinrealterms compared with the end of 2004 to approximately the average of 1982-2003 - the debt to GDP ratio is projected to the decline slowly to 72% o fGDP in2014 (Table 5, Scenario 2). 89. Ifthe primarysurplus declined further (to 2% of GDP) or ifthe exchangerate would stabilizeat the end-2004 level, publicdebt would decline initially (as a share of GDP) but then would increasepermanently.Suchan increase is partly explained bythe rising financial cost o fsubstitutingmultilateral financing sourcesby more expensivebonds carrying a higher spread (600 basis points) and partly by low growth and an inadequate fiscal stance. Insuch cases, debt could rise to 84% o fGDP (Table 5, Scenario 3) or 88% o f GDP respectively by 2014 (Table 5, Scenario I)). The implication is that in a scenario without reforms, high debt will continue to be a factor o f vulnerability inthe presence o f external or domestic fiscal shocks thereby leading to increased uncertainty for investors andgovernment financing. 90. On the other hand, in a scenario of structuralreformsit would be possibleto achieve and maintaina primary fiscal surplus consistentwith debt sustainabilityand estimated to bein the rangeof 4% of GDP in the mediumterm. Reforms are necessary both to achieve fiscal targets and to foster growth through efficiency-enhancing measures. Under this scenario, growth is projected to converge to 3% over the medium term and country risk to stabilize at around 400 basis points (the level o f March, 2005) or below. Assuming the same level o f real exchange rate appreciation as in the no-reform scenario, the debt to GDP ratio could decline to around 60% in2010 and48% in2014 (Table 5, Base Scenario). 91. Nevertheless, even in this optimisticscenario, it is estimated that debt wiU fall gradually, which implies a certain degree of vulnerability to possibie shocks during the transition. Under adverse shocks, rather than converging to lower levels, public debt- GDP ratios may diverge. For example, employing a stochastic fkamework (Guerson 2004) inwhich the exchangerate responds endogenouslyto simulated external shocks -based on past experience - there is a 12% probabilitythat over the next 10 years the debt ratio could grow above 100% (Table 7). 23 Table 5 Debt Sustainability DeterministicSimulations - - 2004e 2005 2006 2007 2008 2009 2010 2014 BaseScenario Stock ofpublic debtiGDP 92.2 77.5 72.3 68.0 65.3 62.6 59.8 48.2 Stock ofpublic debt, US$billion 12.2 12.2 12.1 11.9 11.7 11.6 11.4 10.3 Debt ServiceiGDP 11.7 13.1 15.3 13.1 10.8 10.1 11.0 9.6 Debt ServiceiRevenues 39.0 43.9 49.2 41.1 33.4 31.5 34.3 29.7 MultilateralDSlTotalDS 50.2 53.3 56.7 69.3 52.4 52.1 44.2 29.5 BaseScenario Assumptions GDP real agrowthrate (%) 12.3 6.0 4.0 3.5 3.0 3.0 3.0 3.0 Nominal GDP, UR$billion 379 422 461 499 532 567 604 780 Public Sector PrimarySurplus, % ofGDP 3.8 3.5 3.7 4.0 4.0 4.0 4.0 4.0 Sovereignspread 1170 400 400 400 400 400 400 400 Alternative scenario 1 Stock of public debtiGDP 92.2 87.9 86.6 84.5 84.3 84.3 84.5 87.6 Stock of public debt, US$billion 12.2 12.4 12.5 12.6 12.9 13.1 13.4 15.1 Debt ServicelGDP 11.7 14.6 18.0 16.0 13.9 13.8 15.6 17.9 Debt ServicelRevenues 39.0 48,7 57.6 50.0 43.0 42.8 48.4 55.4 MultilateralDSiTotalDS 50.2 53.3 55.6 66.1 47.8 45.4 37.4 19.7 Low casescenario assumptions GDP real agrowthrate("?) 12.3 6.0 3.0 2.5 2.0 2.0 2.0 2.0 Nominal GDP, UR$billion 379 379 399 428 452 477 503 625 Public Sector PrimarySurplus, % ofGDP 3.8 2.5 2.7 3.0 3.0 3.0 3.0 3.0 Sovereignspread 1170 600 600 600 600 600 600 600 Alternative scenario2 Stock o fpublic debtiGDP 92.2 78.5 75.1 72.8 72.2 71.8 71.4 71.6 Stock o f public debt, US$ billion 12.2 12.4 12.4 12.5 12.6 12.8 13.0 14.1 Debt ServiceiGDP 11.7 13.1 15.6 13.9 11.9 11.7 13.2 14.6 Debt ServiceiRevenues 39.0 43.9 50.4 43.5 37.0 36.5 41.1 45.3 MultilateralDSiTotal DS 50.2 53.3 55.9 66.9 48.8 46.8 38.8 21.2 Scenario assumptions GDP realagrowthrate (%) 12.3 6.0 3.0 2.5 2.0 2.0 2.0 2.0 Nominal GDP, UR$billion 379.3 422.2 456,6 489.1 516.3 545.1 575.4 714.7 Public Sector PrimarySurplus, % ofGDP 3.8 2.5 2.7 3.0 3.0 3.0 3.0 3.0 Sovereignspread 1170 600 600 600 600 600 600 600 Alternativescenario3 Stock of public debVGDP 92.2 79.0 76.3 75.0 75.6 76.4 77.4 84.3 Stock of public debt, US$ billion 12.2 12.5 12.6 12.8 13.2 13.6 14.1 16.6 Debt ServiceiGDP 11.7 13.1 15.7 14.1 12.3 12.4 14.2 17.1 Debt Servicekevenues 39.0 43.9 50.7 44.2 38.4 38.7 44.2 53.2 MultilateralDSlTotal DS 50.2 53.3 55.6 65.8 47.0 44.1 36.1 18.0 Scenarioassumptions GDP realagrowthrate (%) 12.3 6.0 3.0 2.5 2.0 2.0 2.0 2.0 Nominal GDP, UR$billion 379.3 422.2 456.6 489.1 516.3 545.1 575.4 714.7 Public Sector PrimarySurplus, % ofGDP 3.8 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Sovereignspread 1170 600 600 600 600 600 600 600 Source: World Bank staff calculations. 92. Structural reform options considered under the proposed growth strategy - consistent with the target for a primary fiscal surplus converging to 4% of GDP on average include: parametric and structural reforms to the pension system, reforms to the - system for government procurement, improvements to tax collection and social security contributions in particular, increases in the efficiency of public infrastructure companies, 24 reforms to public banks, and increasedprivate sector participationinproviding infiastructure services. Other reforms proposed under the growth strategy will on the other hand involve fiscal costs: finding of the deposit guarantee scheme, modernizing of institutions, research and development costs, reforms to the education sector, and the social emergency program. The mainreformoptionsare describedbelow, As asummary, Table 6 presents anestimateof the incrementalquantitativeimpactofeach reform onthe reference primary surplus (3.8% of GDP in2004). Reform scenario Fiscal impact of structuralreforms - 93. Modernization and increased autonomy of the Tax Administration Department @GI) and coordinationwith the Banco de Previsidn Social (BPS) could lead to improvedcompliancewith tax and social security obligations. The government i s already committedto overhaulthe organizationandprocedures ofthe DGI, improve staff training and increase incentives. It is also importantto proceed with the establishment of a specialunit for dealingwith largetax payers and ensurethat DGIofficials are employedon a hll-time basis. There are even greater prospects for enhancing revenues from social security contributionswhich declinedfiom 6.2% ofGDP in2000 to 4.1% ofGDP in2003, Better coordination betweenthe DGI and the agency which administersthe social security system (BPS) couldresult ina recoveryofrevenues (IMF,2004). Combiningthese reforms with cyclical factors couldcontribute to raisingrevenues by the equivalent of 1.2% ofGDP (Table 6) on average during2005-12 (ofwhich 0.7% would be dueto cyclical factors).I5 94. Cost reductionscould enable publicutilitiesto reducetariffswhile, at the same time, increasingtheir dividends for the government (Chapter rv). Such savings are expected to arise from cost efficiency gains inthe energy and water sector (World Bank, 2003) 0.3% of GDP and greater private sector participation intelecommunications and - - also inthe power sector. On the other hand, there are likely to be contingent liabilities in the rail and Mega concession (Irwin, 2004) and investment costs for the new Thermal Combinedplant, Innet terms, there are estimated to be potentialgains for fiscal accounts in the order of0.6% ofGDP (Table 6). 95. Deepeningof procurementreformsand in the civil service could contributeto the efficiency of the state and lead to significant savings in public spending. The greatest challenge from the point ofview ofthe efficiency o fthe state arethe reformsofthe civil service (Chapter V); this presumes among other matters a professional up-grading, including a review o f the salary structure for the sector, In fiscal terms, net gains are expected from areductioninpublic employment (around 0.1% ofGDP on average); part of these savings will be offset initially by the needto finance severance payments, Similarly, the government has committed to important procurement reforms -on which it has made fum progress. Nevertheless, reforms remain pending that estimates by CEPE suggest could leadto potentialgains inthe order of0.3% ofGDP (Chapter V). Is The newadministrationhaspromisedto introduceapersonalincometax, andthis couldprovidean importantnewsource ofrevenue. Nevertheless, personal incometax is administrativelycomplex andwill requireto beplannedanddraftedwith care ifit is to beappliedefficiently and fairly. Implementingthe proceduresandthe administrativestructures for the collection ofsuch atax will requiretime, as well as a significantlevelof coordinationwiththe BPS. 25 96. Pension expenditures account for approximately 50% of public spending in Uruguay, and explain most of the growth in expenditures over the last ten years. Parametric reforms including retirement age, years o f contribution, replacement rates and the system for adjustment or indexation could lead to significant fiscal savings. For example, an increaseo f five years inthe retirement age, inline with the age requirement in comparable countries, could inthe medium term generate savings o faround 0.4% o fGDP (Forteza, 2004). The raising o f the retirement age could be combined with a reduction in the requirement for years o fcontribution that would reflect the reality o fthe labor market and its trend towards informal hiring the alternative would mean the state having to - assume contingent liabilities in the face o f a growing number o f retirees not meeting minimum years o f contribution requirements. A second -and equally difficult to implement- reform option would be to change the indexation o f pensions from a wage- based system to one based on prices, or a mixed basket based on both prices and wages. This could provide additional financial relief to public finances estimated at around 0.3% o fGDP (Forteza, 2004). A change inthe pension indexation mechanismcould contribute to protecting the real value o f pensions in the face o f strong fluctuations in real wages recorded inrecent decades. 97. In addition to the state pension system, Uruguay has a wide range of social protectionprograms that need to be restructured and targeted more specifically, to bettermeet the needsof the populationas a whole. Inmany cases, instruments o f social protection do not adequately cover the more vulnerable groups, which include self- employed workers, those informally employed, and the unemployed. Specific proposals for an improved targeting o f social security and social assistance could yield the necessary fiscal savings. Nevertheless, the growing needs arising fiom vast segments o f the population falling below the poverty line will probably imply an increase in social (non- contributory) transfers. The net effect has been estimated at an increase in the order of 0.2% o fGDP on average in2005-2012. 98. Furthermore, there are a series of pro-growth reforms that will necessitate additionalfiscal disbursements(estimated at 0.9% of GDP on average). These include inparticular the needfor investment inareas suchas institutional modernization, research anddevelopment, andthe fimdingo fa deposit insurancescheme. 26 Table 6 Impacton PrimaryFiscalBalance2005-12 ReformScenario - - Cyclical and StructuralSourcesof Annual averageimpact on primarysurplus Fiscal Expendituresand Revenues (as YoGGDP) A. CyclicalFactors 1) CyclicalIncrease inPrimary Expenditures -1.5% 2) CyclicalIncrease Taxes/SocialSecurity c o n ~ i b u t i o ~ +0.7% A. Total(1+2) -0.8% B. Net Fiscal Gainsfrom StructuralReforms I)Financialsector-netgains +0.2% 2) Pensions +0.7% - Raisingretirementage (net of impact of ageing, - Replacing +0.4% wage indexation by mix of price/wage index. +0.3% ------ Savings 3) Infrastructure +0.6% Combinedcycleplant -0.1% Mega- and rail concessioncontingent liabilities -0.1% EfJiciencygains energy/water +0.3% Concessionfees/ toll-roads, ports cannons,etc. +0.1% by AFE, reducedpublic investment in roads +0.1% IncreasedPrivate Sector Participation(Telec.,energy) +0.3% 4) Social safety net -0.2% 5) Increasedcompliance: tuxredsocialsecurity +OS% 6) State reforms +0.4% -Reducedpublicemployment +0.1% - Procurement +0.3% 7) Increasedspendingin R&D -0.4% 8) Funding DepositInsurance -0.2% 6 -0.3% B. Total (1+2 ...+9) +1.3% Net ImpactPrimary Surplus (AtB) +0.5% Primary Surplus2004 +3.8% Primary surplusover 2005-12 +4.3% I 99. The pro-cyclical nature of public spending contributes to macroeconomic volatility. Uruguay could reduce pro-cyclicality through specific reforms -for example, by modifying the pension indexation mechanism- but it could also adopt anti-cyclical fiscal policies. Such anti-cyclical fiscal policies aim to increase the fiscal pressure (difference between tax revenue and expenditures) during growth periods and lower it during periods o f contraction. There are discretional anti-cyclical policies, and the possibility also exists o f adopting anti-cyclical fiscal rules. The latter could contribute to the credibility of fiscal policy as long as the rules adopted are observed, e.g., Chile has in 2001 adoptedand observed a fiscal rule consisting o fmaintaining a structural fiscal surplus equivalent to 1%of GDP, 27 100. To illustrate the impact on the debt of anti-cyclical policies, scenarios were simulatedassumingthe adoptionof a rule for a structuralprimary fiscal surplus in a stochastic framework (see below). Under such a rule, the level of primary public spending is adjusted only in response to permanent changes inrevenues. This implies that transitory revenue fluctuations are compensated through debt issuanceldebt cancellation thereby helping to smooth out primary expenditures along the cycle. A structuralprimary balance rule equivalent to 4% of GDP was simulated usingthe stochastic modeldescribed above (Guerson, 2004). The scenarios tested are consistent with debt sustainability (Table 7). After 10 years the projected debt-GDP ratio would fall to 70%; the advantage of adopting this rule (vis a vis the alternative o f a fixed primary surplus) is that at the same time as it reduces the debt it makes it possible to smooth out the fluctuations in primary public spending (particularly in socialareas) over the lengthofthe cycle. 101. Using the same simulation model, a policy for a fixed primary surplus equivalent to 4% of GDP makes it possible to reduce the debt to a comparable level (75% of GDP in 10 years, Table 7); while such a policy is not anti-cyclical, it has the important advantage of reducing debt volatility. For example, after 10 years the probability o fdebt rising over 100%is 12%under the fixed primary surplusrulewhereas it is 14% under the structural fiscal rule. In this regard, it is conceivablethat as long as debt remains high, it may be fiscally more prudent to adopt a constant primary surplus rule; as debt declines to more manageable levels, a structural primary surplus rule could be adopted. 102. To bringdebt down faster and maintainan anti-cyclicalfiscal policy, Uruguay could consider combining the adoption of a primary surplus rule incorporatingdebt capitalization(a debt-equity swap). This capitalizationcouldtake place by means ofthe sale of public assets -such as the Nuevo Banco Comercial- from associations between public and private companies or concessions. Selling an interest in the to-be-constructed combined cycle power station is also conceivable. Whatever the case, public debt capitalization would allow a faster reduction of debt and would reduce volatility, For example, a debt-to-equity swap that decreases debt by 30% combined with the adoption o f a structural primary fiscal surplus of 2.8% would allow a reduction of expected debt to 53% o fGDP in5 years; debt volatility would be reducedina similar manner (Table 7).16 l6Simulations usinga stochasticdynamic model are reported inGuerson (2004). The 2.8% structural primary surplus balance is calculatedendogenouslyas the level requiredto obtain a public debt to GDP ratio of 50% infiveyears. 28 Table 7 -Debt Sustainability StochasticSimulations - 1. Constantprimaryfiscalsurplus Assumptions FiscalRule Effective primary surplus Long-termgrowth, annual%rate 2.1 Spread, basis points 500 SharePublicDebt inDom Currency 0.0 Primarysurplustarget (%GDP) 4.0 PublicDebtDynamics At year 5 At year 10 At year 15At year 20 ExDectedPublicdebt I GDPratio 75.3 74.9 76.1 72.9 Standard deviation 18.4 24.2 33.0 36.1 Probabilitydebt ratio < 100%ofGDP 0.88 0.82 0.79 0.78 2. Structuralprimaryfiscal surplus rule Assumptions FiscalRule Structural primary surplus Long-termgrowth, annual%rate 2.1 Spread, basis points 500 Share Public Debt inDom Currency 0.0 Primarysurplustarget (%GDP) 4.0 PublicDebt Dynamics At year 5 At year 10 At year 15 At year 20 ExpectedPublic debt I GDPratio 73.6 70.4 68.9 61.6 Standarddeviation 23.3 34.6 49.6 60.1 Probabilitydebt ratio < 100%ofGDP 0.86 0.79 0.76 0.74 3. Rule for structural primary fiscal surplus debt-for-equityswap (reduces debt by 30% at end of + 2004) Assumptions FiscalRule Structural primary surplus Long-termgrowth, annual %rate 2.1 Spread, basis points 500 Share PublicDebtinDom Currency 0.0 Primarysurplustarget ("76 GDP) 2.8 PublicDebt Dynamics At year 5 At year 10 At year 15 At year 20 ExpectedPublic debt I GDPratio 52.8 50.0 48.4 42.4 Standarddeviation 18.5 28.6 41.8 51.7 Probabilitydebt ratio < 100%ofGDP 0.99 0.90 0.90 0.89 Source: Guerson(2004). 3.3 Debt management 103. Debt management objectives include (among other factors): reduction in the cost of financing and the risk of re-financing, minimizing the exchange risk and ensuring continued access to capital markets.The following considerations are relevant inthe caseofUruguay: 29 (i) Currency risk. Based on the stochastic simulation model used, volatility o f the debt ratio could be reduced by one-third ifUruguay's public debt were 50% denominated inforeigncurrency-comparedto nearly 100%currently (Guenon, 2004). However, the authorities will have to evaluate whether the probable increased cost (interms o f interest rate) of issuing more peso-denominated debt is justified in the face o f the reduction involatility o fthe debt associatedwith the shift towards peso denominated debt. (ii) Access to markets - Diversification of financing sources and i ~ ~ m e n t s . Diversification o f sources and instrumentso f financing can improve the chances and terms o f accessing markets at all times and can help to deepen domestic capital markets. For example, pension funds may prefer long-maturity inflation-protected instruments, while money market funds prefer low volatility short term instruments. Uruguay has already successfully explored the market for medium-term index-linked securities in pesos. At present, almost half o f Uruguay's debt is with multilateral lending agencies. As long as Uruguay can preserve its access to capital markets, a reduction in the exposure to such bodies could be justified. This would provide a greater marginfor access inthe undesirableevent o fa new crisis. (iii)' Risk of refinancing Maturity and repaymentpeaks. Long-term debt carries with it a - liquidity premium. Nevertheless, short-term debt can exacerbate the risk of re- financing. Uruguay succeededin lengtheningthe maturity o f its commercial debt by over 5 years under the 2003 bond exchange. To minimize the refinancing risk it is advisable to avoid concentration o f principal payments during a given period. There is still scope for lengthening averagematurity and avoiding peaks inrepayment. (iv) Liquid@ risk - Policy on reserves. International reservescanhelp to minimize rollover risk, exchange risk and the risko flosing access to markets. Uruguay's CentralBank has currently a relatively large stock o f international reservescovering 85% o fpublic debt service falling due the last quarter o f2004 and the frst 3 quarters o f2005, and equivalent to over 9 months o f imports. However, international reservesneed also to be measuredagainst potentia1demands fiom the dollarized financial sector. Foreign reserves are approximately 100% o f foreign currency deposits held by non-residents, but barely one-fourth o f the total stock o f foreign currency liabilities o f the financial system as a whole. To build up its liquidity cushion, Uruguay could establish international liquidity requirements for foreign currency deposits, higher for non- residents and inversely related to the maturity o f the deposit (it has already adopted differential reserve requirements for foreign and domestic currency deposits). Uruguay could also seek international liquidity insurance schemes, e.g., a fee-based international liquidity facility like the one Argentina obtained fiom private banks in the 1990s. (v) Optimal degree of inde~tedn~ss. Severalpapersargue that emergin economiesshould target debtlGDP ratios o f lessthan 30% o fGDP inthe long term.` Large debt ratios are associated with high interest rates and spreads through their impact on sovereign risk, adversely affecting economic growth. Following a decade o f debt reduction, l7See Reinhart, Rogofiand Savastano (2002). 30 Chile has reduced its public debt-to- GDP ratio to around 12% (excluding the debt of the Central Bank); this has been one of the pillars of its stellar growth performanceand ability to conduct anti-cyclicalfiscal policy, particularly inresponse to high international commodity price volatility - copper revenues finance a substantialportion ofChile's budget. (v$ Inst~tutjon~l aspects. Although Uruguay was successfully able to cany out a debt exchange covering 92% of its debt with private creditors, the Ministry of Economy does not possess a department that is equipped and trained to carry out planning, monitoring, evaluation and management of the debt on the basis of pre-determined objectives. The government couldanalyze various options o f institutionaldesignto be able to ensurecontinuity inthe administrationofsucha strategicallysensitive area. 3.4 De-dollarizationand monetary policy 104. The objective to issue more peso denominated debt is closely related to the broader issue of de-dollarization.It is widely perceived inUruguay that the widespread use of the dollar for fmancial transactions (over 90% of bank deposits and public debt are denominatedin foreign currency) has beena source of instability. That instability is allthe more acute because there is a currency mismatchbetween the assets and the liabilities of many fmancial institutions and the foreign currency obligations of many households and frms are not covered by secure sources of foreign exchange income. De-dollarkation appears to offer away out ofthose problemsbutthat canonly be achievedbyreversingthe policiesthat gave riseto dollarizationinthe first place. 105, The fundamental reason why the dollar has been so widely used for financial transactionsin Uruguayis that the citizens lackconfidencein the value of the peso. A successful programof de-dollarizationwill depend, therefore, upon building up confidence inthe peso as adependable storeofvalue. That, inturn, will dependuponfollowing sound macroeconomic policiesconsistentlyover time so that inflationary expectationsand, hence, peso interest rates, can be kept low. Inparticular, adopting an inflation target regime can help restoring confidence in the currency; both Chile and Brazil have recently achieved successful results with this. 106. The government has already taken actions to facilitate adoption of inflation targeting. The CentralBank (BCU) currently pursues apolicy ofmonetarybasetargeting which carries implicit inflation targets. To impart greater flexibility to monetary policy operations, the BCU has established a repurchase (repo) mechanism to address intra- monthly variability in the demand for pesos. Also, it started a forward foreign exchange programand has increasedthe transparency o fthe monetarypolicy fiamework throughthe timely and more fiequent publication of data including monetary and inflation targets. The Central Bank has created inflation-indexed instruments to reduce the vulnerability o f the financial sector, as well as the volatility of money demand and thereby ensure a more predictablemonetarytransmissionmechanism(IMF, 2004). 31 107. The main challenge for effectively implementingan inflation targets regime is conceding autonomy to the Central Bank and reform of its charter to establish currency stability as its primary objective. This may require staggeringterms of board members and limiting the government's ability to interfere with BCUdecisions. Eventually it will be necessaryto recapitalizingthe CentralBankto reduceor eliminate its quasi-fiscal deficits(around 1%ofGDP). Other challenges are: the development ofanactive inter-bank credit market, limiting foreign exchange interventions to exceptional circumstances and further development ofthe forward foreignexchange market. Regardingthe latter, caution will be required, to prevent speculationagainst the BCU. The government could promote participationby institutional players like insurance companies or pensionfunds as they are typically long inUS dollars. 108. The importance of fiscal discipline transcends the debt sustainabilityobjective; by contributingto anchor inflationaryexpectations, fiscal austerity grants degrees of freedom to monetary policy in attaining the anti-inflation objective, Among other matters, this preventshaving to resortto excessively high interest rates to halt inflationary pressure -and its fiequent consequence, exchange rate appreciation episodes induced by monetary constraints. The gradual disinflation process under way -compatible with an inflation-targeting policy- is backed by sound and consistent fiscal policy, which, if continued, will simultaneously enable the driving down of inflation without the risk of excessively high interest ratesor abrupt losses ofexchange ratecompetitiveness. 