Documentof The World Bank FOROFFICIAL USE ONLY ReportNo. 44841-UY INTERNATIONAL BANK FORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSEDLOAN INTHE AMOUNT OFUS$400MILLION TO THE ORIENTAL REPUBLICOFURUGUAY FORA SECONDPROGRAMMATIC REFORMIMPLEMENTATIONDEVELOPMENT POLICY PROGRAM December22,2008 PovertyReductionand EconomicManagement Argentina, Chile, Paraguayand UruguayCountry ManagementUnit LatinAmerica andthe CaribbeanRegion This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Rank aiithnrimtinn. ORIENTAL REPUBLICOF URUGUAY SOCIAL PROGRAM DEVELOPMENT POLICYLOAN URUGUAY -GOVERNMENT FISCALYEAR January 1-December 31 CURRENCY EQUIVALENTS (ExchangeRate Effective as of as ofDecember 17,2008) Currency Unit =UruguayanPesos US$1.OO =UR$24.4 WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS ABBREVIATIONAND ACRONYMS AFAP Administradorade Fondosde Ahorro DGI DireccionGeneralImpositiva(GeneralTax Previsional(Pension FundAdministrators) Directorate) AFISAS Administradoresde Fondosde Inversion DMV Division de Mercadode Valores y Control de (pensionfund administrators) Administradorade Fondosde Ahorro AIN Auditoria Intemade laNacion(National Provisional(Uruguay's SecuritiesMarket InternalAudit Office) Regulator) ANTEL AdministracionNacionalde DPL DevelopmentPolicy Loan Telecomunicaciones(State-ownedTelecoms EMBI EmergingMarketsBond Index Company) FA Family Allowance ANCAP AdrninistracionNacionalde Combustibles, FF FideicomisosFinancieros(trust funds) Alcoholesy Portland(state-ownedpetroleum FLAR Fondo Latinoamericanode Reservas company) GDP Gross DomesticProduct ANV AgenciaNacionalde Vivienda (Housing GEF Global EnvironmentalFacility Agency) GOU Government o f Uruguay BCU Banco Centralde Uruguay(CentralBank of IAS InternationalAccountingStandards Uruguay) IASB InternationalAccountingStandardBoard BHU Banco Hipotecariodel Uruguay (National IASS Impuesto de Asistenciaa la Seguridad Social MortgageBank) (social securitytax) BIS Bank for InternationalSettlements IBRD InternationalBank for Reconstructionand BPC Base de PrestacionesContributivas Development BPS Banco de PrevisionSocial(Social Security IBTAL InstitutionsBuilding TechnicalAssistance Entity) Loan BSE Bancode Segurosdel Estado(the State ICA InvestmentClimate Assessment InsuranceCompany) IDB Inter-AmericanDevelopmentBank BVM Bolsade Valores de Montevideo IFRS InternationalFinancialReportingStandards (MontevideoStock Exchange) IMF InternationalMonetaryFund CAF CorporacionAndinade Foment0 IMPEQUE Impuestoalas PequefiasEmpresas CAS CountryAssistance Strategy IOSCO InternationalOrganizationof Securities COFIS Impuestode Contribucionai Financiamiento Commissions de la SeguridadSocial(SocialSecurity IRP Impuestoalas RetribucionesPersonales FinancingContributionTax) (Wage Tax) IRNR Rentade No Residentes CPAR CountryProcurementAssessment Report (residentincometax) CPI Consumer PriceIndex IRPF Impuesto a la Rentade la PersonasFisicas CPNCA ComisionPermanentede NormasContables (PersonalIncomeTax) Adecuadas(PermanentCommissionof MEF Ministerio de Economiay Finanzas(Ministry AccountingNorms) of EconomyandFinance) CPSS Committeeon Paymentand Settlement MVOTMA Ministerio de Vivienda, Ordenamiento Systems Territorial y Medio Ambiente(Ministry of DDO Draw-downOption Housing,Planningandthe Environment) DINAMA Direccion Nacionalde Medio Ambiente NPL Non-PerformingLoan (National EnvironmentDirectorate) FOROFFICIAL USE ONLY ONS obligaciones negociables (private bond RTGS Real Time Gross Settlement issues) SIIF Superintendencia de Instituciones de OSE Obras Sanitarias del Estado Intermediacion Financiera (Bank PANES Plan de Asistencia Nacional a la Emergencia Superintendency) Social (National Attention Plan for the Social SPDL Social Program Development Policy Loan Emergency) SME Small- and Medium-Scale Enterprise PFM Public Financial Management SSAL Social Sectors Special Structural Loan PIT Personal Income Tax TCR Tribunal de Cuentas de la Republica (Court PRIDPL Programmatic Reform Implementation o f Accounts) Development P o k y Loan U C A Unidad Central de Aquisiciones PSIA Poverty and Social Impact Assessment UTE Administracion de Usinas y Transmisiones REC Registro de Estados Contables (Registrry of Electricas (State-owned electricity company) Financial Statements) VAT Value-Added Tax ROSC Report on the Observance of Standards and Codes Vice President: Pamela Cox Country Director: Pedro Alba Sector Director Marcel0 Giugale Sector Manager: Rodrigo Chaves Co-Task Team Leader: James Parks Co-Task Team Leader: EmilySinnott This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. ACKNOWLEDGEMENTS The Second Programmatic Reform Implementation Development Policy Loan (PRIDPL 11) was prepared by a team led by James Parks and Emily Sinnott. Preparation o f the business climate and capital markets component o f the loan was ledby Mario Guadamillas, and the social protection component by Rafael Rofman. The team also included Mariela Alvarez, Enrique Fanta, Maria Ines Ferres, Henri Fortin, Martha Garcia, Michael Geller, Pilar Gonzalez, Jose Janeiro, Ana Lariau, Dolores Lopez-Larroy, Maria Masutti, Juan Martin Moreno, Carla Pantanali, Luis de la Plaza, Adolfo Rouillon, Sylvia Albela Russo and David Yuravlivker. The team gratefilly acknowledges the support and guidance o f Pedro Alba, Rodrigo Chaves, Lily Chu, Todd Crawford and Marcel0 Giugale and the reviewers o f the Regional Operations Committee who provided valuable comments. The peer reviewers were Eduardo Ley and DavidRosenblatt. The team acknowledges and is grateful for the collaboration o f the Uruguayan authorities. ORIENTAL REPUBLICOFURUGUAY DEFERREDDRAW-DOWNOPTION TABLE OFCONTENTS LoanandProgramSummary................................................................................................................ i I Introduction............................................................................................................................... . 1 I1 . CountryContext........................................................................................................................ 1 11.1Political Context ................................................................................................................... 1 11.2 Recent Economic Developments.......................................................................................... 2 11.3 Macroeconomic Outlook and Debt Sustainability .............................................................. 12 111 . The Government'sProgram.................................................................................................. 16 IV. Bank Supportto the Government'sProgram...................................................................... 17 IV.lLinkto CAS...................................................................................................................... 17 IV.2 Analytical Underpinnings................................................................................................. 19 IV.3 Collaboration with the IMF and the KDB.......................................................................... 22 IV.4 Relationshipto Other Bank Operations ............................................................................ 23 IV.5 Lessons Learned ............................................................................................................... 24 V. The ProposedOperation........................................................................................................ 25 V.1Operation Description........................................................................................................ 25 V.2 Policy Areas ....................................................................................................................... 30 Reforming the Tax System-Component I1....................................................................... 30 Business Climate and Capital Markets Reform-Component I11...................................... 31 Social Protection-Component IV..................................................................................... 36 VI. OperationImplementation..................................................................................................... 38 VI.l Poverty and SocialImpact ................................................................................................ 38 VI.2 Environment. Forest. and Natural Resources.................................................................... 39 VI.3 Participation...................................................................................................................... 40 VI.4 Implementation. Monitoring. and Evaluation................................................................... 40 VIS Fiduciary Aspects ............................................................................................................. 41 VI.6 Disbursements and Auditing............................................................................................. 42 VI.7 Risksand RiskMitigation................................................................................................. 43 Annex 1.Uruguay PRIDPL 11: Policy Matrix........................................................................................ 45 Annex 2.Description o f Status of Triggers for PRTDPL I1.................................................................... 53 Annex 3 Tax ReformPSIA .................................................................................................................... 65 Annex 4.Letter of DevelopmentPolicy (inSpanish) ............................................................................ 71 EnglishTranslation................................................................................................................ 98 Annex 5.FundRelationsNote............................................................................................................. 121 Annex 6. Uruguay-Key Economic Indicators................................................................................... 127 Annex 7. Uruguay-Key Exposure Indicators .................................................................................... 129 Annex 8.Uruguay At-A-Glance .......................................................................................................... 131 Annex 9. Map of Uruguay: IBRDMap 33507......................................................................... back cover TABLES Table 1. Uruguay: Macroeconomic Indicators........................................................................................ 2 Table 2.Uruguay: Selected Social Indicators. 2001-2008 .................................................................... 11 Table 3.Uruguay: Baseline Macroeconomic Projections. 2008-201 1.................................................. 12 Table 4.Uruguay: Public Sector FinancingRequirements. 2008-201 1................................................ 14 Table 5.Uruguay: Public Sector Debt Sustainability Indicators. 2008-20 11........................................ 15 Table 6. LinkBetween PRIDPL I1Components and CAS Outcomes ................................................... 18 Table 7. PRIDPL 11-Supported Policy Reforms and IBTAL Institutional Support ............................... 23 Table 8. Status of Triggers and Prior Actions for PRIDPL I1................................................................ 26 Table 9.Evolution of Capital Market Activity (US$ Million. unless otherwise stated) ........................ 58 Table 10.Inequality of Measures Are Estimatedto Fall Following the Tax Reform............................ 70 FIGURES Figure 1. Uruguay: Economic Recovery.................................................................................................. 3 Figure 2.Uruguay: Strong Export Performance ...................................................................................... 4 Figure 3.Uruguay: Public Debt Achievements and Remaining Vulnerabilities...................................... 7 Figure 4.Uruguay: Financial Sector Recovery........................................................................................ 9 Figure 5.Uruguay: Investment .............................................................................................................. 10 Figure 6.BPS Contributors and Family Allowances Beneficiaries, 1995-2007 ................................... 11 Figure 7.Mean Tax Rate on Labor Income IRP and IRPF (percent) .................................................... 66 Figure 8.Mean Indirect Tax Rate (IVA + COFIS) on HouseholdsBefore and After The Tax Reform by Decile (percent) ..................................................................................... 