109. In addition,thereare a number of otherspecific measuresthat could betakento foster the adoption of peso-denominated financial instruments and reduce the risks linkedto dollarization: a The marketmaywell bereceptiveto bondsor certificatesofdeposit denominated in pesos, ifthey were inflation-linked and ifholders were assured that the indexation will be fair, transparentlyadministeredand strictly honored; recentlyUIinstruments (denominatedin inflation-indexedunits)have beencreated. a Bankswhich extenddollar denominatedloansto businessesthat do not earn foreign exchange should be required to provision against such loans at a higher rate. Foreign exchange deposited in banks should be subject to higher liquidity requirementsandlor higher deposit insurance premiums. a Prudential regulations could oblige pension fbnds and insurance companies to matchthe currencyo ftheir hture liabilities against the currencyoftheir assets; this could considerably increase the demand for instruments in UI, at the same time as protectingfbture pensioners fiom exchangerate fluctuations. a Developing a forward market in UI would allow institutions to hedge their portfolios. a Tax rules could be revised accordingly, e.g,, income tax rates need to be based on real(rather thannominal) interest rates. 32 3.5 Strengtheningbanks" 110. A stable financial sector is essential to prevent banking crises and the high related cost. An efficient financial system also facilitates the reassigning o f idle resources to more productive companiesandthe most dynamic sectors. Boththese objectives form an important parto fthe growth strategiesunder pillar 1. 111. After the 2002 crisis, the banking sector was segmented into large, public banks with nation-wide branch networks, and a small number of mostly foreign- owned banks. The two large public banks - BROU and BHU- are being restructured with the aim o f improving their credit and risk management functions and their corporate governance. The BHU is no longer authorized to take deposits (except for peso savings plans). The liquidation o fthe four medium or large private domestic banks during the crisis reduced the share o f private banks fiom 60% to 40% (Table 8). Afier the bulk o f BHU deposits were transferred to BROU, the latter held48% o fall deposits and 44% o fall loans within the system. Table 8 The UruguayanBankingSector - (US$ millions) Assets % Liabilities Equity YO BROU 4,358 39 4,499 42 249 34 BHU 1,236 11 1,214 11 22 3 NBC 1,059 9 911 8 148 20 Total Public Banks 6,653 60 6,624 61 419 57 Private Banks 4,518 40 4,204 39 314 43 TOTAL 11,171 100 10,828 100 733 100 112. The authorities have made a substantial effort in overhauling the existing regulatory framework and strengthening the supervisory institutions.A new banking law in 2002 delineated the basic operating procedures for bank restructuring andlor liquidation. Italso re-defined and expandedthe role o fBCU instrengtheningthe regulatory and supervisory fiameworks, The new banking regulatory and supervisory fiamework introduced important changes: new limits on specific borrowers and risks; higher reserve requirements for non-resident deposits; modifications to creditor classification, accounting for the value o f guarantees and loan provisioning; regulations to encourage banks to account and adequately provide for foreign exchange risk; minimum capital requirements computed according to mark-to-market criteria including adjustments for inflation, price volatility, foreign exchange risk, country risk and interest rate risk; and in general, the strengthening and modernization o fthe BCU's supervisory function. Sectionbasedon de la Plataand Sirtaine(2004). 33 113, The challenge will be to develop a system that can mediate efficiently and effectivelybetweensavings entities and takers of credit; at present the bankingsector operates with highlevelsof liquidity.Indifferent circumstances this could appear to be a sign o f strength, but inthe current situationofUruguay it is a signthat there is still a crisis mentality that is deeply ingrained inthe financial sector, Bank liabilities are largely made up by sight deposits and could, therefore, flee the system at the slightest sign of trouble. Conversely, andpartially as aconsequenceofthe concentrationo fshort term liabilities, the banks' lendingpolicies are broadly restrictive, tending to concentrate on the export sector and inshort maturities. As ofend-2003, bank lendingto the non-financialsector as a share of GDP, was only 22%, versus 57% at the end 2001. In2004, lendingby private banks to the non-financial sector increased around 8%, but credit to the private sector continuedto account for a low share of bank assets (28%). Interms of flows, risk aversion is causing lendingto occur predominantlywithin the financialsector, with 62% ofthe total loanbook being among financial institutions. Thus, the bankingsystem is not fulfilling its missionof transforming savings into long-term lending and channeling capital to more productive investments. Strategicpolicy options 114. To strengthen the banking sector and to encourage bank intermediation, the governmentmay consider the following policy and reformoptions: i. Fundingandimplementingalimiteddepositinsuranceprogram. A partial deposit insurance program was established by law in 2002; it still needs to be funded and implemented. It would help to increase confidence among small depositorsand establish a more level-playing field among banks -at present public banks have the guarantee of the state. The proposed scheme is a partial guarantee system designed to be funded by all banks with contributions based on the relative risk of each institution. An issue to be resolvedis the treatment ofthe asymmetry causedbythe full guarantee on BROU deposits. ii.Increasingcompetition. Thegovernment shouldacceleratethe necessarysteps towards the privatization o fNBC - the new public bank created by combining the good assets and the liabilities o f three liquidated domestic banks. A modern and professionally runNBC will provide a benchmarkwith which to measure BROU's performance. Government could consider strict enforcement of public laws regulating public enterprises to improve corporate governance at BROU (e.g., separation of board fi-om management function, technical credentials for directors rather than political criteria for board appointments). A subsequent step which the government could consider is the accounting separation of commercial and developmental roles of BROU -declaring in its budget the elements of implicit subsidy in its developmentactivities- and, eventually, considerationshould be given to placingthe BROUunder commerciallaw. iii. A more autonomous regulator and supervisor. It is important that BCU's supervisory function is isolated fi-om potential political pressures. Authorities are advised to seek full technical independence of the Banking Supervision Agency. One option would be to segregate the entire supervisory function 34 within BCU (for banks, insurance, pension plans, stock exchange, etc.) into an independentagency. iv. Evaluate options to improve bank resolution legislation. Although the new banking law facilitates the liquidation o f failed banks, Uruguay still lacks a well defined process and mechanismfor the closure, resolution and liquidation o fbanks. A more general kamework for bank restructuring and market exit of insolvent institutions may be required. This could entail activities ranging from adoption o f regularization plans to suspension o f operations, exclusion o f assets and liabilities o f insolvent banksandbank closure. V. Bank credit to SMEs. Standardization o f financial information o f SMEs and a review o f whether there is an anti-SME bias in prudential regulations may be conducive towards mobilizing more bank credit to SMEs. Access to finance by SMEs may benefit om the strengtheningo f asset and debt registers and a regime that effectively protects personaldata - alegal and regulatory fiamework for private credit bureaus. Enhancement o f SME guarantees could be attained through a corporation o f reciprocal guarantee backed by a Guarantee Fund, e.g., as the one created inArgentina. 3.6 Developingcapitalmarkets 115. Capital marketshave a significantpotentialfor the development of innovative products and the mobilizingof resourcestowards expandingfirms and sectors. Even during the recent crisis, a number o f new products have emerged, e.g., investment certificates for dairy farmers, non-performing loan sales, and banking certificates o f deposit. Capital markets (exchanges) are less constrained than banks by currency and maturity mismatches between assets and liabilities. Similarly, they are intrinsically flexible (as the market is constantly setting the price at which transactions are performed) and they adapt to market needs and opportunities, Capital markets are thus called to play an important role both insustaining the economic recovery andthe growth process. 116. Capital markets are necessary for the development of institutionalinvestors. Pensionfunds dependon capital markets for the investment o fthe finds that their members save for retirementand the savings o fthose who have already retired and opt for a system o f programmed withdrawals. Insurance companies offer retirement insurance for those whose only asset is the accumulated saving in the social security system during their working lives, which inturn is invested inthe market. Inthis situation, inview o fthe social responsibility implicit ina mandatory saving system for specific ends, it will be crucial to develop an efficient and reliable capital market. 117, Capital markets in Uruguay are relativety small (Table 9), although growing due to the rising importance of pension funds and their individual capitalization accounts. The share o f savings managed by private pension finds in individually capitalized accounts has been rising steadily, reaching a level o f 13% o f GDP in 2003 (Figure 5). The opposite happened with knds intermediated by investment hnds which collapsed in 2002 and remained at insignificantly low levels during 2003 35 (Figure for sovereigndebt - outstandingsovereign debt securities representednearly 60% of GDP 6). Uruguay's most dynamic segment of securities markets is the market in2003. New corporatedebt andequity issues are exceedinglylow; outstandingcorporate debt issues (under US$200 million at present) have declined to one third of the level in 1999. Insurancecompanies are the secondmost important institutional investors, withtheir investmentsamountingto 3% ofGDP; their business is dominatedby casualty and property premiums (around two-thirds) and the sector is heavily monopolized by BSE - State InsuranceBank. 118. Uruguay lags behind on matters of regulatory and legal frameworks for its capital markets. For example it is behind both developed countries and developing countries interms o f shareholder and creditors' rights (Table 10). The rule of law and the judicial system, although ahead of the developing country sample sample, are well below the developedcountry average. Table 9 Uruguay's capital markets ininternational perspective - Variable Colombia Brazil Chile Mexico Uruguay Market capitalization of listed companies 11.90 27.40 74.20 16.20 0.82 (%ofGDP) Stockstraded, turnover ratio (%) 0.60 3.40 0.90 1.50 0.50 Assets heldby PensionFund(% of GDP) 60.60 5.80 12.70 Table 10 - Investorprotection ratings. Source: LaPorta, Lbpez-de-Silaneset al. (2002). 36 Figure5 Pensionfunds (fundsunder management) millionpesos - - 30,000 20,000 10,000 0 1999 2000 2001 2002 2003 Source: BCU.I9 Figure6 Fundsadministeredby open-endedfunds (thousandsofUS%) - ,.. .. . , .. ". , . " .....",... .. . .......,....,".., ., . I i 2510.000 mom0 150.000 1oo.mo 50.~10 0 119. The lack of independence of regulators and the limited enforcement powers restrict the potential for development of securities markets, the insurancemarket and the pensionfund system: i. IndependenceofRegulators. Subordinationofcapitalmarketregulatorsto BCU gives rise to potential conflicts of interest - given the role o f the BCU as both an issuer o f securities and regulator. The problem gains in significance as the BCU is not independent i?om the Executive which is inturn a provider of financial services (BSE andBROU-ownedpensionfund-AFAPRep~blica). ii.Regulatoryenforcementcapability. The capacityof supervisorsto apply the regulations is ingeneral low. Exampleso fthe difficulties that exist include delays in the provision and publication of information, and the absence of sanctions or difficulties inenforcingthem. Inparticular, physicaland legalresources assignedto l9Inspite ofthe devaluation, savingsmanagedbythe pensionfimds (largelydollar-denominated) also increased indollartermsover 1999-2003. 37 inspection work are limited. Legislation does not grant special powers o fsupervision, such as the ability to require changes or corrections to accounting entries, inspect installations and records, appoint external auditors or initiate proceedings in the ordinary courts. Strategicpolicy optionsfor the~tre~gtheningcapitaImarkets of 120. Apart from strengthening the autonomy of the regulator and the regulatory enforcement capability, the government could consider the following policies and reforms to support the development of its securities markets, pension funds and insurancesectors: Developing linkages between the two stock exchanges and consider their de- mutualization. This would enable the exchanges to more adequately resolve conflicts o f interest arising out o f their ownership structure, raise capital for their development, and competemore flexibly onthe international market. Filling legal voids in the area of securities trading in the stock exchanges. There is specifically the needto feel a void inthe case of the regulationof the traders themselves, for example, in relationto the treatment of conflict of interest inthe case of dealingfor their ownaccount, theprecedenceof orders andtheir execution, Establishingobjectivecriteria in law for the application of criminal penaIties in areassuch as insidertrading. This entails improving specification o ftreatment o f the use o f insider trading, including the nature o f such inside information, presumptions and penalties. Strengthening corporate governance. The rights o f minority shareholders and related parties in general are poorly safeguarded, and procedures for the take over o f control, the existence o f independent directors or justifications for the right o f withdrawal, among other matters, are not contemplated. Integrationto international markets could be facilitated through the enforcement o f international standards in accounting, disclosure, and governance. Promotion of new instruments.The recent development o f financial instruments for the agriculture and livestock sectors could be replicated to other sectors. High innovation sectors, such as information technology (IT) and biotechnology, could be good candidates to receive finding fiom venture capital markets. Other possible alternatives for analysis include the possibility o f issuing warrants -bonds convertible into shares, leasing, factoring and transferable certificates o fdeposit. On the basiso fthe confidence that they generate inthemselves, public companiescould play a stimulating role in capital markets through the issue o f securities for their own fmancing. Issue requirements will in turn force improvements in the transparencyand practices o fcorporate governance insuch companies. 38 (vi) Strengtheningcompetition among pensionfunds. The government could consider several options: eliminating the guaranteedminimumreturn (which favors the stateAFAP as inthe eyes ofworkers, it can count onthe guaranteeofthe state); and separatingthe account managementfbnction -where economieso fscale exist - ftom the investment fbnction - where stronger competition is both feasible and desirable. (vii) Improving risk diversificationof pension funds. The government could evaluate the benefits and risks o f lifting several restrictions on portfolio investments by pension funds. Riskdiversification could, for example, imply raising the percentage of investments in foreign assets or in local assets inpesos outside the state sector. The latter would benefit the development of the local capital market. In addition, the introduction o f prudential regulations as regards currency mismatching limits (between assets and liabilities) for the pension funds, could induce them to invest more in peso or inflation-indexed financial instruments -as long as their fbture requirements are denominatedinpesos. (viii) Eliminate supervisory asymmetries in insurance which privilege the state Insurance Bank (BSE). Such asymmetries could risk the solvency o f existing companies and discouragethe entry o f new competitors. An independent regulator could help to impose market discipline on BSE, for example, by establishing profit benchmarks. Inaddition, the government is advised to evaluate the cost and benefit o fmaintaining BSEs legal monopoly onwork accident insurance. Improving insurance regulation. Inthe field o f regulation, the possible areas for improvement include: controlover the solvency o f annuities and establishment o f a criterion for matching flows inrelation to term and currency. Developingbusiness opportunitiesfor capital market players.To contribute to the development o fbusinessopportunities, consideration could be givento allowing insurancecompaniesto expandtheir distribution base, mainlythrough the use o fthe banking system. Inaddition, the possibility o f insurance companies granting loans could be considered. Consolidated supervision. The potential synergies between banks and insurance companies would be yet another reason to support a shift towards consolidated supervision -the strong links that exist between banks, AFAPs and stock market traders are the main reason behind the need to coordinate and eventually consolidate supervising agencies. 3.7 Labormarkets" 121. Performanceof a country's labor market can impacton economicgrowthat the aggregate level and at the household level. At the aggregate level, a country's output increaseswith the share o fthe population that choosesto participate inthe labor market -up 2oBasedon Packard(2004). 39 from 57% in 1990 to 60.6% in2001 and then down to 58.1% in2003 - as well as the hours that they devote to work. At the householdlevel, labor regulations - employment protection legislation, wage bargaining systems, labor taxes, and pensions affect incentives to work - andthus canalso impact on growth. 122. Uruguay'slabor market functions relativelypoorlywhen compared to that ofits neighbors. Estimates o fthe impact o f economic growth on employment, show that relative to countries in the region, a substantially greater increase in real output is requiredto raise employment inUruguay, and a greater number o fjobs are lost in economic downturns than are gained during periods o f growth.21Duringmuch o f the 1990s, when growth was rapid, there was a rising trend in unemployment (Figure 7). The quality o f employment has also deteriorated as evidenced by the notable increase in informal employment, both non- contractedunregulated salaried employment and self-employment. The fastest increase in self employment has been in short-term, low-income enterprises requiring little or no capital investment. 123. The duration of unemployment hasincreased. The highest increases have been in relatively higher age cohorts, among those aged 40 and over. Unemployment duration remainshigher for youngerjob seekers and for women, as well as for the economically active from poorer households. Since 1990, the increase in the duration o f unemployment for workers with less than seven years o f education has been greater than for other groups (Amarante, 2003). 124. Changes in labor markets over 1990-2003 have stemmed from shifts in the orientationof economic policy, from out-dated labor market institutionsand from the interactionbetween these two factors. Stabilization and structural adjustment policies in the mid 1980s brought price stability and shifted the economy away fkom protectionist import substitution, and toward an outward orientation reliant on exports. Shifts in the macroeconomic climate were accompanied by a real appreciation o f the peso during the 1990sthat forced changes inthe largely non-competitive manufacturing sector. This resulted in a shift in the sector allocation of labor away fiom manufacturing, towards export production and services. The share o f labor in the manufacturing sector fell from 21% o f employment in 1990to only 14% in2001. 125. These changes were accompanied by an increase in the share of the population that is economically active, largely attributed to a steady rise in the number of women choosingto work outside the home. The rate o f economic activity o f women in Uruguay increased-from43.5% in 1990 to 50.9% in2001. Further, the structure ofproduction became less centralized. There was an increase in the concentration o f employment in small firms. At the end o fthe decade, almost half of all private employment was incompanies with five or fewer workers; a large proportion was informal. As shown in Figure 7, during the same period public-sector employment declined, while the share o f the labor force privately employed, employed informally, and selfemployed has notably increased(Amarante, 2003). In1994,whenthe economygrew by 7.3% employmentonly grew by2.7%. Incontrast, in 1999and2000 a contractionof-2.8% and 1.4%ledto a fall inemployment of -2%and 1.3%, respectively (Amarante, 2003). 40 126. Higher unemployment, increases in unemployment duration and evidence of distortions and segmentation can (at least partially) be traced to institutional and regulatory factors. The minimum wage in Uruguay is low and not mandatory, and since 1992 wage negotiations have been decentralized and take place at company level, without government participation. Nevertheless, various other institutional factors hamper the efficient operation of labor markets. Public sector unions remain strong, and high dismissal costs arising from formal job protection(severance payments are one month salary per year of employment) may be dissuading employers fiom creating formal sector jobs (Heckman and Pages, 2000; Fortezaand Rama, 2002). Regulationof public sector employment may be sending detrimental signals to the labor market. In2001, public workers earned 36% more than formal private workers. Women and low-skilled workers in particular, earn relatively more in the public sector. Amarante, et al, (2003) found that the wage premium and wage rigidities inthe public sector have exerted a negative impact on employment as a whole, and particularly among individualswho have only some or completedsecondary education. 127. The share of public sector employment in Uruguay is still relatively large. Despite a steady fall in public employment since 1990, in 2001 the public sector still accounted for 16.5% ofjobs. Among its neighbors, Uruguayhasthe highest share ofworkers inpublic sector jobs. Evenwhen compared to similar countries inthe OECD, the size of Uruguay's public sector employment seems large.22Public employment inUruguay(at 6.9% of the total population) is considerably higher thanthe average for Latin America -although this figure is influenced by the high number of employees still working for the public enterprise sector in Uruguay. During periods of crisis, job losses are more evident in the private sector, while few public sector employees can be dismissed due to strong union activity andregulatoryprotection. 128. Another factor which has impacted negatively on labor market performanceis the high level of payroll taxes (Table 11). To meet the demands of its generous social security and, especially public pension regime, Uruguay had to maintain relatively high levelsofpay-roll tax. The pay-roll tax for social insurance inUruguay is about 3 percentage points higher than the average of selected OECD countries, and 7 percentage points higher thanthe average ofLatinAmericancountries.Total labor taxes represent 40.5% ofthe gross wage in Uruguay, compared with 28% on average inLatin America and 35% inthe OECD. Suchhighrates ofpay-rolltaxationnotonly hinderscompetitiveness, but also may be fueling the rise inthe share ofworkers who take up informal employmentaggravatingsegmentation inthe labor market (Packard, 2001). 22Only 16.1%of Italy's workforce, 15.2%of Spanishworkers, 14.4%ofworkers inthe UKandamere 12.1% ofworkers inthe Netherlandswere publicly employedin 1995, whenthe share ofUruguay's workforce in public employment stoodat 19.1%(Gregory andBorland, 1999, as cited inAmarante et al. 2003). 41 Figure7 MacroeconomicTrends, LaborMarket Adjustments,and Sector ShiftsinUruguay - 200.0 20.0 190.0 180.0 15.0 170.0 160.0 150.0 10.0 140.0 130.0 5.0 120.0 110.0 100.0 0.0 90.0 80.0 -5.0 70.0 80.0 50.0 -10.0 40.0 30.0 -15.0 20.0 10.0 0.0 -20.0 - 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1998 1997 1998 1999 2000 2001 2002 2003 GDPGrowth (annual%, rightscale) Unenploymnt(% of laborforce, rlghtscale) Employment(%, rightscale) RtvateEmployment(index) -PublicSeif Bnploymnt(index) - -c-- tirployers(index) Employment(wlocapital, index) Self Employment(wlcapltal, index) Non PadLabor(index) o RealWagehdex hflation(cff) Source: Amarante (2003), World Bank (SIMA), IMF (IFS), INE, Strategicoptionsto improve labor market efficiency 129. Considerationof a possible reductionof payrolltaxes would have to be part of a comprehensive review of social expenditure financing which evaluates the relative efficiency of alternative financing instruments as a function of the risk which specific expenditures finance and the overall budgetary constraint. The motivation for a reduction in employer contributions and increased participation in non- contributive social benefits is basedonthe one hand onthe creation o f incentives infavor o f formal employment -via a reduction incontributions- and onthe other onthe reduction o f subsidies or transfers to workers inthe formal sector -as these are financed inpart by their contributions and in part by general tax revenue (BPS deficits are fmanced out of general revenue). In assessing the impact o f a rise in non-contributory benefits -better social coverage- it is essential to take into account the impact on the trend towards informalemployment -non contributory benefits could encouragethose who are currently contributing to cease to do so. 42 Table 11 PayrollTaxes for PensionsandAll SocialInsurance - SelectedOECD andLatin American Countries As % of Gross Wage: As % of Labor Costs: All.Social All Social Country Employer Employee PensionsTax Insurance PensionTax Insurance Taxes Taxes Austria 12.6 10.3 22.8 45.O 17.8 35.2 Belgium 8.9 7.5 16.4 38.9 13.0 30.9 Canada 3.0 3.0 6.0 15.2 4.9 13.9 France 10.0 7.0 16.0 51.0 12.0 38.0 Germany 10.2 10.2 20.3 42.0 17.0 34.0 Greece 13.3 6.7 20.0 34.5 16.1 27.9 Ireland 14.4 13.0 Italy 21.3 8.3 29.6 56.7 20.1 38.5 Japan 8.3 8.3 16.5 29.1 14.1 24.9 Netherlands 0.0 32.1 32.1 56.0 28.9 50.5 Portugal 23.8 11.0 34.8 37.8 27.4 29.8 Spain 23.6 4.7 28.3 38.3 21.4 29.0 UnitedKingdom- 13.9 13.0 United States 6.2 6.2 12.4 21.o 10.4 18.5 Argentina 16.0 11.0 27.0 46.0 21.0 35.0 Colombia 10.1 3.4 13.5 33.8 10.7 26.7 CostaRica 4.8 2.5 7.3 27.0 6.1 22.7 Chile 0.0 13.0 13.0 21.0 12.9 20.7 Ecuador 2.4 7.0 9.4 18.6 8.6 17.0 Mexico 10.9 4.6 15.5 26.0 6.5 21.5 Panama 2.8 6.8 9.5 18.0 9.2 9.7 Peru 6.0 3.0 9.0 24.6 7.6 20.7 Brazil 20.0 11.0 31.0 31.0 24.1 25.0 Venezuela 10.0 4.0 14.0 25.5 12.0 21.8 AverageOECD11.7 9.6 21.3 35.3 16.9 28.4 Average LCR 7.7 6.8 14.6 28.1 11.7 22.8 Average All 9.9 8.3 18.2 32.3 14.5 26.1 Uruguay 14.5 13.0 27.5 40.5 22.1 32.5 Source: SocialSecurityProgramsThroughout the World-1997, "InternationalPatternsofPensionProvision" by PaiaciosandPallares-Miralles(2000). 130. Similarly, a possible review of severance pay regulationswould be an integral part of the review ofthe broadersocial safety net. While reducing the cost to the firm o f severancepayments would contribute to labor mobility ingeneral, this may have to be compensatedby some combination of saving instrument(e.g., fimded by workers andlor employers such as the system recently introduced in Chile) and a more effective 43 unemployment insurance regime (currently only 15% of unemployed benefit)23 or a similar incomeprotectiondeviceto cover unexpectedly long periodso flost income. 131. The distorting impact on labor markets of public wage setting and public employment regulations needs to be taken into account in the analysis of civil service reform options. The wage premium and wage rigidities in the public sector exert a negative impact on the operation of labor markets and have a potentially regressive distributional impact on individuals who have not completed secondary education. 132. The performanceand the flexibility of the labor market have suffered from the impediments imposed by employment security rules, the secondary effect of public employment policies and high employer pension contributions. Improving the efficiency of labor markets is crucial to improve incentives for investment in humancapitalandto ensure that such investmentis not wasted, as those who obtainthe qualifications could emigrate in search of a higher and more secure return in other countries . 3.8 Reformingsocialsecurity andthe socialsafety net24 133. Where householdsdo not have a sufficientlywide array of tools with which to protect against shocks, their human capital may suffer and as a consequence growth as well. When such social and economic risks materialize, households are condemned to spend precious resources recovering f?om shocks rather than devoting these resourcesto productiveuse. 134. Uruguay surpasses its neighborsin social spending by far. Spendingis almost 6 percentage points of GDP more inthe social sectors than Costa Rica (the next biggest social spender inthe region), 8 percentage pointsofGDP morethan Braziland almost 10 percentage points of GDP more than Argentina. The unusually high levels of total spending in the social sectors are driven by the cost of social protection, particularly, public pensions (Figure 8). Other social spending (although relatively higher in health andrelatively lower ineducation) is comparable to that ofother countries inthe region, 135. Various factors explainsizable expendituresofthe publicpensionsystemand their fast increase over the last decade. These include the low retirement age (60 for men and women); moral hazard inthe benefit structure (workers can opt for either a 35 year contributionscheme available at 60 or a 15 year contribution scheme availableat 70 -sincethereplacementrateissimilar, mostchoosethesecond"more generous" pillar); wage indexation of pension benefits; high payroll taxes (which encourage informal hiring); andvery highpopulation and socialsecurity system dependency ratios becauseof the longevityofthe population, a low birth rate, andthe emigrationofyoung people. At 23Eligibility for unemploymentinsurance is basedon contributionsto the BPS inthe twelve preceding months. BasedonPackard(2004). 44 34.5%, Uruguay's population dependency ratio (population aged 60 or more over population between20 and 59) is slightly above the average OECD ratio and about twice the level o f comparable Latin American countries. Its system dependency ratio (ratio o f pensioners to contributors) of 70% is more than twice the average of comparable countries inthe region and over 40% higher than inselectedOECD countries. 136. Uruguay has a wide range of social protection systems and programs to protect human capital from different risks along the life-cycle (Table 12). The largest o f these, social security offered through BPS ("Banco de Previsih Social"), provides generous old age, disability and survivor pensions, unemployment insurance, medical insurance and cashtransfersto families with dependent children. Between 1997 and 2002, the share of old pensions declined to just under three-quarters o f total BPS expenditures, whereas the shares o f unemployment insurance and family allowances increasedreflecting the anti-cyclical natureo fthese social transfers. Figure8 Spendingon Social Protection(Social InsuranceandWelfare) as a percentageofGDP, - SelectedLCRandOECD Countriesin1998 1 15 0 100 5 0 0 0 Source:World Bank(SIMA) andOECD. 137. Although Uruguay's social protection system is more comprehensive than that provided by many governments in the region, internationalcomparisonswith emerging countries that have undergone crises in the late 1990s-early 2000s (World Bank, 2003) show that Uruguay has had the second highest increase in unemployment and one of the highest increases in poverty as a result of the crisis. During 1999-2002, poverty increasedby morethan 8 percentagepoints and it worsened krther in 2003. To cope with losses fkom the recent crisis, households cut critical spendingboth ineducation and health; the safety net -though -was able to provide basic social outcomes. 45 b 8 b L L L L 24 l b e a ' I 0 0 0 0 0 0 0 0 0 0 I A A A A I A A A h A A B ea% e -? 2 0 9 M 46 . ... 0 . o n n A A A A h 47 138. One factor contributing to the severity of crises in Uruguay is that social protection instruments do not cover adequately the most vulnerable groups. In addition to the unemployed and the heads of large households, the most vulnerable to poverty include the self employed, workers in informal employment, and those working inthe constructionsector. Since these groups are engaged inactivities inwhich they are not paying pay-roll taxes, they are not gaining rights to formal social protection. This "truncation" of the social protection system is not unique to Uruguay, and becomes apparent with the shifts in production and growth of self employment and informal salaried employment seen inthe region(de Ferranti, Perry, Ferreiraand Walton, 2003). 139. The inequity is aggravated because "contributory" social insurancesystems that deny even minimum benefit levels to individualswithout a history of explicit contributions,pay benefitsto thosewho are covered in excessof their contributions. This is dramatically apparent in pensions and unemployment insurance systems. Financing the public portion of old age pensions places a huge fiscal burden on tax payers: only 60% ofbenefit expenditures are currentlycoveredby contributions. 140. Uruguayhas non-contributorytransfer programsfor the poor and programs like workfare that do not require a formal employment history; however, they are relatively small in size. Social assistance spending rose from 11.7% of consolidated social spending in 1999 to 13.8% in 2002. Social assistance programs in 2002 were allocated as follows: housing programs 40%, social assistance and food 30%, unemployment insurance 18%, family allowances 9%, the rest went into smaller programs. Among the social assistance programs aimed directly at vulnerable groups are: programs in feeding and nutrition, youth training, housing, day care and cash - Housing (MEVIR), PROJOVEN and CAIF day care centers - are well-targeted to the transfers. Some of these programs such as the Full Day Schools (MECAEP), Rural poor, thoughcoverage of some programs is still very low. 141. Among the social assistance non-contributory programs is a means-tested pension program that pays benefits for old age, survivor and disability. The target population is composed o f persons aged 70 and above whose personal earnings do not reach a certain threshold or target pension, and do not have close relatives who could support them. About 29% of benefits are for old age. Beneficiaries of the non- contributorypensionprogramrepresent 9%ofall pensionrecipients. The benefit is about 60% of the average contributory benefit. 142. Other non-contributory programs are poorly targeted and outdated. For example, INDA food programsneedto be better focused and improve their systems and controls - until recently, there was no registry o f beneficiaries. The PAE food program spends only 46% ofresourceson its maintarget: childrenfiom the third (lowest) segment of income levels. The programof family allowances-while recentlyreformedto extend benefits to informal poor- still leaves a large number of informal poor uncovered. In addition, there are problems of duplication between the programs offered by the federal government and those providedby municipalities. 48 143. During the recent crisis a number of social programs focused on the most vulnerable. For example, various non-contributory social programs have beenprotected (Le., cuts inreal terms avoided) inthe 2003 budget, Also, a number o f these programs25 have beenevaluatedto help to improve their design andor adjust their scale. Optionsfor re~ormulatingthe social insurancenetwork 144. The government may need to review the existing supply of instruments provided by the state (social insurance and social assistance) to ascertain whether they are correctlymatched to the risks they seek to cover, examine ways to correct possible miss-matches, and investigatethe extent to which there may be duplication in the protectionofferedby the various instruments. 145. There is an urgent need for flexible programsthat protect the consumption of vulnerable groups that are not completely covered (or uncovered) by the current system. Vulnerable groups comprise the self-employed (who are the ones showing the lowest levels o f coverage o f current programs), the informally employed, and those who lost employment fkom either o fthese groups. 146. In this context, the government could consider extending C`non-contributory" programs. These could include workfare type o f programs and targeted conditional transfers (as proposed for the education sector). These programs have several beneficial features: (i) they provide an income stream that protects consumption o f the poorest segments during hardship, at least o f the basic goods; (ii)they offer protection irrespective o f work status (Le., coverage is not restricted to formal workers); and (iii) they prevent families fkom taking actions deleterious for their long term welfare (dis- investment ineducation and health). protectioninUruguay-could be adaptedto the new socialconditions. For example, 147. Housing, employment and food programs - the historical base of social food programs managedby INDAand PAE needto be better targetedto benefit the most vulnerable. On the other hand, programs like food assistance to poor children up to 4 years and their mothers (CAIF), full time schools (MECAEP) and young training programs (Projoven) are well targeted but their coverage is low. Government may consider up-scaling these programs. The family allowances program may need to consider targeting more the informal sector - recent efforts to extend family allowances to poor households irrespective o fwork statuspoint inthat direction. 148. To finance additional non-contributory programs and to increase the sustainability of Uruguay's PAYG system, the government could consider re- defining age" through changes in the retirement age, and perhaps even the 25These included: "Apoyo aInstitucionesPtiblicasy Privadas" -AIPP -,"Programa Nacionalde Complementacih Alimentaria" -PNCA-, "Centro deAtencidn alaInfanciay a laFamilia" CAIF, and - "Servicio de AsistenciaAlimentariaColectivizada"-SAAC- executedby INDA ("Instituto Nacionalde la Alimentacih"); (ii)SIAV; and(iii) "Asignaciones Familiares"(executed by BPS, "Banco de Previsih Social"). 49 gradual introduction of a mobile retiring age - to be adjusted with gains in longevity. By re-defining (raising) the threshold for access to "old age" andor making changes to the replacement rate -possibly defining new parameters for the ratio on the basis of years of actual contribution, the government may help to reduce fiscally costly assistance to BPS. This would also help to reduce intergenerational inequity - in 2002, 50% o f the population aged 0-18 years was under the poverty line, whereas only 5% of the populationaged 65 or morewas. 149. Extending by one year the effective retirement age would reduce financial assistance to BPS by 0.2 percentage points of GDP (Forteza, 2004). Raising the minimumage ofretirement would havea smaller impact becausethis requirementis non- binding for many workers. The minimum age for retirement would have to be increased to 63 (fiom the current 60) to lower BPS financial assistanceby 0.25% ofGDP. Whether it pursues this option or not, the government cannot afford to ignore the most obvious measure to make public pensions more affordable and thereby contribute to reduce the current regressive bias inthe pension regime - old pensions are paid out of general tax revenuethroughBPS assistance. 150. Much more important as a potential source of fiscal saving would be modifying the current pension indexation system -based on an average index for wages in the economy- to one for which the index is basedon the consumer price of a basket of goods, or a mixed basket of prices and wages. It is estimated that the change in indexation for a rule whereby the index is based on both wages and prices couldgenerate fiscal savings inthe order of0.4% ofGDP on average inthe mediumterm (Forteza, 2004). Were there to be socialand political consensus for this reform-indeed it would require a change to the Constitution- it could be introduced on a gradual basis, and could be linked to expandingthe non-contributory social security channel. The new system would be in line with the systems in several reforming OECD and emerging market countries and possessesthe virtue ofprotectingthe purchasingpower of pensions over the duration ofthe economic cycle. 151. Underany circumstance, the reductioninthe imbalancesofthe BPS requires a strengtheningof compliancewith the existing legalrequirementsfor contributory publicpensions. 50 CHAPTER IV: SUSTAINABLEGROWTH INVESTMENT - CLIMATE..PILLAR2 152. Policies and reforms under the second pillar are targeted at creating a favorable investment climate for physical and human capital accumulation; in particular to be able to grow in a sustained manner at high rates, Uruguay must increase its historically low level of investment (15% of GDP on average in the 1990s) to 20%. This is the mainchallengeto be addressedbythe policies andreforms o f pillar 2 o f the growth strategy. New investment is associated with incorporation o f new technology, which together with factor accumulation represent the basis for sustainable growth. An open trade environment, good access to foreign markets, a well-functioning competition fiamework, and efficient and cost-effective infiastructure provide an ideal framework for a favorable investment climate. An investment climate for the development o f human capital includes opportunities and incentives for families to invest intheir health and their skills. This inturn requires efficient and modern education and health systems that provide access onthe basiso fequality o fopportunity. 153, This chapter puts forward and evaluates policies and reforms for pillar 2 of the growth strategy. First, the focus is centered on the trade integration agenda. Trade policies play a crucial role in ensuring conditions for sustained growth by enabling improved access to external markets, increasingdomestic competition and incorporating technology. Second, options are examined for the development o f infrastructure services -crucial for both productive efficiency and welfare. The focus is on conditions for the development of a regulatory fiamework that promotes competition in the various infiastructure sub-sectors. Investment opportunities in a competitive environment for infrastructure services will enable an increase in global competitiveness and social welfare in Uruguay. Third, options are examined for strengthening the protection o f competition in general, including institutional aspects. Fourth, policy options are put forward for the development o f human capital in the areas o f health and education. Although in both health and education Uruguay has reached a relatively high level o f development compared with the region, there is still a large -and possibly growing- gap comparedwith more developed countries. The challengesare o fan institutional nature, in both health and education, and point to the need for a profound review o fthe regulatory fiamework inthe case o fhealth. 4.1 Trade policy and integrationz6 154. Uruguayhasgone a longway in terms of unilateraltrade liberalizationwhile MERCOSUR has contributedto deepen regionaltrade links. However, there is still significant scope for deepening integration both within MERCOSUR and through bilateral, regional and multilateraltrade initiatives. There is ample scopeto participate in 26BasedonNoques(2004). 51 the growing web of fiee trade agreements (FTA) to minimize adverse trade diversion effects of FTAs between other countries andlor regions. In the last 5 years, non- MERCOSUR developing countries -including Mexico, with which Uruguay has signed an FTA- have beenthe largest growth markets for Uruguayanexports. Trade integration with the rest of the world, either via MERCOSUR or through bilateral agreements, represents the principal channel through which Uruguay will be able to accelerate and sustain economic growth. The gains can be measured interms of greater market access for agricultural and agro-processed products, but also in terms o f better integrated and more stable policiesand regulations as well as modernizedinstitutions. 155. To reduceits exposure to regionalvolatility while improvingaccess to extra- regional markets for its products, Uruguay can benefit from deepening trade and economic links with the rest of the world. Trade and integration policies can help provide an impulseto growththroughat least four three channels: by reducingUruguay's vulnerability to regionalvolatility and fluctuationsinterms oftrade; by facilitating access to cost-effectiveand high quality and technology intermediateand capital goods; and by improving access to Uruguay's products in foreign markets - including those where access is currently limited by agricultural protectionism; and by generating competitive pressure inthe domestic market-competition is the principalincentive for efficiency and innovation. Recent tradepolicy a n ~ p ~ ~ o r ~ n c e 156. Growing trade flows until 1998 and the sharp decline thereafter can be traced back to trade policy, internationalprices and macroeconomic performance (Figure9). Trade policy includesthe unilateraltrade liberalizationofthe late 1980s and early 1990s, as well as the formation ofthe MERCOSUR following the 1991signing of the "Tratado de Asuncih" and the implementation of the intra-regional liberalization programby late 1994. In 1987, Uruguay's average tariff rate was 32% and unlike many other countries in Latin America, its import regime had few non-tariff barriers (NTBs). I t s unilateral reform policies implied that a few years later, the average tariff rate had declined drastically. Using the MERCOSUR average tariff structure as a proxy for that of Uruguay, shows that by 1993 the average rate with third countries had declined to 13%. 157. Import liberalizationmeasuresreducedthe pricesof intermediateinputsand capital goods, thereby contributing to productivity and GDP growth. Exports of tradable services, particularly tourism, grew rapidly and the balance of trade in services was insurplus. Tourism exports rose fiom US$238 million in 1990to US$827 millionin 1997 (when it represented 60% o f all services exports). In the late 1990s, services representedover 30%ofUruguay's total exports. 52 Figure9 Tradeflows - 1 5,000 600 4,500 500 4,000 400 3,500 300 3,000 200 2,500 100 2,000 0 1,500 -1O( 1,000 -20( i 500 -30( ~ 1 fhternalbalanceongoodsandservices(currentUS$MM)left - i l - -&ports of goods and services (current US$MM) lnports of goods and services (currentUS$MM) Source: Nogues (2004). 158. After 1998, the macroeconomic picture of the region deteriorated, initially at a slow pace and then more rapidly following the devaluations of Brazil's Real in early 1999, and Argentina's Peso in early 2002. Such devaluations were related to fiscal difficulties, problemswith competitiveness, and the dramatic decline incapital inflowsto Latin America from around 3% of regional GDP in 1998 to around 0.5% in 2002. Regionalcrises had a severe impact onexportsbyUruguay. 159. destinations - the share of exports to MERCOSUR dropped from 55% of total Exports to MERCOSUR countries declined more rapidly than to other exports in 1998 to an estimated 24% in 2004. A complicating factor has been the introductionof an important number of non-tariff barriers (NTBs) within MERCOSUR, For example, Argentina initiated on average 18 anti-dumping investigations every year over 1995-2001. Also, over 1995-2000 Uruguay initiated 50 dispute resolution consultations. Most often they correspondto agriculturaland agro- industry productsfor which the index o f trade complementarity of Uruguay with Argentina and Brazil is usually high indicating comparative advantage on the side o f Uruguay27. The average MERCOSURtariff rose fiom 11%in 1995 to 14%in2000. 160. at a faster pace than exports to developed countries. The pattem of Uruguay's - Uruguay's exports to developingcountries outside MERCOSUR have grown mostly agricultural exports growing faster to developing countries is consistent with - patterns of agricultural protectionism in industrial countries. Uruguay has a strong comparative advantage inagricultural and agro-industrial products - meat, cereals, dairy ''Vaillantetal. (2001). 53 products, and fish. Among exports ffom the non-agricultural chapters, the most important ones (in2000) were textiles andclothing, skis, fbrs andtheir articles, 161. Existing simulations for Uruguay show favorable impact effects of liberalizing world trade in agriculture. These effects depend crucially on which scenario o f world trade liberalization is simulated. Recent simulations o f the liberalization o f agricultural trade (NoguCs, 2004) show that under the various liberalization scenarios, all Uruguay's export goods would benefit. Increases are larger under the multilateral and US proposals. At an international level the greatest price hikes would be experienced by dairy products -of importance for Uruguay- mainly because they can count on highprotection in industrial countries. The international price o f beef, which accounts for around 50% o fUruguayan agricultural exports, is simulated to rise 8.5% (under the US proposal), and by 3.2% on the basis o f the European Union proposal. Uruguay's agricultural exports are estimated to increase 14.5% under the US proposal; the categoriesaccounting for the bulk o fthis improvement would be beef, rice, dairy products, sheep meat and citrus fruits. 162. The benefits for Uruguay of a liberalization of world agricultural trade would be more significant than those registered by the simulation analysis carried out. Simulation results do not take into account the impact that new investment in response to the new opportunities opened up for commerce could have on trade -for example, opportunities to exploit economies o f scale and scope and increased productivity as a result o f the adoption o f new technologies. The inclusion o f dynamic effects in simulation models can improve the positive static effects o ftrade liberalization by a factor that ranges between2 and4.28 Strategicpolicy options 163. The decisions that Uruguaywill take in relation to its trade and integration strategy growthwill be a key factor for the flow of investmentsin coming decades; investments in turn will have a strong impact on the development of trade trends. The following strategic considerations are relevant: 164. A significantDoha Roundwould reduce the need for regionaland bilateral agreements; importanttrade diversioneffects could be avoided. There is a growing sentiment among efficient agricultural producers (G-20) that no agreement would be better than an unbalanced agreement. In matters o f agricultural trade, the interests o f Uruguay are consistent with those o f other efficient agricultural producers and, in fbture Doha Rounds, Uruguay may want to consider joining with them to strengthenthe lobby for more liberal trade inagricultural products. 165. A FTAwith the US - and by extension FTAA could bringsignificant gains - to Uruguay, not only through better market access for its agricultural and agro- processedproducts, but also, and perhaps more importantly becauseof its eventual impacton investment,incentivesto modernizationand increasedstabilityof policies 28WorldBank(2001). 