67 Figure 9.Tax Burdenas a Share o f Per Capita Pre-Tax Income: Comparison Between the Pre-ReformRegime and the Post-Reform Situation......................................... 67 Figure 10. Variation o f HouseholdDisposable Income Before and After the Tax Reform (percent) ...68 BOXES Box 1.Debt Management Strategy. 2008 .............................................................................................. 14 Box 2. Good Practice Principles on Conditionality ............................................................................... 28 Box 3. Reforming the Tax System......................................................................................................... 30 Box 4. Capital Markets Promotionand RegulatoryFramework............................................................ 32 Box 5. Reform o f Payments and Securities Settlement Systems ........................................................... 33 Box 6.Bankruptcy Reform.................................................................................................................... 34 Box 7.Information Transparency and Disclosure ................................................................................. 36 Box 8. Strengthening Social Protection................................................................................................. 37 Box 9.Family Allowance System inUruguay....................................................................................... 37 LOANAND PROGRAMSUMMARY ORIENTAL REPUBLIC OF URUGUAY DEFERREDDRAW-DOWNOPTION ~~ Borrower The Oriental Republic o fUruguay Implementing Agency Ministryo fEconomy andFinance Terms: The proposed IBRD loan will be a commitment-based, variable spread loan andbe payable in20.5 years, including15 years grace. Financing Data Front end fee: 0.25% o f loan amount to be paid up front from Borrower's own proceeds. Amount: US$400million The proposed development policy loan using the deferred draw-down option (DDO) would be the second and final operation in the Uruguay Programmatic Reform Implementation Development Policy Loan (PRIDPL) series. The amount o f the Loan Operation Type i s to be made available for disbursement in various draw-downs o f a single tranche following effectiveness. In line with priorities set by the government, the proposed Second Programmatic Reform Implementation Development Policy Loan (PRIDPL 11) follows from the previous operation to continue supporting the implementation o f reforms in three key M a i n Policy Areas policy areas: (i) reform; (ii) business climate and capital markets; and (iii) tax the the social protection system where the loan builds on the achievements of the Social Program Development Policy Loan (SPDPL). The key outcome indicators, as detailed in the Policy Matrix in Annex 1, are as follows: ' Tax reform. Create a simpler, more efficient and equitable tax structure, while maintaining government revenues at the level to meet the overall balance target necessary for macroeconomic stability. Business climate and capital markets development. Increase the quality and quantity o f investment, and thereby contribute to growth, through the (i) establishment o f an institutional, legal and regulatory, and infrastructure K e y Outcome framework that provides for a safe and efficient market infrastructure; (ii) reform o f payments and securities settlement systems to improve safety and Indicators efficiency; (iii) modernization o f the legal framework for bankruptcy inorder to provide for efficient and timely resolution o f problem enterprises; and (iv) . improvement o f information transparency in the corporate and financial sector (public and private). Improving the social protection system. Expand and consolidate the social protection system, reinforcing the protection o f the poor and vulnerable; and increase efficiency, transparency and accountability o f social protection institutions. The PRIDPL operations are a cornerstone o f the Uruguay CAS. Development policy lending under the CAS is intended to support government policies in public sector Program Development management, financial sector reform and social programs reform. Objective(s) and Contributionto CAS The proposed PRIDPL I1operation is consistent with the three main objective o f the CAS, namely: (i) reduce vulnerability o f Uruguay's economy; (ii) economic sustain growth; and (iii) improve living standards. As the centerpiece o f the CAS lending 1 program, the PRIDPL program targets all three objectives. Interms o f specific actions, the proposed PRIDPL I1focuses on three areas: (i) implementation o f the tax reform; (ii)firstsetofmeasurestoimprovethebusinessclimateandinitiatethedesignofa a program to promote capital markets development; and (iii) implementation o f on- goingmeasures to improve the social security system. These three areas are consistent with the broader reform agenda set out in the CAS. The tax reform supported by PRIDPL I1 i s the cornerstone o f the government's tax administration and tax policy reforms. The measures identified to improve the business climate and promote capital markets are aligned with the financial sector and capital market reform goals set out in the CAS. Finally, the social protection component builds o n the Social Program Development Policy Loan (SPDPL) presented to the Board with the CAS. The overall risk associated with the PRIDPL I1is considered moderate. The risks can be classified as those related to country context, which consists of economic, political and social risks, and as those related to the PRIDPL I1program, which correspond to managerial, sustainability and outcome risks with regard to program implementation. Economic risks. There are continued high economic risks. The public sector debt remains high and is subject to exchange rate risk. The country remains vulnerable to external shocks. A small open economy, the implications o f a global economic slowdown could be substantial for the real sector in Uruguay. Currency mismatch in the financial sector remains significant, despite the decline in dollarization, the increase in the peso's creditability and the return o f capital to Uruguay. An adverse movement in global interest rates or regional exchange rates would cause stress to the public and financial sectors. T o mitigate these risks, the government has focused on reducing public sector debt vulnerability through: a track record of strong