54 and regulations. An FTAwiththe EUcould bringsimilar benefits.There have beenon- going discussions about possible FTAs between MERCOSURand the USA and between MERCOSUR andthe EU. While export subsidies and domestic assistance by the United States remaina barrier for the FTAA, interms of impact on MERCOSUR's exports, the costs of these policies remain a ftaction of the potential benefits of improved market access. A deep analysis of costs and benefits of this as well as the other potential agreements deserves carehl attention by policy-makers. It is importantto notethat most Latin American countries are supporting the FTAA - as evidenced by an increasing number of regionalFTAs with the U S including Mexico, Chile, Guatemala, El Salvador, Honduras, Nicaragua, Costa Rica, Panama, Colombia, Ecuador and Peru. One characteristic of these FTAs is the high degree of market access which will result eventually infieer intra-regionaltrade inagriculturalproducts. 166. MERCOSUR's relative slowness to advance with regional integration agreements is harmingefficientagriculturalproducersdue to trade diversioneffects producedby recentand forthcomingtrade agreements. Inglobaltrade, MERCOSUR has seen its share ofworld's global exportsdecline ftom 2.3% to 1.5% between1985 and 2001 respectively. To take advantage of this growing web o f regional FTAs Uruguay may consider deepening MERCOSUR internal links and simultaneouslyplay an active role inpromotingnew FTAs betweenMERCOSURand other countries or regions. 167. One approach to deepen MERCOSUR's trade links is to lower the common externaltariff (CET), develop broader commercialpolicy objectives and accelerate the signing of trade agreements with other countries with lower or less binding trade restrictions. Uruguay has obtained an exemption ftom the CET for imports of capital goods; this is of great importance for investment and growth. Just recently announcements have been made o f FTAs with Peru and other Andean countries. More agreements with developing countries are needed and the ongoing efforts to cement closer ties with China, India and other developing countries with low comparative advantage intemperate agriculture, could become promising negotiations. MERCOSUR could also consider strengthening internal trade links beyond the CET. This could encompass, for example, adopting common health and sanitary standards, developing common safeguards, advancing mutual recognition agreements, and adopting common rules on subsidies, countervailingregulationsand dumping. 168. In parallel, Uruguay could consider, within the context of its MERCOSUR commitments, negotiationswith other countries or regionsthat it considers holdthe potentialfor the greatest trade gains. Additional trade agreements like the one signed with Mexico recently could boost the exports of goods where Uruguay has a clear comparative advantage. Uruguay also faces the concern that the FTAs that the U S has recently signed with CentralAmerica as well as its upcomingagreement with the Andean Community are harming its exports inthe region, An FTA with the UnitedStates or the FTAA would halt and couldpotentially reverse suchtrade deviationeffects. 169. The highly complex nature of the negotiations agenda points to the importance of institutional development. It would help, for example, to strengthen 55 communicationsamong public bodies and links with the private sector, as well as to gain a better understandingof the economic costs and benefits of the FTAs, as regards both their trade aspects and those that are not strictly trade-related(rules oforigin, healthand phytosanitarystandards, copyright laws). Formulationof a development and integration strategy with clear political support, together with these institutional developments, will contributeto enhance the capacity and qualityofthe country's trade negotiationswiththe rest ofthe world. 4.2. Fosteringefficiency throughcompetitionininfrastructurez9 170. Uruguay's infrastructure development is a critical element of the growth strategy. By reducingtransport and communicationscosts, infrastructure development contributes to integration with world markets, thereby enhancing Uruguay's growth potential. Competitively priced energy improves the expected return on private investment in general. Regional integration of transport networks is critical for potentiallypositioningUruguayas atransporthubwithin mRCOSUR, while integration of regional energy networks will enable diversification of the supply risk. Universal access to basic infrastructure services at competitive prices will contribute to improving the competitivenessofcompanies, as well as overallwelfare and incomedistribution. 171. Internationalexperiencesuggeststhat market mechanismsare conducive for the development of modern and efficient transport, energy and telecommunication systems. In Uruguay the private sector is playing an increasingly important role in the modernization o f transport, gas and telecommunications networks. Private sector participation(PSP) in infrastructure has been shown ingeneral to contribute to increase cost-efficiency. However, experience and research show that effective competition must accompany PSP to ensure that increased efficiency is transferred to users -both companies and consumers. 172. Uruguay ranks well in the region in terms of infrastructure development. While coverage is high, a gap may surface increasingly in terms of quality, delivery standards and prices as technological change and the sophistication of demand continue to increase. Competition is thus called to play an important role in increasing efficiency in Uruguay; this is not only because of efficiency and welfare considerations, but also because ofthe fiscal constraintsofthe state inthe mediumterm. Statusof infrastructure in Uruguay 173. Uruguay's infrastructure services are noted for their high levels o f coverage, access and quality, especially inthe provision of basic services. Be it telephone or road density, or energy, water and sanitation coverage, Uruguay ranks above its regional neighbors (Table 13). The main concerns in terms of access are in sanitation through connection o the public sewerage system, where coverage averages 52% (82% in Montevideo). There are also some problemswith access inthe naturalgas market, mainly 29Basedon Chisari and Larnbardi(2004). 56 due to the small size of the distribution network. In the case of more sophisticated services, the penetration is much lower, although it has risen fast insome areas in recent years. Table 13 Access to Public Servicesin2002 ("hof total population) - Sanitation* Improved water Electricity Country ("hof source (YOof (YOof mainlines (per Roads per Kms Of Paved roads GDP per capita, population populationwith population Per PPP(current with access) access) with access)1,000 people) `Oo0 eo le worker** international US$) Argentina 85.0 79.0 90.0 175.9 6.1 5.8 11,703 Brazil 77.0 87.0 90.0 111.6 10.8 2.4 6,869 Chile 97.0 94.0 98.0 164.4 5.5 2.3 8,163 Mexico 73.0 86.0 95.0 99.9 3.3 2.9 7,839 Uruguay 99.0 98.0 100.0 223.7 2.7 5.5 8,486 174. Quality has improved in the last decade in most of the infrastructureareas, as well as the commercial services to users, particularly in the electricity and telecommunications markets. Potential or actual competition may have operated as a trigger to improve the productive and the commercial side o f some public enterprises like UTE (electricity) and ANTEL (telecommunications). Progresshas beenmuch slower in water and sanitation. Users are generally satisfied with infrastructure services, although the perception is that tariffs could be lower. 175. Although internationalcomparisonsare difficult-both becausethe exchange rate has been very volatile and becausethe government sets high publictariffs as a revenue source in some sectors prices are relatively high; and the efficiency of - some companies is notablylowerthan that ofother countries inthe region. There are large differences between infiastructure sectors and public services in matters o f efficiency, quality o f service and prices. Until 2001, prior to the steep devaluation in 2002, energy prices were relatively highcomparedwith levels observed incountries both within and outside the region (Figure 10). International comparisons have become more difficult since the devaluation o f the currency. Electricity rates for industrial and commercial establishments are among the lowest in Latin America. On the other hand, transmission and distribution losses are higher than those for other countries in the region, except Brazil and Colombia. In the area of water supply and sanitation services, the relatively high number o f OSE employees indicates a relatively high source o f inefficiency (Figure 11). Similarly, the relatively high price o f oil products in Uruguay suggests that ANCAP is less efficient than potential external suppliers (Table 14). 176. Transport infrastructure is an exception to this general rule, as it records high levels of efficiency and service quality, The primary highway network is in a 57 better statethanthat o fany other country inthe region, largely due to policies that assign priority to maintenance. Port services have improved considerably as a result o f the reforms carried out in 1992, with a consequent 160% increase in container traffic since 1993. The cost of container movement is comparable to that o f other ports operating as concessions in Latin America, and only slightly higher than the average for Southeast Asia. Rail services have also improved as a result o f reforms to the sector, although freight volumes are low and the sector has a long way to go to be able to provide a competitive service. 177. The increasingefficiency oftransportservicesin Uruguay, particularly roads and ports, is directly related to the reform of the sector, and provides a good example ofwhat could be done in other sectors of infrastructureand publicservices if a similar approach were to be adopted. The purpose o fthe reform o fthe transport sector was to modernize and improve the provision o f services, increase investment and take advantage o f new sources o f financing. It placed the formation o f policy, planning and supervision o fregulations firmly inthe hands o fthe government, at the same time as it encouraged the participation of the private sector and public-private consortia in operations and the provision o f services. Although the Transport Ministry did not abandon all its operating activities, these are now secondary to its policy and regulatory role. The reformed institutional framework has turned out to be a very effective way o f reinforcing efficiency and improvingthe competitive position o fUruguay intransport. 178. There is still ample scope for increased private sector participation in infrastructure services; participation by the private sector in Uruguay is much lower than in other comparable countries. For example, private investment in infrastructure was on averageequivalent to 0.5% o fGDP between 1990 and 2003 (Figure 12), compared with investment of 1-3% in a number o f comparable countries. Most o f this investment took place in the context o f concessions or "green field" projects. Although the population appears satisfied with the current arrangements, it will be important for competition and private sector participation to continue to form part o fthe debate on public policy. Greater competition in inti-astructure services will create incentives for investment and the adoption o f more efficient methods o f production, as well as the transfer o fsuch gains into lower prices, 179. The government has been gradually introducingcompetitionand improving regulation in some sectors of infrastructure; however, key sectors are still dominated by vertically-integrated public companies. In Uruguay, the sectors in which increased competition could take place include electricity sector, where the state company UTE ("Administracibn Nacional de Usinas y Transmisiones Eldctricas") controls transmission, distribution and is the sole player in generation; the petroleum sector where the public company ANCAP ("Administracibn Nacional de Combustibles, Alcohol y Portland") controls the distillery, storage and importing infi-astructure; and telecommunications where the public company ANTEL ("Administracicin Nacional de Telecomunicaciones") controls the fvred lines. 180. Cellular and international long distance services have been opened to competition. Private sector participation has been strong in the unregulated gas sector 58 and, as indicated, it has been rising significantly in highway maintenance, ports and airports. Inthe rail sector, althoughthe Ministry o fTransport owns the networks and its usage is open to any operator since June 2002, the sector does not have clear rules to ensure competition -which explains the lack of effective private sector participation in the sectorto date. Figure 10 Internationalcomparison of electricity prices, 2001 - Grenada Barbados Grenada Denmark Barbados Surinam Denmark Jamaica Surinam Netherlands Jamaica Urutuba uay Netherlands Gel"y Uru8 ay b a Panama Germany Panama Portugal Portuga1 Njcaragua Nicaragua Switzerland Spain Saitzerland Spain UK UK Peru Peru Ireland Ireland ominican Rep, )ommicanRep United States United States Chile Arturkey Chile entina Ar entina El Salvador +urkey ElSalvador Poland Poland Guatemala Guatemala Finland Finland Honduras Honduras Mexico Mexico Taiwan Taiwan Norway Nonvaq SouthGreece Korea SouthGreece Korea Hun ary Huni ani a i i i Bo1iv1a Biti Boli%ia Costa Rica Costa k c a Colombia Colombia Slovakia Slovakia Paraguay Paraguay C 2 8 T cZe:;;h"t;ae"P" NewZealand NewZealand Ecuador South Africa Ecuador SouthAfrica kin.& Tobago TrinKazakhstan &Tobago Kazakhstan 0 0.05 0.1 0.15 0.2 0.2s 0 0.05 0.1 0.15 0.2 0.25 u%sI kWh u$sI kWh Source: ChisariandLambardi(2004). 59 Table 14 Ex-refinery Prices(November 2004) - Product EstimatedImport Parity ANCAP Ex-refinery price Difference price (USWm3) (USUm3) Gasoline95 425 495 16% Diesel 465 486 5YO Kerosene 457 539 18% Fuel oil 282 213 -24% LPG(US$/tn) 634 506 -20% Figure 11 Public Enterprise Efficiency - (number of employeesper thousand water connections) Source: Uruguayanauthorities. Figure 12 Private Investment inInfrastructure - Average private investmentas a percentage of GDP 1990-2003 3.0% 2.0% 1.O% 0.0% Argentina Chile hdonesia &xico Wru Thailand Country Source: World Bank(2004), 60 181. The government has created multisector regulators, URSEA for water and sanitation, power, natural gas and petroleum products and URSEC for communications. Although these bodies have acertaindegree of autonomy, some of the more important functions are restricted. Inadditionto the lack o ffinancial autonomy, the agencies have the capacity only to recommend tariff changes while the ultimate say on tariffs remains with the Executive - an authority established in the Uruguayan Constitution. 182. Severalfactors have held back against private investment in infrastructure. These include: an unstable macroeconomic environment, a political process which generates multiple veto pointswhich has ledto blockingimportant PSPreforms approved by Congress, and the relatively small sue of the market with respect to efficient scales (althoughhorizontaland vertical separationof dominant public operatorsand technology can sometimes offset this). 183. There are multiple factors that depend on the government, and which help explainlimitedPSP in key infrastructuresectors. The presence ofthe public sector in all vertical components of the supply chain, as well as in regulation, and tariff setting ultimately decided by the Executive branch discourages private operators. Non- competitive practices and barriers to entry could stem from distortions due to cross subsidizationas well as biased price and quality standards aimed at favoring competitive advantages of public sector enterprises. For example, rules of dispatch of generators could favor UTE, and contracts ofANTEL with public enterprisescould preemptprivate competition. Some prices and contracts in the telecommunications sector are still not transparent and could work as a barrier to new operators. Autonomy of regulatory agencies is limited due to, among other factors, scarce resources (particularly staff.) One example of this is telecommunications where the regulatory agency URSEC is highly dependent ofthe advisoryassistanceofANTEL ontechnicalissues. Infrastructure efficiency and competition Cross-cuttingissues andpolicy - options 184, The verticalseparationofstate assetsmay helpto promotecompetition. This is the case for the vertical separation between electricity generation, transmission and distribution by UTEthat could contributeto entry by private generators. Similarly, while cellular competition is clearly underway, the (accounting and financial) separation of ANCEL accounts from ANTEL may help to hrther strengthencellular competition and eliminate the presumption o f discriminatory pricing by ANTEL to its current cellular division. Inaddition, contracts betweenANTEL and other public sector entities could be opened to biddingwith the participationo fprivatesector suppliers. 185. Some important reforms and regulatory frameworks have not been completed yet. In general, an effective way to improve efficiency consists in clearly differentiatingthe three independent roles ofpolicy definition, regulationand operations. In the case of gas distribution and ports, initial concessions have allowed PSP, but regulatory rules are still determined by previous concession contracts or general 61 practices, more than by specific laws and regulations. Contract incompleteness is a source o fcostly renegotiation. The regulatory framework ingas is neededto ensure fair competition in the future expansion o f the gas network, the development o f regional interconnections, and a well functioning market for medium and long term gas supply contracts. Inthe case o f ports, Uruguay has steadily moved away from a model inwhich ANP is both owner andoperator, tendingtoward a leasingmodel under which ANP owns the basic port infrastructure (piers, docks and storage areas), and the private concession- holders build superstructurefacilities such as office buildings, provide equipment such as cranes, and operatethe port installations. 186. URSEA andURSEC havealreadydeveloped a reputationoftransparency by placing all major proposals, decrees and regulations under public consultation. Publication and broader dissemination o f performance and comparative efficiency . indicators o f public firms would make the management and boards o f these firms more accountable, thereby contributing to efficiency. Increased transparency on the cost o f access to networks - interconnection fees for telephone services, energy transmission prices, railway tolls -would pavethe way for greater and more fair competition. 187. One aspect of the reform process that needs to be sufficiently addressed is universal service. Reduced public sector involvement in infrastructure provision requires rethinkingsocial aid. While insome cases universal service obligations may not be required (cellular phones) in others they may need to be explicitly incorporated (access to water and energy). Ifonly public enterprises face universal service obligations and grant subsidies to the poor, they will not be able to compete on a level playing field. Insome cases, adoption o fa social tariff possibly backed by a state subsidy - may be - desirable. In others, concessionaires may be able to absorb the cost o f universal service obligations in exchange for other benefits. In general a clear separation o f social obligations from the core businesscanhelp strengthencompetition and efficiency, 188. Limited autonomy of regulatory bodies in charge of defending competition and vaguely defined competencies to address competitionand consumer protection issues especially where legalmonopoliesexist (railways, airports, ports, energy) - - can constitute a major barrier for competitionand private entry. Inthis context, a strong competition agency could play an important role, e.g., preventing "capture" o fthe regulator by politically strong and financially dominant state-owned incumbent firms. 189. Inefficienciesin state-owned firms are sometimes ascribed to differences in the legal framework for public and private companies, e.g., labor practices, taxes, procurementandcontracting.Placingpublic firms under commercial law may improve incentives to perform. However, this would not be a risk-free path as long as regulatory and supervisory agencies lack the capacity to monitor, evaluate and sanction such firms. While application o f commercial law and PSP may in some cases be desirable over the medium- and long-term, over the short term a more realistic and potentially more effective approach may be to ensure the enforcement o f basic rules already applicable under public law. For example, existing criteria to appoint boards of directors ofpublic firms basedontechnical capability are not ingeneral followed inUruguay. Similarly, the 62 mechanisms to ensure accountability o f directors in public firms are rarely applied. A clearer separation o f the board from the day-to-day management and explicit prohibition of board membersto be involved inpolitics would also help. This would represent a step prior to the possibleplacing o fpublic companieswithin the orbit o fcommercial law. Issues and strategic options in selected infrastructure sub-sectors I.Power 190. In mid-1990, Uruguay launched a reform program aimed at increasing the efficiency of the sector by means of the verticaldivisionof the industry(generation, transmission and distribution) and the horizontal separation of generation, to promote competition and PSP. It also adopted a regulatory fiamework that was to allow the transfer o f the expected benefits to customers by means o f lower prices. The authorities have promotedthe entry o fprivate investors into electricity generation, calling for tenders for the construction o f a new combined cycle thermal power station (TCC). As no bids were received, the construction and operation o f this power station was awarded to UTE -the state electricity monopoly. Generation therefore continues to belong to the state (UTE and the Salto Grande Hydroelectric Power Station), Depending on weather conditions affecting hydro generation, imports from Argentina can become substantial (Table 15). UTE is responsible for high-tension transmission and operates a single distribution company that administers the network maintenanceactivities, as well as the sale o f electricity. Dispatch is in the process o f being decentralized by the ElectricityMarket Administrator (ADME),an independentoperator. 191, Important actions could encourage vertical separation in the industry and horizontalseparation in generation. The first stepto increasecompetition could bethe effective operation o fthe ADME and the formulation o f detailed dispatch rules to avoid discrimination against potential entrants. Another measure that could be considered is to enable large users to purchase energy directly on the Argentine wholesale market; this would be a significant step and an efTective test o f access to the UTE transmission system. Inaddition, ifthe new TCC generating plant that is planned were to be built and operated by a public company not linked to UTE, this would encourage competition and better preparethe ground for increasedPSP inthe electricity sector. 192. Uruguay faces the challengeofenergy scarcity, diversifyingavailablesources and developinga cost-effective strategy. The country is highly dependent on hydraulic factors (the weather). Supply fiom Argentina is also volatile and uncertain (because of the regulatory uncertainty in that country). A solution to these multiple constraints will need to recognize costs o f diversification o f sources (including possibly more costly inter-connection with Brazil)to minimize risk and to promote competition. The reaching o f long-term agreementsto expand interconnection with Argentina and Brazil is a policy option deserving serious consideration, Nevertheless, if regular gas supply fiom Argentina were to be restored, the best economic option would be to expand electricity generation locally using natural gas, keeping oil as a second option in emergencies caused bya shortage o fnaturalgas. 63 Table 15 Uruguay: Generatedand ExchangedEnergy (GWh), 1997and2002 - Type 1997 2002 Hydroelectric (I) 6213 7108 Thermal 602 26 Own production 6815 7134 Argentina 43 559 Brazil -18 0 Net exchange(purchases less sales) 25 559 Total supply ofelectricalenergy 6840 7693 (1): Includesthe Salto Grandedam. Source: UTE. 193, Final prices of energy imported by Uruguay have been particulariy low and this does not seem to be a long-term sustainable situation. The analysis of future prices of electricity and gas imports is crucial to the cost-benefit analysis of the new thermal combined-cycle plant andlor private generators. This analysis would also be relevant for future public andprivate investment. Also, there is a needto internalizetrue risks ofnaturalgas supply fiomArgentina. 194. The fact that UTE is the legal public monopoly in transmission and distribution, and the sole playerin domesticgeneration does not in principleprevent URSEA from applying regulations to improve the efficiency of the company. This could be done for example through yardstick competition andlor price-cap regulation with an X-efficiency factor to allow for productivity gains. The price cap would be applied inthis case on a notional tariff since the effectivetariff is set by the Ministry of Economy basedon fiscal objectives. The efficiency gains which are not captured by the state couldthen be passedonto frms and consumers. 195. Inadditionto regulatory and institutionalchanges, the government couldconsider measures to increase energy efficiency and reduce losses. Electricity consumptioncould be substantially reduced by encouraging greater energy efficiency. For example, the possibility should be analyzed of introducing incentives for the purchase and installation of energy efficient appliances, and adapting the regulatory fiamework to encourage efficient energy consumption. The potentialgain exceeds the annual increase foreseen in the demand for electricity. Increased energy efficiency could cut energy imports and the need to invest in additional supply. As a result o f the economic crisis, electricity losses have increased significantly in Uruguay. One way to reduce such losses would be to further improvethe distribution installationsand enforce legalconnections.This measure would be especially effective if it is combined with measures to encourage the efficient use ofenergy. 