commitment to fiscal prudence following the 2002 crisis; and active debt management policies to reduce medium-term borrowing requirements and issue more peso-indexed private and public sector debt. The strategy o f the government to reduce these risks i s to sustain macroeconomic stability and continue reforms to strengthen the financial system. Continued fiscal discipline and higher-than-historical economic growth will remain central to reducing vulnerabilities. Political risks. The political risks are evaluated as moderate. Political risks relate to the potential for a reversal o f the current policies in the event o f a substantial external shock or change o f government following the 2009 elections. The PRIDPL I1program is country-driven and supports the key reforms identified by government as priority. The political risk i s fiuther mitigated by the efforts o f the government to buildsupport for the policy reforms included in the PRIDPL I1operation, in line with Uruguay's tradition o f consensus building. Social risks. The main social risk is presented by the potential for labor relations to worsen, particularly if growth rates slow. The government's expansion o f social protection programs and its augmentation o f social spending, particularly in the areas of health and education, offset the risks o f labor unrest as does the government's commitment to collective bargaining and to raising real wages to pre-crisis levels. Managerial risks. Managerial risks for the PRIDPL I1 operation relate to potential difficulties in implementing new programs, particularly the tax reform, and operating information systems because o f possible shortages o f trained human resources. This risk is mitigated by government efforts to strengthen capacity in key implementing agencies and in the executive branch overall. The IBTAL operation that that accompanied the PRIDPL Ito the Board in M a y 2007, together with related technical assistance from other donors, is providing strong support for the implementation o f information systems and processes related to the implementation o f PRIDPL policies. The managerial risks are evaluated as low. .. 11 In the area o f capital markets reforms, the sustainability risks are particularly significant as the reforms are still inprogress and the timetable for the reformprogram i s less clearly defined. Inthe area o f tax reform, there is a residual risk that the reform may be reversed. However, the government has a track record o f coming up with policy solutions to meet controversy with regard to the tax reform. There are significant outcome risks across the capital markets and business climate reform components o f the PRIDPL 11 operation. The outcomes o f these reforms depend not only o n the government, but also on the private sector response. For example, the implementation of a new capital markets reform law may not be sufficient to induce a substantial rise in market activity on the part o f the private sector. Operation ID PE-P106724-LEN-BB ... 111 iv ORIENTAL REPUBLICOFURUGUAY SECONDPROGRAMMATIC REFORMIMPLEMENTATION DEVELOPMENT POLICY LOAN I.INTRODUCTION 1. The proposeddevelopment policy loan (DPL) usingthe deferred draw-down option (DDO) would be the second operation in the Programmatic Reform Implementation Development Policy Loan (PRIDPL) series. The PRlDPL series supports the implementation o f priority economic and social sector reforms as determined by the government. The amount o f the PRIDPL I1 to the Oriental Republic o f Uruguay would be US$400 million. In line with priorities set by the government, the PRIDPL I1would support the implementation o f reforms in three key areas: (i) reform; (ii) business climate and capital markets; and (iii) social tax the the protection system. The US$lOO million PRIDPL I'was disbursed in local currency inMay 2008, as the World Bank became the first foreign issuer to launch a public bond in inflation-indexed Uruguayan pesos. This was the first time that the World Bank has issued a local currency bond for the purpose o f a back-to-back disbursement o f a specific loan and the local currency disbursement contributed to Uruguay's strategy o f de-dollarizing public debt. 2. The move from the DPL envisagedin the CAS to a DPL with a DDO is warranted by the changed financing position of the Government of Uruguay. The medium-term financing needs o f the public sector have fallen substantially due to successful debt re-profiling operations. The government is following a debt strategy focused on obtaining contingent credit financing inorder to meet resource needs incase o f a macroeconomic shock. This has become an increased priority as global economic turbulence continues. The DPL DDO instrument would make resources available to be drawn down on request, unless the borrower has received prior notification from the Bank that one or more draw-down conditions are not met and that a subsequent review is necessary. 11. COUNTRY CONTEXT 11.1.POLITICAL CONTEXT 3. Since taking office in 2005, PresidentTabarC Vazquez's administrationhas largely delivered on its economic program. This outcome is based on achieving macroeconomic stabilization through fiscal discipline, and on pursuing social justice by enhancing social protection and increasing equity. The steady economic growth and overall improvement in the economic situation have helped maintain a relatively high level o f support for the government and the ruling Frente Amplio coalition, which is now nearing the final year o f its five year mandate (2005-2010). The presidential candidates are due to be selected inthe first halfo f 2009, and the Frente Amplio and the two main traditional parties are already considering potential candidates. The presidential and parliamentary election is due to take place in October 2009, with the next administration taking office in2010. The build-upto the elections is likely to result 1. The PRIDPL Ioperation was approved by the Board on May 22,2007 (Report No. 38885-UY). 1 in a reduction in legislative activity and major reforms should not be expected to go through Parliament after end-2008. 11.2. RECENTECONOMIC DEVELOPMENTS 4. Growth performance has exceeded expectations, averaging 8 percent over 2005- 2008, and allowing Uruguay to consolidate economic gains made since the 2002 crisis (Table 1 and Figure 1). Real GDP surpassed its pre-crisis peak o f 1998 by end-2006. Unemployment declined in 2008 to its lowest rate in over a decade, falling from an average o f 13.1 percent in 2004 to 7 percent in October 2008. Growth has been driven by a rebound in domestic demand from 2004 onwards due to rising private consumption spurred on by declining unemployment, rising real wages and increased bank lending; and higher capital investment in agriculture, industry and transport. The country benefited from a generally favorable external environment until mid-2008, with high regional growth and buoyant agricultural commodity prices, though this was partly offset in recent years by high oil and gas prices. The economy is expected to expand by 10.6 percent in 2008, driven by foreign direct investment (FDI) inpulp mill projects, expanding commerce and telecom services, and a strong construction sector. Table 1. Uruguav: Macroeconomic Indicators 1999 2000 2001 2002 2003 2004 2005 2006 2007 200841 National accounts Real GDP growth (%) -2.8 -1.4 -3.4 -11.0 2.2 11.8 6.6 7.0 7.4 10.6 GDP (US$ billion) 20.9 20.1 18.6 12.3 11.2 13.2 16.6 19.3 23.1 30.4 Gross domestic investment (% o f GDP) 15.1 14.0 13.8 11.5 12.6 13.1 12.5 15.0 15.1 17.5 External sector Current account balance (%of GDP) -2.4 -2.8 -2.7 3.1 -0.8 0.0 0.3 -2.1 -1.0 -2.7 excluding: pulp mill projects I/ n/a d a n/a d a d a d a d a -1.1 0.0 -2.6 Real exports growth (%) -7.4 6.4 -9.1 -10.3 4.2 30.4 16.3 8.0 9.7 12.0 Real imports growth (%) -5.8 0.1 -7.1 -27.9 5.8 26.8 10.8 17.6 10.3 20.0 Prices CPl (YOchange, period average) 5.7 4.8 4.4 14.0 19.4 9.2 4.7 6.4 8.1 7.8 CPl (% change, end o fperiod) 4.2 5.1 3.6 25.9 10.2 7.6 4.9 6.4 8.5 7.5 Real effective exchange rate (2000=100, + = appreciation) 99.7 100 98.8 78.3 60.3 62.9 74.9 79.3 85.4 - Merchandise Terms of Trade (2000=100) 106.2 100 104.4 104.6 131.9 143.6 129.5 112.0 112.0 - Labor market Unemployment (NE) (%) 11.3 13.6 15.3 17.0 16.9 13.1 12.2 11.4 9.6 7.8 Fiscal (YOof GDP) Revenues 21 30.6 29.6 30.6 29.5 30.0 29.0 29.2 28.8 29.0 27.1 Current surplus o fpublic enterprises 2.3 2.0 3.0 2.4 3.8 2.8 2.2 1.4 2.5 0.9 Current expenditures 21 27.8 27.2 27.9 26.6 23.8 22.3 22.9 22.6 22.7 22.3 Public investment 2/ 4.3 3.4 3.6 2.5 2.7 2.6 2.4 2.6 3.0 3.2 Primary balance (deficit (-)/surplus (+)) -1.9 -1.4 -1.2 -0.3 2.9 3.8 4.0 3.6 3.6 1.9 Central government & Public Sector Enterprises -1.6 -1.2 -1.0 -0.2 3.1 3.9 4.0 3.4 3.5 1.7 Central bank -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.1 -0.1 Local government 0.0 0.0 0.0 0.1 0.0 0.1 0.2 0.4 0.2 0.3 Interest payments 1.8 2.4 2.6 3.8 5.8 5.7 4.6 4.2 3.6 3.1 Overall fiscal balance (deficit (-)/surplus (+)) (% of GDP) -3.7 -3.8 -3.8 -4.1 -2.8 -1.9 -0.6 -0.5 0.0 -1.2 Indebtedness External sector debt (% o f GDP) 40 44 48 86 98 88 69 55 53 46 Public sector debt (% of GDP) 3/ A I .. 45 54 93 I O 8 97 76 66 62 62 Sources: Central Bank of Uruguay, Ministry of Economy and Finance, National Bureauof Statistics(INE), IMF, and World Bank staff calculations. Notes: I/Current account balance excluding imports relatedto the construction of pulp mill projects(Botnia and Ence). 21 Covers the central government and public sector enterprises. 31 Overall public sector debt, net o f free reserves o f the Central Bank of Uruguay. 41 Basedon government and World Bank staff estimates. "-" refers to data that i s not available; "nia" refers to data that is not applicable. Notes. 11Current account balance excluding imports relatedto the construction of planned pulp mill projects (Botnia and Ence). 2 Figure 1. Uruguay: Economic Recovery Real GDP recovered to pre-crisis levels in 2005 GDP growth has been driven by a recovery indomestic demand 20 100 15 Contributionto GDP growth (in percent) 15 50 5 25 0 0 -25 -5 -5 -50 I -10 -15 0Consumption -RealGDP (1998=100) (rhs) -100 -15 -125 Inflation has fallen from crisis levels, but recently moved Unemployment has fallen to lows not seen for over a above the central bank's target range decade 35 20 CPI Inflation% (12 mths cumulative) Unemployment Rate (in percent) 30 15 I O 5 0 m N m m m o - N m d . m w b ~ m m m m o o o o o o o o Oct-98 Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 m m m m m o o o o o o o o - - - - - N N N N m N N N Sources: Central Bank o f Uruguay; Instituto Nacional de Estadisticas(NE) and World Bank staff calculations. 5. The impact of recent global turmoil on Uruguay has up to now been moderate. Since September 2008, notwithstanding some intervention by the Central Bank, the exchange rate fell about 20 percent against the U.S. dollar. Sovereign debt spreads have widened substantially this year, by about 500 points, to 775 basis points as o f mid-December 2008. In September 2008, there was a small decline in bank deposits o f the private sector and a shift from domestic currency into U.S. dollar deposits. The bankingsector has not been adversely impacted so far by the strong presence o f foreign subsidiaries in the local market. Local enterprises have not been severely affected yet, since they typically finance themselves from internal funds, followed by domestically-provided suppliers credits and bank lending. Prices for the most important exports-meat, dairy products, grains, leather, textiles, chemicals and wood-have decreased. Fallingexport commodity prices are beingpartially offset bythe sharp drop inoil prices. Despite the recent financial turmoil and a worsening o f the terms o f trade, exports are expected to perform well in 2008. Exports o f goods (FOB) amounted to over US$5.7 billion in January- November2008, up by 36 percent compared to the same period last year. 3 6. The economy is better positioned to withstand external shocks than in 2002. Financial soundness indicators have improved considerably. The banking system i s better capitalized, has substantial liquidity, and non-performing loans have sharply decreased. Non- resident deposits, at the centre o f the 2002 crisis, have fallen as a share o f total deposits from 50 percent in 2002 to 18 percent in October 2008. Export markets are more diversified, as the share o f merchandise exports going to the two largest regional partners, Argentina and Brazil has halved. High growth and a strong fiscal consolidation has led to a faster than anticipated fall in the ratio o f public debt to GDP. The flexible exchange rate regime adopted since the 2002 crisis assists the country to absorb external shocks. Figure2. Uruguay: StrongExport Performance Exports are o f growing economic significance for Uruguay Merchandise exports volumes have grown substantially 1 T 0Totalexportsas%of 250 -Quantity index 38 GDP (left am) -.