64 2. Hydrocarbons 196. The import of crude oil and refined products, the refiningof crude, and the transport, storage and sale of oil derivativesare an ANCAP monopoly. The price of delivery at refinery is significantly higher than the import parity for most oil derivatives. This provides protection to ANCAP but weakens competitiveness of the economy as a whole. The payment of subsidies on liquid gas places natural gas at a competitive disadvantage. The tax structure o f gasoline, diesel and fuel oil distorts the market and generates an increased consumption of diesel oil. As a result unnecessary refining costs are incurredto meet the demandfor diesel. 197, Policy options include: (i) reducing price distortions generated by discriminatory taxes; (ii)increasing the efficiency of ANCAP; and (iii)increasing the use of naturalgas. Import price parity for oil derivativeswould encourage ANCAP to improve its efficiency andwould leadto lower prices for gasoline, diesel andkerosene. The efficiency o f ANCAP could improve with the vertical separation o f its different businesses and the applicationofregulator accounting. This could be complemented by open access to port and storage facilities3'and the sale o f loss-making businesses. The market for industrial and residential gas would also benefit from the elimination of subsidies on fuel oil and liquid gas. 3. Tollroads 198. Highwaytransportis the preferredmodeof freightand passengermovement in Uruguay. The highway network is one of the densest in Latin America, with a coverage comparable to that of other middle-income countries, but low in comparison to that of high-income countries. In 1993, 86% ofthe highway links with Argentina and Brazil -critical for regional integration- were inan average, good or very good state of conservation. As regards maintenance, only 3% o f internationalcorridors and 7% ofall pavedroadsare ina poor state. Secondary and ruralnetworkshave suffered the greatest deterioration. 199. A significant success of the highway sector reform has been ensuring that user tolls are usedto finance highway maintenance and investment. Participationby the private sector has contributed to achieve this objective. Nevertheless, the private sector does not representyet a significant source of investment inthe sector. 200. Under the Megaconce~sion~~,highway maintenance and expansion is financed jointly out of toll income and general revenues. The rest of the network (secondary and rural roads) remainswithin the orbit of the Ministry of Transport's National Highway Bureau (DNV). To improve the concession framework, the government couldconsider various options: 30A 2004 referendumrejectingthe associationofANCAP with privatefirms also precludedopen accessto fyrt andstoragefacilities belongingto that company. A country-wideroadconstructionandroadand infiastructuremaintenanceconcessionawardedto astate- owned company that operates under private law. 65 1. Evaluating and incorporating into the budget contingent fiscal liabilities fiom minimumrevenuethresholdsto concessionaires. ii.Minimizingthe"cost-plus" issuestemmingfromthecomplementarysubsidyunder the Megaconcession(by eliminating the incentive to reduce costs) by conditioning the subsidy to specific cost andtechnical efficiency targets. iii.To hrtherencouragePSP, leavingoutDNVfromtheallocationofsubcontracts for construction, maintenance, and operationunder the Megaconcession. Effiency and competitionin infra~tructure-Evaluation of the impact on welfare using a c o ~ u t ~ bgeneral e~uilibrjummodel l e 201. Simulations on the basisof a computablegeneralequilibrium model make it possible to demonstrate how potential efficiency gains in infrastructure sectors could be translated into faster growth and greater welfare (Table 16). Specifically, the simulations show how, in a scenario in which efficiency gains o f 25percent are assumed and 40% of the efficiency gains are transferred to prices -from the effect o f a competitive fiamework, - GDP could increase by 2% and overall welfare by 1.7% o f GDP (last column o f Table 16). The stronger the transfers o fefficiency improvements to prices, that is to say, the stronger the competition, the greater the gains. Table 16 Simulationsofthe computablegeneralequilibriummodel - Gainsinefficiency -25% Unemployment (reference level 16%) 15.00 19.40 17.70 Total welfare percentage of GDP 3.23 0.71 1.67 Note: Household and government welfare is measured in terms o f Equivalent Variation. The change inGDP is measuredin 1997dollars. Source: Chisari andLambardi (2004). 202. Even if public companies dismiss workers, under full price flexibility the dynamic effect on employment of efficiency gains (from increased competitiveness) could lead to a reduction in unemployment (second column of Table 16). Under a 66 competition regime lower demand for labor in basic services sectors, given the greater labor productivity, is compensated for by an additional demand in the rest o f the economy stemming fiom productivity gains and lower infiastructure prices. This demonstrates why competitiveness policies can be essential to improve employment prospects. 203. The industries that could most clearly benefit from improvements in the competitiveness in infrastructure sectors are very significant for Uruguayan exports. Although all economic sectors benefit from efficiency gains, sectors such as "Food Production". "Cellulose and Wood", and "Metal Products and Minerals" in particular stand to gain. All these sectors account for a significant share o f Uruguayan exports. As they are sectors that make an intensive use o fpublic services, they obtain the greatest reduction in spending on inputs, and as a result obtain the largest gains in their rateso freturn. 4.3 Competitionpolicy 204. Competitionbetween companiesprovidesincentivesfor achieving productive efficiency and for passing on efficiency gains to consumers and users in general. Competition policy as such has never been given a significant place on Uruguay's political and economic agenda, and untilrecently there was no legislation on the matter. Inpart, this could be the result o f a history of strong state intervention, and inpart to a lack o f a competitiveness culture. This situation appears to have begun to change as a result o f Uruguay's joining the World Trade Organization, as well as o f obligations arisingfrom its status as a member country ofMERCOSUR. 205. The first legislation on competition was passed in 2000. Under the law "all companies o f whatever legal form performing economic activities must comply with rules on competition, without affecting any limitation that might be established by law and for reasons o f interest or which arise fromthe nature as a public utility o fthe activity inquestion." Inaddition, the law specifies: "When market distortions were to cause any significant harmto the general economic interest, all accords and practices establishedby economic agents shail be forbidden, as well as the decisions taken by business associations, and any abuse o f a dominant position by one or more economic agents that results in a restriction, impediment or distortion o f competition and fi-eedom o faccess to the market for the production, processing, distribution and sale o fgoods." The Executive appointed the General Bureau o f Trade (DGC) as the body responsible for the implementationo fthese regulations. Co~etitionpolicies in small economies 206. A minimum efficient production scale in small economies usually implies higherconcentrationlevels - and an increasedpresenceof monopoliesor oligopolies- in most of its industries. The fact that there is less room for efficient-scale producers could impose an additional barrier to entry, leading some companies to produce at sub- 67 optimal levels. As stated by Gal (20011, the competition policies in small economies should be understood as a means for promoting economic efficiency o fparticipants inthe market -at the same time as allowing consumers to receive the benefits o f such improvement. 207. In small economies competition policy needs to be based on rules and assumptionswhich, appliedon a case-by-case basis (followingthe "rule of reason"), assign to efficiency considerations a central place. Competition laws in small economies should be very cautious when including per se rules such as those usually present in legislation in larger economies - e,g., limits on concentration ratios, structure regulation and, more specifically, merger and acquisition control. A high degree o f flexibility is needed as far as implementation is concerned, with the focus on a case-by- case approach. 208. There are significant obstacles to the application of a "case by case" rule. In the first place, it requires a compromise between flexibility (required for individual treatment or case by case) andthe discretion with which such flexibility can be used. The risk is the potential unpredictability, as well as the opportunism, particularly inthe case o f influential interest groups. Second, applying a "case by case" competition policy can require fairly intensive use o f highly-qualified human resources. Third, lack o f competition culture may imply that agents do not understand how some conducts and decisions are in opposition to the competition policy's objectives. To minimize the problem o f absence of a competition culture, the authorities can play an active part in so- called "competition advocacy". This entails communicating the most significant decisions on competition protection to the public with the rationale being stated as clearly as possible, clearly identifyingthe resulting potential winners and losers. Strategicpolicy options 209. The general objective of completion law could be restated. The government could consider including inthe legislation an article expressly stating that the purposeo f Uruguay's competition policy is to protect competition in order to promote efficient market performance and benefit consumers. 210. Legislationcould more clearlyspecify the subjects bound by the competition law. So far, only companies which may have legally become a monopoly would not be bound by the competition rules. However, even in these cases, the scope o f the exemption is unclear. The state in Uruguay often performs simultaneously, through its agencies and institutions, a dual role o f market agent and regulator. Although such distinction is generally subtle, the competition regulations could be made applicable whenever it may be determined that the state is not exercising any regulating powers but acting as a supplier or buyer. 211. The government could consider strengtheningthe institutionalframework. The competition authority could be made more independent fiom political pressuresand 68 financially autonomous; the latter would facilitate recruiting, training and retaining skilled staff. Specific options for institutional development include: i) Legislationcouldspecifyproceduresrequiredfordecisionmaking. ii)Thecompetitionregulatorcouldbemadethelastadministrativeauthorityinthat field so that its decisions are not reviewed by politicalauthorities. iii)Consideration could be given to the creation of a permanent judicial court specializing in competition protection issues or, alternatively, an intermediate appeal mechanismcomposedo fan ad hocjury, e.g., composedo f a federaljudge and independent specialists, 212. The agency in charge of defense of competition could coordinate and complement its activities with existing infrastructure regulators. Its greater independence and financial autonomy may allow it to perform different functions than those agencies. Inthe case o fpublic infiastructure monopolies, and in coordination with existing regulators, it could for example promote yardstick competition and develop benchmarks o f efficient enterprises. This could entail comparative cost studies and evaluate the scope for international competition. Inthose sectors inwhich competition is open, the competition agency could play a role in evaluating barriers to PSP imposed by pub1ic monopolies, 4.4 Human capitaldevelopment and equity-Health and education32 213. Sustained growth requires opportunities and incentives for individuals to invest in human capital. Government policies and direct interventions ineducation and health can help households build, maintain and protect their human capital investment thereby contributing simultaneously to human capital development and equity. Equity in access to quality health and education is a key dimension o f equality o f opportunity; and as more people get access to higher education and better health, prospects for human capital and growth improve too. a) Health 214. Uruguaydedicatesa generous portionofits incometo health. At 11% ofGDP (including the private and public sector) Uruguay's health expenditure is greater than Argentina, Chile, Ecuador, Venezuela, Mexico, Brazil and Costa Rica. The government covers about 46% o f this expenditure, either directly or through subsidies. The total amount Uruguay spends in health is in fact more typical o f mid-range OECD countries than the average LatinAmerican country (Figure 13). The main obstacleto growth posed by current health policies and institutions lies inthe potentially unsustainable investment inthe health insuranceandcare-delivery system. 32 BasedonPackard(2004) and contributionofthe HumanDevelopmentTeam ofthe World Bank. 69 215. Uruguay's health system offers some of the best coverage and health- outcomeindicatorsin the region and among middleincomecountries. Uruguayhas the lowest infant mortality and maternal mortality rates in Latin America. Uruguayans outlive most oftheir neighbors, which, addedto a long history o f low fecundity, andthe strong emigrationby young people, has resultedinthe highest ratio ofelderlyto working age population inthe region. Figure 13 Nationalexpenditure inhealth -Selected countries - $.G o.m ".n. t expenditureon healthas %oftotal expenditure Source: Packard(2004). 216. Health care coverage is almost universal, and the private sector is an important partner in providing both financial protection and medica1 care. The private health insurance and care providers, the IAMCs, are mostly owned and managed by physicians and cover the population by direct enrollment or as collective members through the BPS. Overall, the IAMCs cover around 46% of the population (INE 2003), especially homes with medium and high income levels. The Ministry o f Health (MSP) along with other public institutions ("Hospital de Clinicas" and municipalities) cover about 41% of the population, principally the poor. Together with the healthcaresystem for the armed forces and the police, cover is providedby the public sector to around 51% of the population (INE 2003). Around 3% of the population is attended to by other providers. 70 217. The country hasachievedsignificant improvementsin the performanceof its healthservices in recentyears. Boththe Ministry ofHealthand the National Resources Fund (FNR) have improved their effectiveness and efficiency. The Ministry has expanded its coverage for low-income families. It has substantially reduced the number ofunnecessaryhospitalizationsand consultations, and hasreformed its procedures for the purchase of medical materials. Inaddition, the FNR has gone from recording losses to a surplus by lowering unnecessaryservices and costs. 218. However, there is still significant inequity in the distribution of fiscal subsidies for healthcare, including direct fiscal subsidies paid to the health insurance of the social security instituteand important direct subsidies paid to the IAMCs. The'IAMC's compete to affiliate low risk segments of the population (the young, relatively well-to-do and healthy), leavinghigher risk segments (the elderly, poor andunhealthy) to the public sector. Inadditionto aging ofthe populatio~~~ the highcosts of healthservices is attributableto, an excessively complex institutional structure with an overlapping of responsibilities and high transaction costs which reflects a system that is not fdly in line with the health needs o f the population. Primary and secondary prevention is marginalized within the healthcare system, thus increasing the cost of complextreatments at tertiary level. Only 7% ofthe ofthe Ministry ofHealth's budget is allocatedto public healthprograms. 219. Despite the subsidies and the marked increase in monthly premiums in the last ten years, mostIAMCs havesteadily built up long-term debt, and seven of them have failed since 1999. Almost one quarter ofthe IAMCs recorded operating losses in 2003 equivalent to 25% or more oftheir income. Factorsexplaining such results include the existence of a deficient IAMC regulatory system -which provides families neither financial protection nor adequate information for decision-making purposes (Fiedler, 2004). Another factor is the existence of a highly distorted medical labor market noted for oversupply of doctors stemming in part fiom regulations that encourage part-time work. Strategicpolicy options 220, Policygoals. The goal of healthpolicy inUruguay is to harmonizethe system so as to ensure more equitable access to and use o f services, improvedquality o f care and increased financial protection(preventingpoverty as a consequence of healthproblems), while at the same time reducingthe financialburdenofthe system. 221. Inthis context, one importantstrategic need is to improvethe frameworkof incentives for all players in the system (consumers, healthcare service providers, State HealthServicesAdministration-ASSE and IAMCs). Keyto the improvement in incentives is the need to reduce fragmentationand increase the effectivenesso f fmancial incentives and regulations for greater efficacy and equity. The government must determine the specific strategy to ensure harmonization. Options could include: (i) improvements in existing incentivesand regulations, essentially maintainingthe current 33Over 13% ofthe populationis over 65. 71 organizationof the system; (ii) "virtual" single risk-pool -a reformed system inwhich a there are multiple insurers but all of them will be subject to a single set of rules with respectto the benefit package, the portability ofbenefits, and accessto public and private providers; and (iii) a single (actual) risk-pool such as the system inthe BritishNational Healthor the Frenchsystem. Manyofthe countriesinthe regionhave beenconfionted by similar options. Decisions taken by countries in the region have been based both on historicaland cultural preferencesand fiscalconstraints, 222. Regardlessof which of these three key strategic options the new government chooses, a transitionalphaseis advisable to meet the urgent needto movetowardsa more efficient framework of incentives for the system. There are at least five key reforms that the govemment could consider in its progress towards a system of more harmoniousand effectivehealthcare. First, is the priority to achieve a better balancebetween insurance and prevention. There appears to be insufficient emphasis on prevention for a country with significant challenges inthe area ofchronic non-transmissiblediseases. Second, is the importance of simplifying and applying the regulatory fiamework of the IAMCs. The system needs to be made more effective in providing: (a) consumer protection and (b) mandated, guaranteed coverage for all members. This includes ensuring access to key health services and ensuring that health events do not pushIAMC affiliates into poverty. Third, is a definition ofthe guaranteed coveragethat is explicit and obligatory for all beneficiaries o f public subsidies. The fiscal subsidy in the absence of such regulations or an explicit coverage contributes significantly to the lack of equity andthe inefficiencies ofthe system. Fourth, reforming the existing fiscal subsidy policy (including the creation of mandatorycoverage) is a priority, as it is inequitableand inefficient. Subsidies to any insurer (public or private), when necessary, need to be re-targeted to those participants with the greatest needs. There are many ways o f defining and establishing stages for the redesignofthe system. Fifth, are reforms within the Ministry of Health that deserve to be deepened including, inparticular, a provider payment mechanismreform for the ASSE that will link financing with the actual provision of services to Ministry of Health beneficiaries. 223. Difficultdecisionsawait regardingthe medical labor market, one of the most complex in the world. This appears critical to managing the fiscal burdenof the health sector, and especially to improve the fiamework of incentives for the IAMCs. Current labor market legislationcomplicates cost management for many institutions that operate in the sector, and encourages the proliferation of part-time jobs. Physicians have on average 3.5 different jobs. This proliferation o f part-time employment has affected the 72 efficacy and quality o f healthcare in Uruguay. Another important consideration linkedto labor market reforms involves requirements for training, licensing and continuous training o f physicians. Here also the objective and primary purpose o f the reform is to improve quality inhealthcare. b) Education 224. Educationindicatorsin Uruguay are positive, in particular when compared with Latin America (Figure 14). The country was a pioneer inthe region by introducing nine years o fmandatory education for all in 1973. Almost all studentsbegin schooling at the age o f four and continue to attend school for the following eight years. There is almost universal coverage o f basic education including for poorer segments o f society. Around 90% o f primary school graduates enter the first year o f secondary school, Real expenditure in primary education rose 50% between 1995 and 2003. Uruguay has seen rapid increases in enrollment with a 25% increase inprimary school students from 1985 to 2003, and a 65% increase in secondary school students in the same period. Importantly, this surge has beenprogressive, as halfo fnew students who entered primary education and over 40% o f current secondary school students live in households in the lowest income quintiles (MECAEP,2004). Figure 14 Average Number ofYearsof Education, Uruguayand - SelectedLatin American Countries, (population25 yearsand older) 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Argentina Bolivia Brasil Chile Paraguay Uruguay m1960 111980 132000 Source: Amarante (2004). 225. Various policies and interventions were conducive to improvements in education performance. These included improved access to pre-primary school and the program o f full-time primary schools - which helped both to improve learning performance and to diminish the learning gap between low income and more privileged students. A new culture o f evaluation has developed along with the implementation o f national assessments o f language and mathematics skills inprimaryschools. Insecondary schools, learning assessments in language, mathematics, natural and social sciences, and English language were implemented, Curricular changes in the second cycle o f 73 secondary education included a better articulation between tracks in technical and traditionalsecondary education, aswell as new options for diplomas. 226. According to the 2003 results of the International Student Evaluation Program, Uruguay recorded a better performancethan the other countries in the regionthat took part, although it was stillsignificantlybelow the OECD level(Table 17). Steady growth founded on aknowledge-based economy impliesthat Uruguayaspire to achieve the standards o fOECD countries. A permanent increase inthe rate o f growth will be dependent on the effectiveness ofUruguay in improving its results inthe field of education, especially at secondary andtertiary level. 227. Public spending on education in Uruguay amounts to 3.6% of GDP, a considerably smaller percentage than the average of 4.5% for Latin America, and lower also than the average of 5.3% in high-income countries. Investment in education may need to increase over time if Uruguay is to establish a high level of education for all its children and young people. Additional resources on their own will not produce the desired improvementsas regards access, equity and quality ofeducation. It will be important to achieve improvements in the delivery of education services, including strengtheningof the organizationaland institutional structure of the education system, to ensure that additionalresources will be used inaneffectivemanner. Table 17 PISA Ratings(2003) - Source: OECD. 228. Uruguay's education system is dominated by the state almost 90% of all - students (pre-primary to tertiary levels) attend state-managed facilities. Pre- primary, primary and secondary public education is administered by ANEP ("Administracih Nacional de Educacicin Publica") and tertiary public education by UdelaR ("Universidad de la Republica") - both operate as largely autonomous state 74 agencies with scarce influence fiom the Ministry o f Education. This Ministry has regulatory and supervisory powers over private sector nurseries and private sector Universities - supervision o f primary and secondary education is the responsibility o f ANEP. This structure is reflected in budgetary allocations: ANEP received 9.4% o fthe 2004 government budget whereas the Ministry o f Education received a small 0.9%. UdelaR was allocated 0.7% o fGDP on average over the last decades. Figure 15 EducationalAttainmentof Uruguay's Employed Labor Force, 1986-2002 - 40.00l 35.00 'o-- h 40 B 9* 30.00 w f 25.00 'c P 20.00 .L E e 1500 I? 10 00 5 00 0.00 - 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 -0-RimryComplete -Secondary lncornplete --a-Secondary Complete Technical Qualfication +Artesan Qualification Unnrersitylnconplete +Unlverslty Conplete -Other ource: Amarante (2004). 