-o---Priceindex 6,000 200 5,000 4,000 3,000 1( 2,000 1I 1,000 0 * m L D t . c o m O - N m b m a P 50 0 m m m m~m m o o o o o o o o ~ ~ ~ ~ ~ 0 0 0 0 0 0 0 0 N N N N N N N N Geographical concentration o fmerchandise exports has ...but merchandise exports remainhighly concentrated in a fallen... few product categories 0.35 - 0.30 1 -T d H i r s c h m a n n index 0.25 0'30 I +Herfindah1 index 0.20 0.20 - 0.15 - m m 0.15 - index 0.10 - +Herfmdale 0.05 0.05 - index o . o o ! 0.001 , I , , , , , I I , , , I I I 1 , I I , I I I I , I 1995 1997 1999 2001 2003 2005 2007 1995 1997 1999 2001 2003 2005 2007 Sources: Central Bank of Uruguay; Instituto Nacional de Estadisticas (NE) and World Bank staff calculations. 7. Strong export performance has contributed substantially to economic growth (Figure 2). Real export growth was on average 16.1 percent over 2004-2007. While Brazil, Argentina and the United States continue to be the major destinations for Uruguayan products, their combined share has fallen from 53 percent in 1994 to 37 percent in 2007, giving way to a substantial growth in exports to non-traditional markets, particularly to the European Union, Russia and China. The completion o f major wood-pulp plantsby Botniahas given a further boost to exports in 2008, estimated at contributing 2.4 percentage points to GDP growth. The pulp millshavebeenamajor source o fFDIinrecent years. 4 8. Imports of consumer and investment goods have expanded rapidly. Imports grew on average 16.4 percent inreal terms over 2004-2007, driven by the dynamismof bothconsumption and investment. Intermediate goods represented 66 percent o f total imports in 2007, over one quarter o f which were oil. The external current account position has recorded low deficits since 2006. In 2008, a current account deficit of 2.7 percent i s expected, driven by strong capital imports and high oil prices. Financing o f these current account deficits has been unproblematic inview ofstrongFDIinflows. 9. The economy has benefited from sound macroeconomic management in recent years. Policy achievements include a substantial fiscal adjustment. The government adopted a flexible exchange rate regime in mid-2002. The resulting currency devaluation increased the competitiveness o f Uruguayan exports, particularly of agricultural products, in world markets. This is a temporary boost, however, and longer-term competitiveness will hinge on fundamental structural changes. Fiscal adjustment and prudent monetary management enabled the inflationary impact o f the 2002 devaluation to be contained. The public debt ratio has continued to fall and the government's debt management policies have successfully reduced medium-term debt obligations. The central bank has accumulated gross internationalreserves of US$6 billion as o f December 2008. 10. Fiscal policy has become the linchpin of macroeconomic stability. Fiscal adjustment has resulted in a primary surplus for the consolidated public sector o f about 3.6 percent o f GDP on average over 2003-07 (a major departure from primary deficits averaging 1.5 percent of GDP through 1999-2001). Nominal expenditures o f the non-financial public sector rose by 18.5 percent in2007 and are expected to grow by 16 percent in2008. Strong growth inrevenues gave rise to a primary surplus o f 3.6 percent o f GDP in 2007, resulting ina very small overall balance deficit (equal to 0.01 percent o f GDP). However, the fiscal outcome for 2007 was somewhat lower than the 4 percent primary surplus envisaged. Higher than expected fiscal surpluses and the success o f debt management operations to repay short-term, floating interest rate and more expensive emergency credits has freed fiscal resources and lessened the medium-term financing burden. Therefore, the government has-earlier than expected-found itself in an improved position with regardto public sector financing needs. The government considers it appropriate to switch the fiscal target from the primary surplus to the overall fiscal balance. In doing so, however, the government has made clear its intention to continue following policies consistent with fiscal sustainability and to reverse the relaxation o f the primarysurplus, ifnecessary due to adverse economic developments. The target set inthe M a y 2008 budget document (Rendicidn de Cuentas 2007) was for an overall deficit o f 0.4 percent o f GDP in 2008 and 2009, leading to increased fiscal resources for priority areas such as health, education, social assistance programs andbasic infrastructure. 11. The fiscal outcome for 2008 is expected to be lower than targeted. The government estimates that the overall deficit will equal 1.2 percent o f GDP, with a primary surplus to GDP o f 1.9 percent. The reason for the fall inthe primary surplus has been a decline inthe balance o f the state-owned electricity company (UTE) equal to about 1 percent o f GDP in 2008. Uruguay is experiencing one o f the worst droughts on record in 2008, reducing hydroelectric generation capacity. This coupled with risingpetroleum product prices has led to an increase inthe costs of electricity generation in 2008 for UTE. The fiscal costs associated with the transitory shock posed by the drought-the fall in hydroelectric power generation and the need to use imported 5 energy sources to cover the hydroelectric gap-have not beenpassed on to the end consumer and are estimated at about 1 percent o f GDP in2008. 12. Price stability remains a key objective in the face of renewed inflationary pressures. Inflationary pressures began to emerge in 2006 and became more pronounced in 2007. At end- 2007, annual CPI inflation reached the 8.5 percent level, above the central bank's target range. The causeswere increasingfuel and commodity prices worldwide, weather-related shortages and strong domestic demand. A further challenge has beenpresentedby the relaxation of the primary surplus target in 2008, with a resulting fiscal stimulus that may have addedto aggregate demand pressures. The authorities' response has been to tighten monetary policy, together with introducing a series o f administrative measures. In early 2007, the central bank announced a reduction o f the annual target rate o f M1 growth from 15 percent to 9 percent, but money continued to expand rapidly. The monetary aggregate target was abandoned infavor of the inter- bank interest rate. There followed three reference rate hikes, increasing interest rates from 5 to 7.75 percent over the period October 2007 to October 2008. In an effort to contain domestic demand and prevent capital inflows, reserve requirements were increased by the central bank from 17 percent to 25 percent for local currency deposits and from 25 percent to 35 percent for foreign currency deposits (effective June 1, 2008). Despite monetary tightening, inflation remained at 8.5 percent for the twelve months through to November 2008, above the 3 to 7 percent target range o f the central bank. Falling international food and oil prices are expected to leadto a weakening o f inflation pressures. 13. A series of administrative measures were taken by the government in October and November 2007 to combat rising inflation. These included cuts in electricity (Administracidn de Usinas y Transmisiones Elkctricas, UTE) and telecoms (Administracidn Nacional de Telecomunicaciones, ANTEL) utility tariffs and health care fees, the introduction o f transportation subsidies (reduction inthe price o f urban bus transport tickets), the introduction o f subsidies on fresh milk andthe exemption o fpoultry and pork meat from VAT. InJanuary 2008, the specific internal tax (Impuesto Especifico Interno, IMESI) on fuel tariffs was reduced by 20 percent and VAT exemptions for poultry andpork were maintained. The IMF estimates the fiscal cost o f these administrative measures to control prices at 1.4 percent o f GDP over 2007-2008.* The authorities havebegunto reverse these measures. 14. One of the major economic vulnerabilities of the economy-the public debt burden-has fallen as a share of GDP since the 2002 crisis. Total public sector debt has fallen from 108 percent of GDP in 2003 to 62 percent o f GDP at end-2007 (Figure 3). The improved fiscal stance, strong growth, lower interest costs and the strength o f the peso have all contributed to lower the public sector debt-to-GDP ratio. Public sector debt composition has changed significantly: 83 percent of total public debt is held by private creditors, compared to 45 percent in2003, while the multilateral share of debt declined from 45 percent to 16 percent, reflecting restored access to market financing. The foreign currency share o f global public sector debt fell from 94 percent in 2003 to 65 percent at end-June 2008. However, the ratio o f public debt to GDP remains high and the large foreign currency component still engenders considerable 2. Here, we exclude the fiscal cost, equal to 0.4 percent o f GDP, that resulted from the elimination o f the foreign exchange purchases tax (Impuesto Compra Moneda Extranjera, ICOME) paid by the public sector enterprises. 6 vulnerability. Uruguayan debt i s rated 3-4 steps below investment grade, which Uruguay lost in 2002, largely because of the highlevel of indebtedness resulting from the crisis. Figure3. Uruguay:PublicDebtAchievementsand RemainingVulnerabilities Public sector debt has fallen since crisis, but is still Debt compositionhas shifted to longer maturity higher than pre-crisis levels Public debt by Term 16,000 14,000 12,000 10,000 g C 8,000 2-. 6,000 ' 4,000 2,000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 1111TotalPSas %ofGDP NFPS as % ofGDP Less than 1 yr H Between 1 and 5 yrs - v I -TotalPS US$nm -D-NFPS US$mn The local currency share o fpublic debt has increased, While Uruguay's EMBI spreads had fallen but debt remains heavily denominated inforeign significantly since the crisis, current financial turmoil currency has ledthem to climb back up Currency composition ofpublic debt Bran1-Uruguay -Global Latin 2007 600 Local Dollai currency 400 62% 31% 300 200 3% DEuros 4Yo Sources: Central Bank of Uruguay; IMF and World Bank staff calculations. Notes: Total PS is total public sector debt; NFPS is non-financial public sector debt; and Central Gov. is central government debt. Public debt is defined as the total public sector and central bank debt, unless otherwise indicated. 15. The government's debt management policies have achieved considerable success. Further enhancements have been made to the amortization profile since the 2003 public debt restructuring. The government has managed to re-profile debt, refinance expensive emergency financing and gradually increase the peso share o f debt by issuing US. dollar and inflation- indexed peso-denominated debt in domestic and international markets. The re-profiled debt has reduced the country's vulnerability to external shocks. By issuing long-term bonds to repay short-term and more expensive debt, the term structure o f public debt significantly improved. As of end-June 2008, short-term debt (less than 1 year) o f the total public sector was 5 percent o f overall debt, with long-term debt (over 5 years) representing 83 percent o f all obligations, up from 65 percent in 2003. Particularly important for increasing the peso share o f total public sector debt were peso-denominated bond issues in 2006 and 2007, when three large issues of 7 long- term peso-index bonds took place totaling US$1.7 billion dollars. Although the government has succeeded in smoothing short-term obligations, attention should be paid to the medium-term debt calendar. Despite the efforts made to repurchase debt due until2012, there is still some concentrationo fpayments around 2011 and 2017-2018. 16. Uruguay's banking system has recovered from the severe crisis of 2002. Improvements can be noted both from the prudential and profitability standpoints, but the banking system is smaller than before the crisis with reduced lendingportfolios. Bank regulation and supervision have improved significantly. Banks have increased their liquidity, which is currently 40 percent o f total assets compared with 14 percent at end-2001, and reduced duration mismatches. They are now better capitalized: equity capital accounted for 18 percent o f risk- weighted assets as o f December 2007, compared to a reported 9 percent at end-2001. Bank solvency i s solid, with banks' capital 2.2 times the risk-based assets capital requirement. Profitability has grown, with a return on assets o f 3.4 percent and a return on expenses o f 32.1 percent. Asset quality has improved with non-performing loans (NPLs) below 1 percent o f total loans. Loans to the private sector declined to 25 percent o f GDP at August-2008 from about 68 percent prior to the 2002 crisis, reflecting the decline in deposits, the rise in demand for liquid assets and the write-off o fbad assets. 