229, Uruguay's long legacy of investment in education is borne out in comparative statistics. The stock o fhuman capital (proxied by the average number o fyears o feducation in the population over 25), grew steadily over 1960-2000and is currently one ofthe highest inthe region - about 8 years (Amarante, 2004). Further, there has been a marked increase in the human capital of Uruguay's labor force in the last two decades. The share o f workers with only primary education has fallen steadily, in tandem with an increase in the share with completed secondary and some tertiary education (Figure 15). There have also been gains as regards the progressiveness o f academic performance. In at least three national evaluations 75 (1996, 1999, and 2000) on sixth-grade use o f language and math skills, the lower-income segments were improving at a faster rate than that o f the higher-income groups. This can be attributed to a progressivestructureo feducationspendingand specific programstargetedat the poor, such as the full-day schooling model. 230. At the tertiary level, until 1985, Uruguay had just one university-UdelaR. The opening of the first private universitythat year marked the start of a period of rapidgrowth in coverage-from 62,000 in 1988to over 80,000 in 2002; in 2002 there were 5 private universities and 8 university-levelinstitutes. The UdelaR still attracts 89% of university students. At the same time, there has been a diversification o f programs and diplomas. In 1998, all MERCOSUR countries launched a process o f regional accreditation for university programs. Issues in education 231. Against this favorablebackground, the followingtrends can be noted: i. Accessandequity.Mostworryingareincreasinglevelsofschooldesertionatthe secondary level. Out o f 100 entrants to secondary school, only 55 will remain after four years, and only 35 will finish the fillsix-year course. School desertion is not evenly distributed among the population. These indicators are worse among those at the lower end o f the income distribution. While 80% o f high school students in the highest income group will complete their secondary education, only 30% o f students inthe lowest income group will do so (Opertti, 2004.) In spite of the rising number of university students, take-up of higher levels of education has declined dramatically. The rate o f growth o f the population with tertiary or professional qualifications is one o f the lowest inthe region. Whereas tertiary qualifications inthe population aged 29-59 rose less than 2% on average in 1990-1999 in Uruguay, growth incomparable countries inthe region has been far more rapid - 4% in Brazil, over 5% in Argentina, 6%, in Chile, Colombia and Paraguay, and inMexico over 9%. ii. Equity.Tertiaryeducationprovidesaclearcaseoflackofequity. Only0.8% of households from the lowest income quintile include people with tertiary education (da Silveira, 2004). The equivalent figure for the highest income quintile is 32.2%. Since the bulk of enrollment is at public universities finded by general tax revenue, public expenditure intertiary education is regressive. iii. Quality. Inprimaryschools,concernsextendtothequalityoflearning.In2002 tests, 33.7% o f primary school students did not reach a minimum level of sufficiency in language and 51.7% in mathematics. Learning performance also varies by income level-only 39% o f students inschoolsthat primarily serve low- income students obtain a high score inmathematics, compared to 85% inschools serving high-income populations. Returns compared to OECD countries show a significant gap inbasic competenciesofreading, math and science. 76 iv. Efliciency. Public expenditure inefficiency is an issue, particularly at the tertiary level. The average time to completion at UdelaR is about 50% higher than the expectedtime, and averagedropout ratesare about 70% o ftotal enrollment. With 11% o fenrollment, private universities contribute 16% o f graduates (da Silveira, 2004.) University efficiency is also low when measured in terms o f scientific production. Strategicpolicy options 232. A key objective of education reforms is to ensure that ail Uruguayan youth have access to quality schooling and may enter the labor market prepared to meet the demands of a competitive, increasingly knowiedge-based economy. The education system can be structured to meet this objective in a way that fulfills its obligation to compensate for differences insocio-economic backgrounds among students. Progress toward this objective may be assessed by: (i) quickly the current rates o f how repetition and especially o f desertion fi-om secondary school - particularly among students &om lower-income households - can be lowered; (ii)improved and more equitable (across income segments) learning performance in primary and secondary schools based both on domestic tests and on international tests - such as PISA; (iii) a faster pace o f growth o f university graduations and shorter average stay at the state university; as well as (iv) a more equitable distribution o ftertiary and technical education graduatesaccording to the needs o fthe labor market. 233. Reform of the curriculum. The government could consider analyzing steps to re- equip the educational system so that it provides the humancapital that is most relevant to current and future economic demands. This could be achieved through changes in the curriculum, placing greater emphasis on learning skills than on specific content, and granting increased attention to technology to give students skills they need to become employable (Opertti, 2004). 234. Teacher incentives. It is important to achieve a better understanding o f the teacher labor market in Uruguay. Much could be learned from analyzing teachers' incentive structures and by seeking answers to key questions, such as: How are teachers selected? How are they assigned to schools? What are the promotiodcompensation criteria? Deeper understanding o f these issues would help elaborate on the following policy options: 0 Autonomy and responsibility for school directors. They could for example be given a greater role in the selection o f teachers. Criteria for evaluation o f principals could take into account, for example, evolution o f dropouts, repetition and learning rates, andcontrolled according to characteristicso fthe student body. 0 Role of director vs. role of inspector. This role could be strengthened, for example, by modifying the rules that currently grant more weight to the judgment o fthe inspector than the evaluation o fteaching performance bythe director. 77 Teacher evaluation. Changes could include an evaluation o f individual performance (e.g., judgment o f the director, ability to successfully integrate with the educational community, improvement in results) as well as indicators of impact that measure the educational success o f the school where they work (evaluation o f grade failures, desertion rates, controlled against the socio- economic characteristicso fthe students). Teacher commitment. Teacher's time commitment to working at a specific school could be extended, cutting teacher rotation and increasing accountability. 0 Remuneration. The basis for teacher remuneration could be expanded beyond seniority. For example, they could receive a basic wage and a series o f complements related to improvement in academic performance, teacher re- training and educational and curricular updating. 235. Incentivesfor schools. Education authorities could assign every school a basic budget that would make it possible to pay a core teaching staff and essential operating costs. This basic amount could be determined on the basis o f the average number o f students enrolled inthe school inprevious years, but it could also be linkedto a series of performance indicators in relation to academic achievements, desertion and grade repetition rates. To prevent an increase in inequality -with schools recording the worst performance receiving the least resources, leading to a further deterioration in performance- the government could consider transferring additional resources to such schools basedon the agreemento fan improvement program with ANEP. 236. Efficiency. ANEP could promote increased transparency in cost structures, teaching approaches and academic results. This could also help to raise awareness o f school directors andteachersregardingthe need for reforms. 237. Cost-efficiency. There is room for improving cost-efficiency in tertiary education. For example, stricter curriculum requirements could be established to reduce the number o f students taking advantage of the generous public university system. At present the only requirement to be registeredas a student is to pass one subject every two years. Limits could also be placed on the number o f times a person can enroll on fiee graduatecourses. 238. Equity. Reform o f higher education could retain the positive elements o f the current system while improving equity in the opportunities available for students from homes with different income levels. Widening access to credit would reinforce efficient investment in human capital. Such a system should bear in mind the need for: (i) equilibrium between technical and professional studies; (ii)greater flexibility in the financing o f public education -especially higher education, where there in increased ability to pay; (iii)synergies between universities, research centers and business undertakings; and (iv) subsequent reforms o f the public university system, including for example, the creation o f a national university accreditation entity (as required by 78 MERCOSUR), and competitive allocation of public resources for research (without discriminatingbetweenpublic and privateuni~ersities).~~ 239. Interventionon demand. High levels of desertionamong lower incomegroups, points to difficulties of poorer households to fmance education. Uruguay may benefit from growing experience in the region with demand-side interventions such as conditional cash transfers targeted at the neediest households to keep poorer students in school. Similarly, a better returncould be obtained from the generous public transfers to finance fiee tertiary education, targeting subsidies to create better opportunities and incentives so that students fiom poorer homes complete their secondary education and enter the university, whether by means of direct (means-tested) transfers or loans. Improved incentives for students to complete their secondary schooling and enter university could reverse the relative decline in numbers o f those entering higher education inUruguay. 240. Administration of public education. Administration of public education in Uruguay is in the hands of ANEP, an autonomous body. Within the ANEP, primary, secondary and technical education are administered separately, each by an independent council formed by members appointed at a political level, The three councils are coordinatedby the CentralDirective Council, formed by five members appointedby the legislature. The organization of the management structure into three separate administrative councils leads to compartmentalization of the educational system, hampering global planning and reducing the effectiveness of the ANEP. It would be usefbl ifthe revision of the education administration in Uruguay were to center on simplifying the structure o fANEP, so asto enable abetter planningand administrationof the education process as a continuum from pre-schoolingthrough graduation fiom high school. One option would be to strengthenthe role of the director ofANEP vis-&vis the councils. 34There is muchto be learntfrom countries suchasColombia,Mexico and Chileinthese areas. 79 CHAPTER V: INNOVATION-DRIVENGROWTH PILLAR3 - 241. Sustained economic growth over the long term will depend on rapid total factor productivity growth driven by processes of innovation and knowledge development. Innovation has been the most important source of productivity growth in fast growth countries. Many successful innovating countries are small, open economies with sound macroeconomic fundamentals. Catching-up on innovation vis-&vis these countries will hinge on a comprehensive strategy including modernizing education, increasing expenditure in R&D, high business sector participation in the financing of R&D, and providing an enabling environment for private sector development and financing of innovativeactivities. Developmentofa diversifiedbase o finnovators, with a major role for Small and Medium Enterprises (SMEs), requires improved linkages between science and industry and a high level o f networking among leading players in the area of innovation (companies, research centers, universities, state agencies) both within the countryand aroundthe world, 242. The state has a crucial institutional responsibility in the promotion of innovation-drivengrowth. This includes designing innovation policies and strategies, and providing an enablingenvironment for Private Sector Development (PSD). Inorder to be able to perform the latter, the state faces the challenge to modernize itself both by transforming its institutionsto be able to assign resources strategically, and developinga skilled, adaptable and motivatedcivil service-that will ultimately be incharge ofdesign and implementationof policies in close coordination with the private sector. Reform of the state in support of innovation-drivengrowth could create opportunities for SMEs to improvethe quality, designand innovationoftheir products. 243, Many of the profound transformations required for institutional development will take time to mature. Several of the proposed reforms could entail significant fiscal cost, such as, for example, increased investment inR&D - eventhough the private sector is expectedto cover most ofthe additionalinvestment. Inview ofthe strategic significance of the objectives, which cannot be delayed, the implication is that priority shouldbe assignedto the introductiono fthose reformsthat are slowest to mature (civil service, business culture, interconnectionwithin the innovationsystem), postponing those with a greater fiscal impact. Inaddition, there are significant reforms -such as that of the state procurement system- which in addition to efficiently serving the innovation process, can also havea favorable fiscal impacteven inthe shortterm. 244. This chapter describes the policy and reform options for innovation-driven growth - pillar3 of the growth strategy. First, emphasis is placedon improvementsto the businessclimateto encourage PSD, Second, an analysis is made o fpolicy options to favor development of SMEs. Third, an outline is provided of a strategy for the development of a national innovation system (NIS). Fourth, reform options are analyzed to increase the efficiency o f the state, and particularly its civil service, the government procurement system, and the development of a results-based budget -essential for 80 allocating resources coherently with the adopted strategy. Increased efficiency by the state can underpinmodernizationofthe NIS. 5.1 Privatesector development (PSD)35 Legal, regulatory and instit~tionalenvironment 245. Laws and business regulations, and the quality of public institutions that enforce them can have a strong impact on growth (World Development Report, 2004.) This impact directly on the structure of incentives faced by the private sector in conducting regular business, new investments and innovation activity. The security provided by property rights, predictable legislation and trade regulations with a low compliance cost contribute to linking investment efforts by agents to the rewards and benefitsderived fiomthem. 246. Uruguay in general ranks relativelywell in terms of laws, regulations and institutions. Uruguay has relatively stable institutions and perception of corruption is relatively low - it ranked2ndinLatinAmerica inTransparency International's Corruption PerceptionIndex. However, there are important areas for actionto improve the potential for PSDand innovation. 247. An evaluation of a comparative database indicates that legislation in Uruguay contains significant shortcomings as regards market entry and exit and protection of small investors mainly because of the lack of transparency (Figure - 16). Starting a business in Uruguay requires companies to comply with at least 11 separate procedures, takes about 45 days, costs 48.2% of income per capita. These indicators are slightly better than the region average but well off the average of OECD countries. Uruguay compares unfavorably with the region in terms of the minimum capital required to start a business - 181.6% of income per capita. The information disclosure index is halfthe levelo fthe region's average level. 248. There are also drawbacks to the legal framework in Uruguay for bankruptcy. In addition to a problem caused by the existence of different legal procedures, dependingonthe type ofdebtor, disadvantages include: 0 Timeliness and efficiency of bankruptcyproceedings. A bankruptcyprocedure takes approximately4 years, costs 8%ofthe estate and anefficient outcome is not generally achieved invalue terms. 0 The "acuerdo preventivo" - the main restructuring mechanism for economically viable companies under bankruptcy procedures - does not work For example, the debtor files apetition evenwhen it is certainto default. 35Basedon Rozenwurcel(2004) andGuinet (2004). 81 Most SMEs do not use bankruptcy protection. Among the reasons for this are the highcost andpoor accountingrecords. Figure 16 Comparisonofbusinessclimate - 50- n48.2 27.4 16, 11.5 117 1 Cost of enforcingcontracts(O hofvalne ofdebt) M - N m y USA Chile Spain m n b a 8rmd Cslombm MeXim U~guay I Source: "Doing Business", Database, World Bank, 2005. Note: The indexranges between0 and7, the higher values indicatinggreater disclosure. Other countries showingthe greatest disclosureofinformationat world levelare Israeland the UnitedKingdom. 249. Uruguay also ranks below the region's average in terms of cost and time for registering property, and procedures and time to enforce contracts. Some o f these issues have to do with performance o f the judiciary. Although the independence o f the judiciary is long-standing in Uruguay, the system is often slow in its actions. Uruguay is also noted for having a limited number of alternative mechanisms for resolution of commercial and administrative disputes, and a lack o f technical capacity and legal 82 training to deal with complex economic cases. Economically important and strategic specializedcourts, suchas the two bankruptcy courts, are under-fundedand lack adequate facilities and professional staff. The clearance rate -the ratio between the number o f cases solved and the number o f cases initiated each year- is an indication o f the judiciary's capacity to produce inrelation to the demand for service. Evidence indicates that the averageresolution rate for commercial and administrative disputesover the 1995- 2000 periodwas under 1%. Policy and reform options 250. Many of the reforms to create a favorable environment for PSI) could be implemented and generate benefitsinthe short term. The options that the government could consider for improvingthe legal andregulatory environment for PSDinclude: a Simplificationof proceduresand regulationsand reductionofthe numberof steps needed to start a business.A review o fthe implications o fthe tax system for new firms could help to determine ifsome taxes on companiesand labor could be deferred inthe first few years o foperation. Promotion of cooperation between businesses through legal instruments. Cooperation could help to address high unit transaction costs, improve the bargaining power o f micro businesses and SMEs for purchases including public services. Expanding the use of IT for doing business with government. The development o f the legal fiamework for government procurement could be designed to develop quality standards on a continuous basis and promote purchases fiom SMEs. Improving contract enforcement. This could be achieved by simplifying and reducing the number o fproceduresto enforcecontracts. a Reducing court involvement in business matters. Educating the private and public sectors on the benefits o f alternative dispute resolution mechanisms- in andout o fcourts -could help. a Bankruptcy legislationcould be updated-e.g., along the lines o f the proposed legislation already sent to Congress- facilitating rehabilitation processes for economically viable companies. This includes the unification o f bankruptcy proceedingsamong other actions. Training of judges: Specialized training and programs for continuous legal educationwould helpjudgesto handle economically complex cases. a A special unit or committee could be set up in the Presidency with the specific purposeof contributingto improvethe businessclimate. Its function, 83 authority and responsibility should center on issues of deregulating and simplifying commercialprocedures. Modernizingaspects of the judicial system to guaranteemore effectively the rights of the individual -property rights in particular. The agenda could include measures to improve the administration of cases, increase the use of hearings, and simplify the notificationand appeals process. 5.2 SMEsandInnovation 251. In 1997 micro businesses and SMEs contributed nearly half of GDP and accounted for 71% of Uruguay employment, of which 27% corresponded to micro, 25% to small, and 19% to medium-sized firms. These percentages are similar to those observed in other countries of the region; however, the average number of workers per enterprise (around 4) is substantiallylower thanthe regionaverage (around 10). 252, The micro enterpriseand SME universeis highlyheterogeneous. The bulk of micro enterprises and SMEs have practically no managerial, technological or marketing capacities, and ahighproportion ofthem operate informally. Nonetheless, there is a small core of innovativeenterprises with a scientific and technologicalbase, well established in the software and information technology sectors, which is dynamic and has an internationalprojection. 253. Between the two extremes there is a host of enterprises; most are companies with limited managerial, technological or marketing capacities, lacking an innovative approach and having little or no presence in international markets. However, also within this category, there is a minority o f dynamic and innovative SMEs with an associative inclination and an exporting disposition, concerned about enhancing their capacities and the quality of their products and processes - these are found more fiequently in: natural resources, foods and non-food agro-industry, chemistry and pharmaceuticals, health, animal and vegetable sanitation, transport and logistics, and tourism. 254. Most SMEs have a very limited innovative capacity. A recently published report - DINACyT (2003) - which presents the results o f the 1998-2000 innovation activity survey, shows that only one of every three Uruguayan industrial companies carried out innovative activities during the mentioned period, of which only 30% obtained innovations in products or processes. These indicators are much lower than those of Argentina, where 78% of companies studied in a survey covering the period 1998-2001 carried out innovative activities, with 56% o f these managing to produce innovations. 255. Uruguay's science and technology indicators are a long way from those of advanced countries and, in most cases, lag behind those of regional comparators (Table 18). R&D expenditure, both inper capita terms and as a share o f GDP, and the 84 invention coefficient (patents per thousand inhabitants) are significantly below the average inthe region,as well as lagging behindthe levels achieved by Chile, Argentina and Brazil. The R&Dto GDP ratio was 0.24% in2000 comparedwith aregionalaverage of 0.58% (which in turn was around one third of the level in the European Union), However, Uruguay fares relatively well - region-wide - in terms of number of researchers, and shows a relativelyhighpercentage ofprivateparticipationinR&D. Table 18 Science and Technology Indicators, Year 2000 - Source: Rozenwurcel(2004). * Year 1999. ** Patent *** Correspondingto applicationsby residents per 100,000 inhabitants. total innovationactivities.The rest is R&D. 256. There are several favorable factors that could serve as a basis for the development ofthe SME sector andthe futureNIS: Qualified human resources are in general available (see Chapter 4.4). According to UNESCO (2000), in 2000, Uruguay had the second highest secondary school attendance level inLatin America, with a 97% literacy rate, one ofthe world's highest. 0 Strong ties between R&D and production in some sectors. This is the case particularly in agriculturewhere localR&Dhas playeda significant role inthe re- conversion of Uruguayan livestock in the last decade, as well as in other traditional and non-traditionalagricultural activities. Similar capacities can also be found in the chemical industry and its applications, forestry, information, biotechnology and communicationstechnologies. 0 A strong dynamism has been observed in "new" sectors with a high participationof SMEs. Such is the caseofsoftwareand information services and 85 cultural industries. According to CUT1 estimates, the Uruguayan software industryexported US$83.5 million in2001, with an accumulated annual increase o f 62.3% between 1989 and 2001. In 2000, cultural industries sales contributed US$555 million to GDP and directly or indirectly absorbed50,000 employees. Dynamic traditionalsectors. Renewed dynamism is observed in the following sectors (only partly due to improved relative prices since the devaluation): beef, leather and textile manufactures, wine production, citrus fruits, forestry activity, fine chemicals andtourism. A growingnumberof companieshavecertifiedquality standards. According to a study by the Uruguayan Institute o f Technical Standards (UNIT, 2002), Uruguay had 230 companies with an I S 0 9000 certification, a high number in comparison with other countries inthe region after adjusting for relative size. Programs to support SMEsand theNIS 257. The DINACyT (National Directorate for Science and Technology) was created in 2001 as the unit responsible for coordinating, managing, executing and evaluating policy instruments relating to science, technology and innovation. CONICyT (National Innovation, Science and Technology Council) is the advisory committee, which puts forward plans and policy guidelines in relation to innovation processes, science and technology. It also promotes the development o f research in all areas ofknowledge, as well as actions leading to the strengthening o fthe NIS. CONICyT is also responsible for the evaluation andapproval o fprojects. 258. As regards specific programsfor innovationand support to SMEs, Uruguay would benefit from a clearer strategic vision and stronger coordinationbetweenthe various institutions responsible for its implementation. Services have been under- utilizedandthere are important mismatchesvis-his private businessneeds. Institutional challenges include the need for more autonomy in terms o f operational guidelines and certain areas, while in other areas - there has been a lack o f adequate coverage (Sutz, improved incentives for staff. Also, there are important overlaps and duplications in 1998). Among the latter, is the inability o fthe financial system and funding agencies to address needs o f innovative ventures. 259. One significant institutionalweakness of the NIS is that the main agencies are located within the orbit of the Ministry of Education. Since the Ministry is focused on educational themes, these offices are not duly ranked and are inadequately articulated with other areas o f government. In addition, their budget has proven vulnerable to frequent cuts during periods o f crisis. There is also a lack o f program evaluation culture. 260. The NIS also reveals some strengths. These include recent attempts -although not perhaps on a desirable scale- to improve the strategic focus and internal consistency o fthe system. The development o fcloser ties betweenimportant researchinstitutions and 86 privatebusiness, and various privateor mixedprojectswhich, althoughrecent, may have a strong impact on Uruguay's innovation potential, There has been, for example, an incipient articulation among some institutions providing support to SMEs - including "Red ProPyme" and sectoral programs like FOMIN (wine production and software). Recent initiatives include the launching by the government in 2001 o f a Program for Technological Development with the aim of mobilizing the innovating potential of SMEs. The measures supportedby the Programprovide greater strategic and operational coherence to the NIS, including the process of planning and execution of the various programs and their related funds. The program also intends to improve coordination betweenresearch and commercial applications, and in more general terms, between the public and privatesectors. After three years, however, executionneedsto be steppedup. 261. UdelaR has implementedvarious successful initiativeswhich illustrate how public-private initiatives can be fostered within the boundaries of existing institutions. Perhaps the most successful research institute - based on institutional design, continuity, governance structure, professional staffing and administration, performance, and network experience - is INIA (National Institute for Agricultural Research). Apart fiom managing its own budget, it administers specific funds allocated under competitive procedures. There are a number of private and mixed projects which have emerged more or less spontaneously -though often with some kindof government support - and which are at the fiontier of innovation in the areas of information technology, software services and ingeneral knowledge-basedsectors. These include: (i) a software testing center at the Pando Technology Pole with support receivedby UdelaR fiom the EU; (ii)installation of an informationtechnology business incubator stemming fiom an agreement between LATU and ORT University; (iii)the United Nation's EWRETEC incubator program; and (iv) creation o f the Information Technology Industry Academic Center (CAITI) with participation o f all the institutions involved in the developmentofthe sector. Optionsto reformulate SMEprograms 262. The government could consider consolidating existing funds into a single Fund for Competitiveness and Innovation. Its main aim would be to co-finance programs and projects based on competitive mechanisms, with transparent rules for presentationand evaluation of proposals, and strict mechanisms for follow-up, control and evaluation o f results. The Fund would offer partial funding or matching grants decreasing over time. Technical assistance services would complement funds for investment or to develop projects. 263. Innovationprogramscould beguidedbythreeobjectives: a) Strengtheningthemanagerialbase i)AnEntrepreneurDevelopmentProgramconsistingofprojectssubmittedvia institutions such as UdelaR, ORT, LATU, EMPRETEC, etc. to train and develop 87 technical, commercial and financial networks and other key activities for companiesjust startingup. ii)AQualityProgramaimedat improvingcompanyaccesstoconsultancyand specialized training. This could be achieved by strengthening existing institutions, suchas the RedProPYMES. iii)AnITDiffusionProgramforSMIEs. b) Promotion of innov~tionandproduc~ionnetworks i) DevelopmentProgramforsuppliersandclientsoflargecompaniestoimprove access to knowledge, markets and quality standards. Benefits may also include shared training and consultancy services, Good examples include the programs developed recently in Argentina, such as the program for suppliers ofRepsol- YPF or the programfor the development ofTechint customers. ii)Programfor the development ofclusters - a network of companies and institutions that interact at a physical location defined on the basis of cooperative and competitive relations. The main challenge will consist of stimulating relationships between the various players, such as researchers at technical schools or universities and companies or commercial associations. Good examples of this include the SEBRAE initiative called "Arranjos Produtivos Locais" that is having a significant impact in various regions and sectors inBrazil, andthe IDBFOMIN MIF programs inLatin America which includesupport for wine-growers inUruguay. iii)Allocation ofscarce funds for innovationandR&Dinastrategic manner, favoring the formationof consortia between universities and companies inthe private sector, and large companies with SMEs. One important objective would be to strengthen relations between R&D institutions, agricultural producers and agro-industries, which could contribute to the change in focus inprimaryproductioninfavor ofprocessedagriculturalproducts. c) ~nternationalizationof SMEs i)ProgramforthePromotionofSMEExports. IncoordinationwiththeMinistry of Foreign Relations, the program could consider market diversification, the promotionofnew exports, andthe formationofexport groups. 5.3 Development of a strategy for the NationalInnovation System 264, Challenges of innovation policy. Business innovation is not limited to the acquisitiono ftechnology or the purchase ofcapitalassets that embody it. It comprises as well tacit knowledgegeneratedat the firmthroughexperience andwhich, by its nature, is 88 difficult to transfer tolor be absorbed by other firms. In general, creating dynamic competitive advantages involves the generation, dissemination, transfer andadaptationo f coded and tacit knowledge, as well as the development o f new ways o f linking actors, particularly links between private companies, going fbrther than traditional market relationships might imply. A well functioning innovation systemthus incorporates fluent interactionshelationships between: universitiesltechnology centers and business companies; SlMEs and large corporations; corporations and suppliers o f technological consulting and training services; business and scientific-technological languages; and companies, networks and local systems to adapt andtransfer knowledge. 265. Good innovation policies reflect the new global environment for innovation, characterizedby growing globalization o fR&D activities, rapid devebpment o f markets for knowledge, high mobility o f highly qualified labor, and regional integration of innovation systems (e.g., EU). Inthis environment, innovationpolicy design inadvanced countries shares the following minimumset o fguidelines (Guinet, 2004): e New steering and fbnding mechanisms for public education and research (innovation networks and consortia, technology market-places); e Shifting support from large to small firms (project-based, business incubators, regulations to encourage SME relevant public research); e New policy tools to support innovation: e.g., Public-Private Partnershipsto foster industry-science relationships inOECD countries (risk and cost sharing, improved procurement, complementarities betweenpublic and private R&D); e New policy targets: networks or clusters instead o f individual frms or sectors (cluster programs, innovation cooperation programs.) the microeconomic level - incentives and support for R&D activities, development of 266. Bottom-up/top-down approach. Innovation policy design comprises actions at technology competencies, business networks and systems to help create regional and sector clusters - and at the institutional level - enhancemento fthe institutions and spaces for the interaction o f agents. A modern innovation system combines a bottom-up approach, which is responsive to the needs and demands o f local systems and businesses, with a top-down approach leading to adjustments in the institutional and regulatory fiamework (Guinet, 2004). Diagram 1 summarizes the main sources o f knowledge and innovation - technical, organizational and institutional - as well as the set o f policies to foster the generation and systematic application o fknowledge within and across sectors - cluster policies, Public-private partnerships, and policies to strengthen innovation competencies, as well as R&D and linkages betweeninnovation systems. 267, Uruguay can draw valuable lessons from the experience of the most successfulinnovatorcountries - many ofwhich are developingcountries: 89 0 They were generally small in size, with good macroeconomic fundamentals and very open economies. 0 They record above average improvement in innovation performance linkedto: a high rate of investment in education, Information and Communication Technologies(ICTs) andR&D, and a highshare of business financing ofR&D. 0 They have an increasinglydiversified base of innovators, with a greater role for SMEs, improved linkages between science and industry and a high level of networkingamong innovators. 0 Their fmancialsystems support innovativeactivities. 268. It should be noted that being small is not a barrier -and could in fact be considered an advantage- perhaps because small countries can be flexible in adjustingto dynamicchangesinglobalinnovation.Uruguayfacesthe challenge to: (i) introducereformsto its educationsystem (especially higher education), (ii) the level raise of its spending on R&D, (iii)increase private participation in R&D, (iv) diversify the innovator base, (v) connect innovators by means of networks, (vi) improve linkages between SMEs and R&D activities and (vii) promote the financing o f risk capital and start-upcapital. All ofthese represent significant efforts. 269. In addressing these challenges, Uruguay could draw on specific lessonsfrom countrieswhich haveestablishedbest practices: A strong policy governance of the innovation system, including an effective coordinationbetweenpolicy instruments and institutions(Finland, Korea); Development of a diversified set of innovative clusters around large firms or knowledge institutions(Finland); Promote cooperation among SMEs to compensate for the lack of large firms as engines of innovation(Denmark, Taiwan); Promote science-based innovation and innovation in services to extract more value fiom naturalresources (Iceland, Norway, Chile); Exploit innovation synergies between services and manufacturing to create competitiveadvantages infast growingglobal market niches (Australia). 90 Diagram 1 Sources of Knowledge and Innovation - I Sourcesofknowledgeandinnovation I I I Technical Organizational Institutional P Researchinscienceand > ~ Technologicaladoptionand Institutionsare integralto the technology expandsthe stock workplace learningdepend structure and governanceof offormal, codifiedknowledge on humancapitaland `nationalinnovationsystems' P Knowledgeevolvesmore organisationaleffectiveness that linkknavledge and broadlythroughstructured 9 High performancew d wealth creationpmcesses collaboration, networking, systemsreleasecreativity 9 NISare constitutedby spill-oversanddiffusion > Organizationalknowledge linkagesbetweenpublic is generallytacitis a major agencies,research and factor in productivity education and companies I I I I Generationandsyslemalic appllcatianof knovAedgewithinand acrosssoc!ors I Cluster I inscienca and Public-private partnerahips Source: Guinet (2004). Refor~ulatinginnovationpolicy in Uruguay Catching-upstrategies - 270. Designing a forward looking NIS in line with the experience of successful innovators involves targeting the following broad strategic objectives and implementingthe related tasks: 271. First, avoiding the "low equilibrium trap" inR&D and investmentsinknowledge entailsthe following: 0 Check framework conditions (competition policy, regulations, taxes, intellectual property rights) that affect incentives to innovate and private returns on innovation; 0 Stimulate private initiative without replacing it; instead of a "magic bullet," aiming for a groupofwell-coordinatedinstruments; 91 0 Look for leverage points at the interface between public research (including public companies) and private research, and betweeneducation and in-house firm training; 0 Avoid expensive generic financial support and differentiate the specific needs o f different types ofenterprises(SMEs) andtechnological areas; a Articulate and balancetop-down and bottom-up approachesfor localand national initiatives through instruments such as public-private partnerships for innovation or network and cluster-basedpolicies. 272. Second, ensuring political and budgetary commitment to sustained and balanced investment inknowledge involves efforts to: 0 Protect investments inknowledge from macroeconomic instability; 0 Continue to invest inthe scientific base; free-riding is not anoption; 0 Leverage limited national resourcesthrough intensified international cooperation and linkages inareas o feconomic relevance; a Focus on scientific excellence and improve responsiveness o f public educative and research organizations to social and economic needs by adopting internationally proven best practices regarding steering and fimding o f public research. 273. Third, bridge "innovation islands", andbuild"innovation polders" through action to: 0 Diagnosethe N I S to identifyunder-exploited potential, and associatedgaps; 0 Avoid picking "winners", instead identify "role models" in areas with potential andencourage industry-led collective initiatives to diffuse good practices; 0 Promote cluster development by providing platforms for discussion and through schemes to stimulate knowledge exchange, reduce failures o f information and strengthen cooperation among firms in the fields o f market intelligence, design and branding, knowledge management (for example copyright) and the development o fhuman andtechnological resources; 0 Reduce financial obstacles to new undertakings, especially in the field o f technology; 92 0 Encourage international partnerships in order to access complementary foreign competencies, and to ensure that the innovation strategy is consistent throughout the value chain, particularlywhenpartofit is locatedabroad; Maximize national participation instead of national benefits when designing innovationprograms. 274. Effective innovation policy creates conditions for an innovation process which can be sustained over time. Inthis regard, developinga common vision shared as broadly as possible by the state, businesses, innovationagents andcivil society may be an importantpre-requisite. Chile's "Pro GrowthAgenda" ("Agenda Pro-Crecimiento"), a public-privatepartnershipaimedat creatingconditionsfor fast growth and innovation, ,is a good example of a shared vision leadingto a combined bottom-upltop-downapproach that detects and pro-actively meetsthe needs ofprivate companies. The second, ongoing, phase of the "Pro-Growth Agenda" in Chile places greater emphasis on innovation, includingthe promotionofrisk funds. 275. A strong institutionalframework and effective coordination of policies help avoid overlapping, atomization and wasting resources; this ideally points to a centralized policy design in a single agency, not subordinated to ministriesor other agencieswhich do not have innovationas their main mission. Sucha body, including private representation on its board, could establish priorities, define instruments and assign resources. On the other hand, the implementationof policies and programs could be widely decentralized across a network o f local or sectoral institutions with a strong privatesector presence. 276. I t is important to ensure transparent allocation of public resources in accordancewith pre-established project selection criteria. At least inthe first stage, the mainrecommended vehiclesare subsidies or grants, decreasingover time andgranted on the basis of co-fmancing (matching grants). Equally important is the continuous monitoring of programs - technical, financial, results evaluation - on the basis of predeterminedparameters and adoption of strict criteria to terminate those programs or projects which do not provide the expected results. Programs should include criteria for the evaluation of their costs and impact. This is a basic criterion for control and transparency in the use o f resources, and also helps with the process of institutional learning-it couldhelp inbroadening, reducingor reformulatingprogramsor projects. 277. The success of programs will ultimately depend on the quality of the institutions that apply them. Public funds may be partially assigned to institutions taking into account the extent to which these contribute to their own sustainability, e.g., through charges to beneficiaries. This would help to leverage public resources and commit beneficiariesto actions they carry out. 278. By way of example, a model institutionalframework for Uruguay could be centered on the creationof the "Fund for Competitivenessand Innovation" -funded out of the resources of existing programs. The proposed institutional setup to 93 coordinate and provide coherence to the different programs for SIME: development and innovation would be anchored by the creation of a "National Network for Business `Developmentand Innovation" madeup ofthe following organizations:36 0 An Agency for BusinessDevelopment and Innovation (ADEI), the hub ofthe network, could be a second tier institution which missionwould be to develop a system of national, local and sectoral institutions in charge of business development and competitiveness. ADEI could be managed by representatives fiom the Executive and Legislative Powers, local governments and private business. Itwould administratethe Fundfor Competitiveness andInnovation. 0 A BusinessDevelopment and InnovationCabinet, directly under the President of the Republic, would fbnction as an area of coordination of all the national government organizationsinvolvedwith competitiveness, 0 An autonomous Office of Deregulation for Competitiveness would be in charge of evaluating public regulations with the aim o f securing a level-playing field and improving conditions for businessdevelopment. 5.4 Modernizingthe state3' 279. Successive governments have demonstrated an.ability to effectively build uponpaststate reforms.State reformshavetackledareas suchas the budgetaryprocess, procurement, the civil service and administrative reform. Despite progress achieved, there is still a vast agenda ofreformsto improvethe efficiency ofthe state. Inefficiency is not related only to the cost of provision of public goods and services, but also to the ability o f the state to design and implement policies and complex reforms as well as to decide strategicallyonthe reformsto bepromoted, 280. This section centers selectively on those areas of the state modernizationof the state that are particularly relevant for the design and implementation of of innovation policy. These include results-oriented budgets -crucial for the use of the budget as a strategic tool- a government procurement system -directly relevant to innovation- and the reorganization of the civil service. The importanceof these reforms clearly transcends their impact on the processes of innovation and PSD. Reformsto the system of government procurement and to the civil service could also have a potentially significant fiscal impacttherebycontributing to macroeconomic stability. ~ o d e r n j ~ n g state (I)-Results-Based Budgeting the 281. Results-based budgeting policies can contribute to improve the Executive's options for strategic planning and results monitoring. At present, the budget process 36 Detailsofthe proposedinstitutionalsetup areprovidedinthe backgroundpaper "Una Propuestade Politicaparael DesarrolloEmpresarialen Uruguay'' by Guillermo Rozenwurcel, World Bank, 2004. 37 Basedon Bhansali(2004) andValladares (2004). 94 includes an annual review of activities, targets, and management indicators defined by executive units. This allows for some possibility for correction, if necessary, or adaptation to new circumstances in the budget preparation process, which is generally done prior to eachReview ofPublic Accounts beforeCongress. The process ofbudgeting by results adopted inUruguay -part ofthe process of state reforms- includes regulations, information systems, and procedures.. Initial progress became evident in the 1998 Review of Public Accounts and in the management plans for the 2000-2004 national budget. 282. Although there have been evident improvementsin controls on spendingand the implementation of results-based budgeting, these have mainly involved establishingthe basis for evaluatingthe efficacy, efficiency and quality of services. So far neither the Central Administration nor the Legislative branch seems to have internalizedthis system in its operations, neitherfor preparationo fthe budget nor for the evaluation of results. In the last Review of Public Accounts, reported performance indicatorswere on average less than satisfactory - 40% of324 efficacy indicators, 20% of 164 efficiency indicators, and only 4% of29 quality indicators showed positiveresults in relationto their targets, Optionsto strengthenresults-based budgeting 283. The government could consider the following options to assist in improving its results-based budgetingsystem: 0 In order to operate efficiently, the targets of the performance evaluation system could be defined by the respective units or departments. It may be necessary to standardize different incentives in different executive units. Technical and political leadership is important indefining management goals and indicators, as well as inevaluatingresults. 0 Specific targets and indicatorswhich reflect efficiency and quality could be made public so that the population can evaluate the public sector's performance. This system would provide a greater level of objectivity in the evaluation of budget allocations, and would help to measurethe level of political will inthe Executive andCongress. The government could introduce procedural reforms to the timetable for evaluating budgetarygoals and results. Legislation establishes that the President must submit to Congress the report on the execution of the Budget -and the evaluation o f results- for the previous year by June 30. Since the Congress decisions are retroactive in nature, Le., approval of the budget is given months after execution has begun - the executiono fthe budget by the line ministriesand departments is complicated when the Congress modifies the targets, making implementationdifficult and inconsistent with government's priorities. Although the budget must be presented on or before June 30, there is nothing to prevent a focused discussionprior to that date. 95 Modernizing thestate (2) -Publicprocurement 284. Modernization of procurement helps lower public expenditure and also promotes competitionand innovation.SMEs may improve their access to government purchases through competitive purchase mechanisms. Technical and quality standards requiredby the government may also contribute to improve the quality of SME goods and services andthe processesthroughwhich they are produced. 285. The Central Administration's recurrent purchases and investment in 2002 reached approximatelyUS$500 million; approximatelyhalfof these purchaseswer.e channeled through regular procurement procedures, and the rest was channeled through direct purchases. Direct purchasing is faster and can therefore be justified in some cases; however, the prices obtained through calls for bids are usually considerably lower than those for direct purchases. Prices for direct procurement in 2002 were on average between38% and 58% higher thanthose obtainedthrough calls for bids, and on some occasions havebeendoublethose obtainedthoughtenders. 286. CEPRE ("ComitC Ejecutivopara la Reforma delEstado") has estimated the potential cost reduction for the CentralAdministration by purchasing products at cheaper prices resulting from competition and calls for bids vs. non-competitive means, such as direct purchasing. The potential amount of cost reduction was estimated at close to US$52 million. This potentialreductionis equivalent to 10%ofthe total amount ofprocurementbythe CentralAdministration in2002. Optionsto improvegovernmentprocurement 287, The government could consider full implementation of the Project for Modernization of state purchasing that currently exists. Congress is currently studying a bill to modify procurement legislation, including new procedures which seek to generalize the substantialreductionincosts already achieved. 288. The SICE (Integrated State Purchasing and Contracts System) could be brought into a more general use among the executive units, or at least those within the CentralAdministration. This would facilitate the standardization of procurement procedures and compliance with the country's legal ftamework. Bringing SICE into general use would provide a guarantee of compliance with proceduralrules, such as the obligationto publish on the website and ensure payments by the state are recognized for purchasing. Itwould also allow for a more wide-ranging control ofthe calls for bids and the extension of such calls, an aspect that is currently difficult to control in Uruguay. Generalized implementationofthe system would also be usefkl for keeping suppliersup to date withtheir tax payments, 96 Modernizing thestate (3) -Human resources(Civil Service) management 289. "The greatest weakness in the state apparatus and in the government personnel system in Uruguay is ineflciency. This is not like the situation in other Latin American countries in that it has to do with deficient peflormance by employees and with the low level of their professional profile. The low productivity of personnel is due partly to aspects of organizational culture, people having a second job, and low levels of application to the job, and also very much to the fact that many professionals are working in functions and positions which have little to do with their specific knowledge. jJ8 290. Uruguaystands out among the countries ofLatin America for havinga large 2002, publicsector employment in Uruguay represented23% of totalemployment- percentage of publicemployeesas a percentage of the totalworking population. In downsizing - an 11% reduction of public employees over 1995-2002 as a result of the general government accounting for 16.7%. These high figures follow a period of Administrative Reform that took place in Uruguay in that period. The general government wage bill inUruguay represented9.9% of GDP in2002, above the regional average(7.1%), but below the OECDaverage (11.6%). 291. The reduction in public employment in recent years was not followed by a decrease in the expenses for compensationof employees. Inthe central government, where public employment decreased 5% between 1996 and 2002, there was an increase inwage expensesof2% inrealterms. This canbeexplainedbythe fact that most ofthe savings inthe executive units can be used inside the same executive unit as payment of performance bonuses, or for financing highly specialized positions andlor positions of greater responsibility. 292. The Central Administration's human resources management is heterogeneous and unarticulated with regard to results evaluation. This is particularly true in the area of salaries, which depend to a considerable extent on each individual agency and do not reflect equal pay for equal work or responsibility. Furthermore, wage setting in the public sector may be distorting private labor markets, particularly at the lower end o f skills. According to CEPRE, average hourly pay for public employees is generally higher than (for mediumand lower categories) or the same as (for higher categories) payments to personnel in similar categories in the private sector. In the case of the most highly qualified group of public sector personnel, the average wage is 79% of that paid in the private sector. Nevertheless, if Public Health Ministry employees are excluded, the average hourly wage is 13% higher than in the private sector. The overall compensationreceived by public employees - especially low skilled workers - would be greater if other benefits which public employees enjoy are taken into account (i.e., job security, holidays). 38LaEconomiaPolitica de laReformadel ServicioCivil enUruguay: 10s aiios 90, F. Filgueira,B. Heredia,P. Narbondoand C. Ramos(2002). 97 293. A system of performance incentives (awards) was created in 1996. It established a monetary payment to employees who were rated as "excellent" or "very good". The same evaluation for incentive payments is used for rating the employee's substantive career path. However, a considerable number of executive units have found the system difficult to apply, leading to delays in calculating and paying the awards. From 1998 to 2001, despite havinga budget surplusavailable for incentive awards in 57 executive units, only 40% paid the incentives on time every year. The performance evaluation of public employees in Uruguay appears unrelated to whether (or not) the units to which they belong achieve their targets. Supervisors have used the system of performance management not to promote competition with the aim of achieving an overall improvement, but mainly to maintain, and eventually raise, levels of motivation among acore group ofemployees who are better trained and moreengaged. 294. Further adding to the complexity of incentives in the public administration, public employees in Uruguay have been hired under different regimes. Formal public sector employees (those "budgeted") represented 70% of personnel in the public administration. These employees are part ofthe formal career structure for civil servants and cannot be dismissedwithout authorizationof Congress. This represents a rigidity in the public sector labor force, as dismissal is virtually impossible. The remaining public sector employees are hired on contracts and, althoughthey can be dismissed, inpractice they also have de-facto job security adding to the rigidity of the system, The way different types o f contracts coexists fbrther distorts civil service incentives permanent - contractedemployees function as a parallel structure to the public sector career, involving hiring, appointment, promotionanddismissal. Optionsfor civil service rejiorm 39 295. The followingoptionsfor civilservice reformcould beconsidered: 0 Define which activities are to be provided by permanent employees, and which ones could be executed by temporaries or other categories of employees. This would require a better definition of the regime for permanent employees to ensure consistency betweenthe various public sector employment regimes. 0 -Createset consistent remunerationpolicy. Efforts are neededto include all a "civil service decision committee'' -alongthe same linesas CEPRE to employees inthe RemunerationSystem(SR) inthe CentralAdministration. 0 Extendthe Supervision System for ObjectiveWork Conditions(SCOT) to all units on the Central Administration and implement its direct connection to the payroll. Informationabout attendancegives more control on civil service and shouldhave direct consequenceson the remunerationofemployees. 39Based on Valladares et al. (2004) a backgroundpaper for the civil servicereform chapter of "Uruguay - - Public Expenditure Review", World Bank(forthcoming). 98 0Link performanceevaluation, bonus and promotionto the achievementsof the targets of the executive units. The process o f implementing a budget for results should link the indicators o f efficacy, efficiency and quality of the executive unitto the employee evaluation. 0 Base evaluation of employees on more objective and standardized criteria between all executive units. This is specially relevant within the Central Administration. 0 Increase control over compensation policy to reduce discretion. In order to simplify the remuneration system, with increased control and transparency, the restructuring should decrease the importance of compensation mechanisms inthe total salary. 0 Continue efforts in workforce right-sizing; reallocations should take into account qualifications ofpublic servantsandthe administration's needs. 99 CHAPTERVI: CONCLUSIONS 296. Uruguay has well-educated people, stable and democratic institutions and valuable natural resources. In spite o f declining growth in the last half-century, Uruguay has been able to preserve these assets. A new path to prosperity may be built around these strengths. The fast pace of global change and its own structural transformations, leaveUruguay with the challengeo fembracing a new agenda for growth with equity. As examples inthe region like Chile's "Agenda Pro-Crecimiento" or Ireland inthe EUcontext helpto illustrate, the latter is feasible but will requireda sharedvision, persistenceand determination. Unless shared, the policies and reform options chosenare unlikelyto be well designed, implemented, or be credible. Persistenceand determination are needed because the benefits o f many reforms are unlikely to materialize in the short or even the medium term. Much will depend on the ability o f political, social and business leaders will have to demonstrate strong leadership and determination to implement the program. 297. The most immediate priority for Uruguay is to set the country on a path of fiscal and financial stability - episodesofcontagion, and strengtheningofthe socialsafety net - to protectthe most necessary to avoid new macroeconomic crises or vulnerableinthe face of risinginformalemploymentand increasesin poverty.These are the conditions necessary to consolidate the recovery -making use o f idle factors o f production and reallocating factors to more productive sectors -and for sustained growth with equity. The recovery stage also demands efficient factor markets -capital and labor- to facilitate reallocation o fresources from less productive sectors and companiesto those with greaterpotential. 298. Social security reformwill improveinter-generationalequity and create fiscal space that will make it possibleto strengthensocial programswhile servicing public debt. Fiscal sustainability also requires focusing on a series o f state reforms -including tax and social security revenue administration, the government procurement system, and participation by the private sector in infiastructure -to prevent the pro-cyclical nature o f public spending fiom again creating episodes o fmacroeconomic instability inthe fkture. Although growth is in itself an important determinant o f fiscal sustainability, it would be riskyto assumethat it willtake place inthe absenceo ffkrther structural reforms.. 299. Sustaininggrowth over the mediumterm will requirenew investment;hence the importance of developing a favorable climate for investment including strengthened linkswith the globaleconomy. Uruguay's past prosperity was associated with its traditional comparative advantage in agriculture, an open commercial regime, and sound infiastructure (particularly in railroads and ports). The introduction o f a competitive framework for infrastructure is kndamentalto the improvement o fthe global competitiveness of the country, to raising the welfare o f its citizens, to the creation o f new businessand investment opportunities for the private sector, andto a reduction inthe 100 government's borrowing requirements(inview o fthe significant needs for investment in infrastructure inthe mediumand long term). Sustaininggrowth will also demand strong links to the global economy, including both trade policies that improve access to international markets for Uruguayan exports and an efficient infrastructure to narrow the economic distance from global markets. 300. Maintaining growth depends not only on a favorable investment climate for physical capital but also, and in a related manner, a favorable climate for investment in human capital. Hence the importance o f modernizing education and health policies and institutions to ensure the development of human capital - which, in turn, is intimately linked to policies leading to the development ofan economy basedon knowledge. Sustained economic growth will indeedrequire rapid growth o f total factor productivity led by knowledge and innovation. In addition to creating a favorable environment for development o f the private sector, this will require institutional modernization and development ofa national innovation system in line with the trends in countries that are successfhl innovators. 301. To return to the path of shared prosperity Uruguayans will face difficult tradeoffs and the challenge of committing to deep reforms. 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World Bank, "World Development Indicators",2004. 104 STATISTICAL ANNEX Uruguay: Key Economic Indicators est. 1999 2000 2001 2002 2003 2004 RealSector real growth PA) GDP at market prices -2.8 -1.4 -3.4 -11.0 2.2 12.3 Investment -9.8 -13.0 -9.1 -34.5 18.0 27.0 Exports ofGoods and Services -7.4 6.4 -9.1 -10.3 4.2 22.7 Importsof Goods and Services -5.8 0.1 -7.1 -27.9 5.8 24.5 GDP (billion USD) 20.9 20.1 18.6 12.3 11.2 13.2 shares to GDP (?A) Gross Domestic InvestmentlGDP 15.1 14.0 13.8 11.5 12.6 13.3 DomesticSavingslGDP 13.9 12.3 12.1 13.5 14.1 15.0 Pricesand Inflation CPI inflation (% change) 5.7 4.8 4.4 14.0 19.4 9.2 Nominal exchange rate, p.a. UR$AJS$ 11.3 12.1 13.3 21.3 28.2 28.7 Nominal exchange rate, e.0.p. UR$AJS$ 11.6 12.5 14.8 27.2 29.3 26.4 Realeffectiveexchangerate, 2000=100 99.7 100.0 98.8 78.3 60.3 65.2 Balanceof Payments shares to GDP (?A) Exports ofGoods & Services 16.6 18.2 17.6 21.9 27.6 30.4 Importsof Goods & Services 19.1 20.9 20.1 20.3 24.4 27.8 Net trade inGoods & Services -2.5 -2.7 -2.5 1.6 3.1 2.6 CurrentAccount Balance -2.4 -2.8 -2.7 3.1 -0.5 -0.8 Acummulation ofInternationalReserves 0.1 1.1 1.5 -19.0 12.3 4.3 ExternalDebt, US$bn. 8.3 8.9 8.9 10.5 11.0 11.6 External DebtlGDP(%) 39.5 44.3 48.1 85.9 98.4 87.8 PublicSector Shares to GDP (?A) Revenue 32.2 31.4 32.7 31.1 31.1 29.9 Primary expenditure 34.2 32.9 34.0 31.1 28.4 26.2 Primary balance -2.0 -1.5 -1.2 0.0 2.7 3.8 Interest payments 2.1 2.6 2.9 4.7 6.0 6.0 Overallbalance -4.1 -4.1 -4.2 -4.6 -3.2 -2.2 GrossPublic Sector Debt 30.8 35.5 42.9 83.5 101.5 92.2 GrossPublic Sector Debt, US$ bn, 6.5 7.1 8.0 10.2 11.4 12.2 Source: Uruguayanauthorities andWorld Bank staff estimates. 105 NationalAccounts Shares to GDP (%) est. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 GDPatmarketprices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 GDPa* factor cost 103.0 103.1 102.9 102.3 102.4 104.1 104.8 105.8 106.2 104.7 102.6 Agriculture 7.9 8.6 8.0 7.5 7.0 5.6 6.2 6.1 9.3 13.0 11.7 Industry 28.0 28.9 28.5 28.2 28.6 27.4 27.2 26.4 26.7 27.1 29.3 Services 67.1 65.5 66.3 66.6 66.8 71.1 71.4 73.3 70.2 64.6 61.6 Resourcebalance -0.6 -0.1 -0.2 0.0 -0.7 -1.3 -1.7 -1.7 2.0 1.5 1.7 ExportsofGoods& Services 19.8 19.0 19.7 20.5 19.9 18.0 19.3 18.3 22.0 26.1 29.6 ImportsofGoods& Services 20.4 19.1 19.9 20.5 20.6 19.3 21.0 20.0 20.0 24.6 27.9 Total consumption 84.7 84.7 84.9 84.8 84.9 86.1 87.7 87.9 86.5 85.9 85.0 Generalgovernmentconsumption 11.9 11.8 12.8 12.4 12.5 13.0 13.2 13.7 12.9 11.4 10.8 Privateconsumption, etc 72.9 72.9 72.1 72.4 72.3 73.1 74.5 74 2 13.6 14.6 74.2 Grossdomestic investment 15.9 15.4 15.2 15.2 15.9 15.1 14.0 13.8 11.5 12.6 13.3 Gross domesticfixed investment 14.5 13.5 14.0 14.4 15.2 14.5 13.2 12.5 10.1 9.4 11.4 Changeinstocks 1.3 1.9 1.3 0.8 0.7 0.6 0.8 1.3 1 4 3.2 1.9 Net incomefromabroad -1.8 -1.6 -1.4 -1.4 -1.4 -1.4 -1.4 -2,I -1.0 -4.5 -4.2 Netcurrenttransfersfromabroad 0.2 0.4 0.4 0.3 0.3 0.4 0.3 0.3 0.7 0.7 0.7 Grossdomestic savings 15.3 15.3 15.1 15.2 15.1 13.9 12.3 12.1 13.5 14.1 15.0 Grossnationalsavings 13.4 13.7 13.7 13.8 13.8 12.5 10.9 10.0 12.5 9.6 10.8 Grossnationalproduct 98 2 98.4 98.6 98.6 98.6 98.6 98.6 97.9 99.0 95.5 95.8 Grossnationaldisposable income 98.4 98.8 99.0 98.9 98.9 99.0 98.9 98.2 99.7 96.2 96.5 Source: Uruguayan authorities. NationalAccounts Realgrowthrates(%) est. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 GDPat marketprices 7.3 -1.4 5.6 5.0 4.5 -2.8 -1.4 -3.4 -11.0 2.2 12.3 GDPat factorcost 5.7 -0.9 5.1 4.3 4.5 -1.0 -1.1 -2.7 -7.8 0.3 9.2 Agriculhue 11.8 5.5 9.4 -6.1 5.2 -7.5 -3.0 -7.1 5.1 10.6 12.8 Industry 3.7 -2.5 3.3 5.7 4.8 -5.0 -2.3 -6.1 -12.8 0.9 16.1 Senices 5.7 -1.3 5.1 5.8 4.3 2.0 -0.2 -0.5 -7.7 -1.6 6.0 ExportsofGoods& Services 15.1 -1.9 10.3 13.0 0.3 -7.4 6.4 -9.1 -10.3 4.2 22.7 ImpoltsofGoods& Senices 18.3 -3.0 11.3 ' 13.2 7.6 -5.8 0.1 -7.1 -27.9 5.8 24.5 Totalconsumption 8.3 -3.2 7.8 5.4 6.4 -1.3 -1.4 -2.1 -15.9 1.1 11.4 Generalgovernmentconsumption 4.5 0.2 5.0 2.3 4.0 0.6 6.3 -2.9 -9.3 -4.8 2.5 Privateconsumption 8.9 -3.7 8.3 5.9 6.8 -1.5 -1.6 -2.0 -16.9 2.0 12.8 Grossdomesticinvestment 12.8 4.6 -1.0 8.3 12.1 -9.8 -13.0 -9.1 -34.5 18.0 27.0 Grossdomesticfixedinvestment 6.3 -5.0 10.2 10.2 7.7 -8.1 -13.1 -9.4 -32.5 -11.4 32.0 Changeinstocks 138.3 88.0 -50.1 -9.9 64.4 -23.4 -12.0 -6.2 -52.3 386.6 15.5 Source: Uruguayanauthorities. 106 Uruguay: Balanceof Payments est. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 million dollars ExportsofGoods& Services& IncomeReceipts 3530 3911 4308 4808 4779 4241 4441 4095 3146 3298 4143 ExportsofGoods& Services 3248 3507 3847 4168 4061 3478 3660 3262 2693 3084 4012 Exportsof Goods 1913 2148 2449 2793 2829 2291 2384 2139 1922 2281 3025 ExportsofServices 1335 1359 1399 1375 1232 1187 1276 1123 771 803 987 ImportsofGoods& Services& IncomePayments 4010 4200 4624 5130 5277 4793 5035 4622 2836 3439 4337 ImportsofGoods& Services 3485 3568 3974 4390 4471 3997 4193 3722 2492 2734 3675 ImportsofGoods, f.0.b. 2600 2711 3135 3498 3601 3186 3311 2915 1874 2098 2990 Importsof Services 885 858 839 892 870 810 882 807 618 636 685 Trade balance -686 -563 -687 -705 -772 -896 -927 -775 48 183 35 Nettrade inGoods& Services -237 -62 -127 -222 -410 -519 -533 -459 202 350 337 Incomereceipts 282 404 461 640 718 762 782 833 453 214 131 Incomepayments 525 631 649 740 806 796 842 901 344 705 661 Total interestdue 287 345 355 404 440 728 753 798 660 592 524 Other incomepayments 238 287 295 336 366 68 89 102 -315 113 137 Netincomereceipts -243 -227 -189 -100 -88 -34 -61 -68 109 -491 -531 Totalcurrenttransferreceipts 49 84 91 83 15 55 48 48 84 91 99 Totalcurrenttransfer payments 8 8 8 9 16 5 21 18 12 8 10 Nettotalcurrenttransfers 41 76 83 74 59 50 27 30 72 a2 89 Current Account Balance -439 -213 -234 -248 -439 -502 -566 -498 382 -58 -105 Source: Uruguayanauthorities. Uruguay: ExternalTrade est. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 millions of dollars Trade Balance -873 -769 -938 -1001 -1042 -1120 -1176 -1003 -103 8 35 Exports Total Merchandise Exports(fob, US$) 1913 2106 2397 2726 2769 2237 2290 2058 1861 2198 3025 Total Primary Commodities 958 1126 1327 1502 1502 1257 1233 1091 1077 1358 1750 Meat 489 562 631 729 729 673 699 514 543 688 887 Vegetables 248 304 408 478 478 354 255 293 270 385 497 Oils and Fat 9 9 13 16 13 11 15 8 12 17 21 Leather 212 251 276 278 249 218 264 276 251 268 345 Manufactures 956 980 1070 1224 1267 980 1057 967 784 840 1083 percenaiagechange Total MerchandiseExports 10.1 13.8 13.7 1.6 -19.2 2.4 -10.2 -9.6 18.1 37.6 Merchandise ExportsQuantity Index (% change) 15.1 -1.9 10.3 13.0 0.3 -7.4 6.4 -9.1 -10.3 4.2 22.7 Imports Total MerchandiseImports (cif, US$) 2786 2875 3336 3727 3811 3357 3466 3061 1964 2190 2990 Food 254 262 304 340 347 306 316 279 179 200 264 Other Consumer Goods 594 616 693 764 817 725 767 732 506 478 631 POLand Other Energy 320 340 452 492 512 490 462 469 342 381 503 IntermediateGoods 598 669 805 817 727 787 948 756 543 784 1034 Primary . 432 468 588 563 469 552 700 529 384 585 772 Manufactures 166 201 217 254 258 235 248 227 159 198 262 CapitalGoods 1020 987 1081 1314 1406 1050 973 824 394 349 460 percentagc!change Total Merchandise Imports 3075 3377 3723 3847 3751 3323 3431 3030 1945 2168 2960 Merchandise Imports Quantity Index (% change) 18.3 -3.0 11.3 13.2 7.6 -5.8 0.1 -7.1 -27.9 5.8 24.5 Source: Uruguayan authorities. 107 Uruguay: ExternalDebt est. 1999 2000 2001 2002 2003 2004 US$miIIion I.By debtor Total Gross ExternalDebt 8261 8895 8937 10548 11012 11597 NonFinancial Public Sector 4733 5301 5208 7737 8787 9175 Central Government 4120 4697 4586 7161 8200 8632 Local Governments 83 105 128 136 147 151 Public Enterprises 530 499 494 440 440 392 CentralBankofUruguay 858 791 621 562 770 1034 Public Banks 26 24 26 28 27 25 Private Sector 2644 2779 3082 2221 1428 1363 2. By Creditor Total Gross ExternalDebt 8261 8895 8937 10548 11012 11597 Official Creditors 2414 2534 2551 4780 5650 5900 Multilateral 1922 2109 2223 4503 5427 5721 Bilteral 492 425 328 277 223 179 PrivateCreditors 5129 5508 5434 5110 4925 5265 Financial Sector 4637 5033 4953 4627 4371 4702 ComercialBanks 2239 2185 2234 1672 804 722 Other 2398 2848 2719 2955 3567 3980 Non-Financial Sector 492 475 481 483 554 563 Private 0 2 3 0 0 0 Suppliers 492 473 478 483 554 563 Other 718 853 952 658 437 432 * 3. By Instrument Total External Debt 8261 8895 8937 10548 11012 11597 Public Bonds 3042 3441 3150 3365 3723 4123 Bonds 2398 2848 2719 2955 3567 3980 Brady Bonds 644 593 431 410 156 143 InternationalLoans 2496 2603 2625 4881 5709 5949 Suppliers 493 474 478 483 554 563 Net Deposits 1513 1525 1729 1161 590 530 Other 717 852 955 658 437 432 Memo: Total External DebdGDP (YO) 39.5 44.3 48.1 85.9 98.4 87.8 Total External DebtExports G&S (YO) 237.5 243.1 274.0 391.6 357.1 289.0 Source: Uruguayanauthorities. 108 Uruguay: Public Sector Finances InUR$millions 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Revenue 26463 36998 48688 61739 76592 76427 76347 80866 81137 98180 113574 Tax revenue 16814 23471 31821 42334 50044 50030 50774 54008 57831 70096 83002 Socialsecurity contributions 6214 8548 10491 12185 14350 14967 14879 14381 12836 11794 12865 Nontaxrevenue 1298 1539 2156 2383 6352 6505 5849 5250 5274 6200 7831 Operatingsurplus ofpublicenterprises 2137 3440 4220 4837 5846 4925 4845 7227 5196 10090 9876 Primary expenditure 27322 36108 47894 60674 74378 81192 79964 83954 81065 89529 99349 Wages andsalaries 5582 7605 10876 13290 16016 17026 17221 18074 18158 19701 23416 Goods andservices 3730 5231 6237 7923 11510 13120 11260 12833 12057 15031 16297 Transfers 13572 18548 25074 31994 37007 40936 43053 43964 44437 46989 50333 SocialSecurity 11763 17116 23299 30391 35622 39558 40992 41907 42818 44218 47395 Other 1809 1432 1775 1603 1385 1378 2061 2057 1619 2771 2938 CapitalExpenditure 4438 4724 5707 7467 9845 10110 8430 9083 6413 7808 9303 Primary balance -859 890 794 1065 2214 -4765 -3617 -3088 72 8651 14225 Interestpayments 1726 2593 3187 3998 4463 4867 6308 7276 12163 18881 22666 Overall balance -2585 -1703 -2393 -2933 -2249 -9632 -9925 -10364 -12091 -10230 -8441 Source: Uruguayan authorities. Uruguay: Public Sector Finances As a percentageofGDP 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Revenue 30.0 30.2 29.8 30.1 32.7 32.2 31.4 32.7 31.1 31.1 29.9 Tax revenue 19.1 19.2 19.5 20.7 21.4 21.1 20.9 21.8 22.2 22.2 21.9 Social security contributions 7.1 7.0 6.4 5.9 6.1 6.3 6.1 53 4.9 3.7 3.4 Nontaxrevenue 1.5 1.3 1.3 1.2 2.7 2.7 2.4 2.1 2.0 2.0 2.1 Operatingsurplusofpublic enterprises 2.4 23 2.6 2.4 2.5 2.1 2.0 2.9 2.0 3.2 2.6 Primary expenditure 31.0 29.5 29.3 29.6 31.7 34.2 32.9 34.0' 31.1 28.4 262 Wages andsalaries 6.3 6.2 6.7 6.5 6.8 7.2 7.1 7.3 7.0 6.2 6.2 Goodsandservices 4.2 4.3 3.8 3.9 4.9 5.5 4.6 5.2 4.6 4.8 4.3 Transfers 15.4 15.1 15.3 15.6 15.8 17.3 17.7 17.8 17.0 14.9 13.3 SocialSecurity 13.3 14.0 14.2 14.8 15.2 16.7 16.9 17.0 16.4 14.0 12.5 Other 2.1 1.2 1.1 0.8 0.6 0.6 0.8 0.8 0.6 0.9 0.8 CapitalExpenditure 5.0 3.9 3.5 3.6 4.2 4.3 3.5 3.7 2.5 2.5 2.5 Primary balance -1.0 0.7 0.5 0.5 0.9 -2.0 -1.5 -1.2 0.0 2.7 3.8 Interestpayments 2.0 2.1 1.9 2.0 1.9 2.1 2.6 2.9 4.7 6.0 6.0 Overall balance -2.9 -1.4 -1.5 -1.4 -1.0 4.1 -4.1 -4.2 -4.6 -3.2 -2.2 Source: Uruguayanauthorities. 109 Uruguay: Financial System 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 millions ofpesos Net ForeignAssets 22784 29879 41600 51807 29683 32261 35507 45898 20831 48809 55431 NetMmestic Credit 30224 44071 57203 73143 115139 129824 131699 141894 243488 224075 223278 To Government 5940 7269 7758 7419 7418 11261 7170 7975 69456 83537 83240 GovernmentBudget 2312 2555 2102 961 1215 5025 920 1022 56766 73467 73206 Other OEcial Entities 3628 4714 5656 6458 6202 6236 6250 6952 12690 10070 10034 To RestofEconomy 24285 36802 49445 65724 107721 118564 124529 133920 174032 140538 140038 PrivateSector 21027 32392 43843 58630 96094 105766 111088 119465 155248 125369 124923 Other!inancia1institutions 3258 4410 5602 7094 11627 12797 13441 14455 18784 15169 15115 TotalAssets& Liabilities 53008 73950 98803 124950 144822 162085 167206 187793 264319 272884 278709 Money andQuasimoney 33259 46243 63147 81059 102777 116221 124540 148169 189915 213574 218133 Other Liabilities 19749 27707 35656 43891 42045 45864 42665 39623 74404 59310 60576 million dollar NetForeignAssets 4517.1 4706.1 5218.4 5487.0 2834.5 2845.1 2934.5 3446.1 979.9 1730.3 1931.2 NetDomestic Credit 5992.2 6941.4 7175.7 7746.7 10994.9 11449.4 10884.2 10653.5 11454.5 7943.4 7778.7 To Government 1177.7 1144.9 973.2 785.8 708.3 993.1 592.5 598.7 3267.4 2961.4 2900.0 GovernmentBudget 458.4 402.4 263.7 101.8 116.1 443.1 76.0 76.7 2670.5 2604.4 2550.4 OtherOfficialEntities 719.3 742.5 709.5 684.0 592.3 550.0 516.5 522.0 597.0 357.0 349.6 To RestofEconomy 4814.7 5796.5 6202.5 6961.0 10286.6 10456.3 10291.6 10054.8 8187.0 4982.0 4878.7 PrivateSector 4168.8 5101.9 5499.8 6209.6 9176.3 9327.6 9180.8 8969.5 7303.4 4444.3 4352.1 Otherfinancial institutions 645.9 694.6 702.7 751.3 1110.3 1128.6 1110.8 1085.3 883.7 537.7 526.6 TotalAssets & Liabilities 10509.3 11647.5 12394.1 13233.7 13829.5 14294.5 13818.6 14099.6 12434.4 9673.6 9709.9 Money andQuasimoney 6593.9 7283.5 7921.3 8585.1 9814.5 10249.7 10292.6 11124.7 8934.2 7571.1 7599.5 Other Liabilities 3915.4 4364.0 4472.8 4648.6 4015.0 4044.8 3526.0 2975.0 3500.2 2102.5 2110.4 shares to GDP (76) Net ForeignAssets 25.8 24.4 25.4 25.3 12.7 13.6 14.6 18.6 8.0 15.5 14.6 Net Domestic Credit 34.3 36.0 35.0 35.7 49.1 54.7 54.2 57.4 93.3 71.0 58.9 To Government 6.7 5.9 4.7 3.6 3.2 4.7 3.0 3.2 26.6 26.5 21.9 GovernmentBudget 2.6 2.1 1.3 0.5 0.5 2.1 0.4 0.4 21.8 23.3 19.3 Otherofficial Entities 4.1 3.8 3.5 3.2 2.6 2.6 2.6 2.8 4.9 3.2 2.6 To Restof Economy 27.6 30.0 30.2 32.1 46.0 50.0 51.2 54.2 66.7 44.5 36.9 Private Sector 23.9 26.4 26.8 28.6 41.0 44.6 45.7 48.3 59.5 39.7 32.9 Other financial institutions 3.7 3.6 3.4 3.5 5.0 5.4 5.5 5.8 7.2 4.8 4.0 TotalAssets & Liabilities 60.1 60.4 60.4 61.0 61.8 68.3 68.8 76.0 101.3 86.4 73.5 Money andQuasimoney 37.7 37.7 38.6 39.6 43.9 49.0 51.2 59.9 72.8 67.7 57.5 Other Liabilities 22.4 22.6 21.8 21.4 17.9 19.3 17.6 16.0 28.5 18.8 16.0 MemorandumItems: NetForeignAssets(end year US%)- 3204 3429 4143 4789 2556 2578 2404 1687 711 1852 1908 Source: International Financial Statistics, IMF. 110