17. The restructuring of the national housing bank (Banco Hipotecario del Uruguay, BHU) has advanced. A legal structure has been approved, and a new board of directors appointed. Most o f its personnel and the bad loans portfolio have been transferred to the National Housing Agency (Agencia Nacional de Vivienda, ANV). Systems for information technology and risk management have improved. The Bank Superintendency (Superintendencia de Instituciones de Intermediacibn Financiera, SIIF) recently gave authorization to BHUto reoffer mortgages. The National Housing Agency is to be responsible for housing policy, and BHUi s to resume lendingonly under commercial terms. 18. Despite low short-term risks and improved performance indicators, financial vulnerabilities still exist. Since the crisis, soundness indicators, have strengthened considerably and are now inline with comparator countries. Bank profitability ratios recovered and compared well with regional standards in2007. However, as only one-third o f total bank assets are invested inloans to the private sector, bank profits haverelied on the ability to attract deposits and invest them abroad at higher rates rather than from a resumption o f credit. The advent o f the financial crisis has weakened this intermediation margin as international interest rates began to fall in the last quarter o f 2007. This has resultedina mild deterioration inprofit ratios inthe twelve months ended June 2008. Profits are expected to fall further inthe second halfo f 2008 given the increase in unremunerated reserve requirements. Although the level of dollarization in the financial system (both credit and deposits) has fallen since the 2002 crisis, it remains high(Figure 4). The continued highdollarization leaves Uruguay exposed to exchange rate risk. 19. The key to continued economic success in Uruguay is attracting greater quantities and higher quality investment. Investment levels have recovered substantially since the crisis and, in particular, foreign investment inflows have increased significantly ( 8 Figure 5). Public investment has recovered from a low o f 2 percent o f GDP in 2005 (with a primary surplus o f 4 percent o f GDP) to 3.1 percent o f GDP in 2007 (with a primary surplus o f 3.4 percent o f GDP). The increases o f 1.1 percentage points o f GDP in public investment i s almost twice as large as the deterioration inthe public surplus o f 0.6 percent o f GDP over 2004- 2007. Yet, investment remains low in Uruguay relative to other countries in the region. The World Bank's recent investment climate survey (ICA) suggests critical investment climate areas for enhancing productivity in Uruguay. Several issues emerge as key to attracting investment, necessitating a comprehensive competitiveness agenda. Inparticular, the assessmentpoints to the need to enhance labor regulations, improve access to finance, reduce burdensome procedures and regulations, and improve government efficiency. Regarding access to finance, the ICA indicates that low levels o f enterprise financing compared with other middle income countries ensue from both demand and supply constraints. On the supply side, the banking system and capital markets play a minimal role in financing companies. On the demand side, low credit demand may be explainedby increased risk-aversion due to the 2002 crisis and highly leveraged firms. Lingering perceptions o fmacroeconomic uncertainty dating back to the crisis may also be a factor. Figure4. Uruguay: Financial Sector Recovery The banking system has rebounded from the crisis... ...butthe levels o f financial intermediationremain well below pre-crisis levels. 20 ___--_- 90% 1 I 18 Deposits (US$billion) Deposits as a % o f GDP - Credits(US$billion) 70% 0 Credits as a % of GDP 12 60% 10 50% 40% , * 4 - 30% 2 - 20% 0 10% 0% 2001 2002 2003 2004 2005 2006 2007 - - - Share of Dollar Denominated DepositsKredit 90% -- - - - - " , I 9 # *I - * *.w 9 Figure5. Uruguay:Investment Investment and FDIhave grown since the crisis.. . ...but investment remains low relative to regional comparators 30 20 Gross domestic investment (YOof GDP) 18 16 14 12 10 8 6 4 2 2" r E= us ; ." .- s2 ~6 ~ a 0 g U a m +-01 " r n F 2 1999 2000 2001 2002 2003 2004 2005 2006 2007 3 < 2 Sources Central Bank o f Uruguay;Instituto Nacional de Estadisticas(INE) and the World DevelopmentIndicators2007, World Bank 20. The government's strategy for raising productive investment involves increasing access to financing and policies aimed at improvingthe business climate. One part o f the government's strategy is to improve investor access to financial resources, particularly small- and medium-sized investors who have difficulties tapping external sources o f finance, and the other i s to improve the business climate to attract local and foreign investors. The government sees the development o f capital markets as a channel to link the growing supply o f long-term savings by the private pension fund administrators (AFAPs) and the demand for long-term financing by private and public enterprises. In addition, the government has taken a number o f steps to improve the business climate. A new competition law was enacted in July 2007 which aims at eliminating market distortions and ensuring a competitive business climate. The competition law is expected to impact on oligopolistic markets, other than state monopolies, where there already exists some degree o f competition (e.g. breweries, beverage distribution) and where cases o f dominant position abuse are more likely to bebrought forward by competitors. 21. The government is also developing innovation policies to face the long term challenge of enhancing productivity in order to sustain rapid sustained growth and employment.An important factor that has been holding back development in most sectors has been a shortage o f qualified workers and incentives to innovate and adapt existing technologies. Uruguay would greatly benefit from adding value to existing production and developing new sectors. To this end, the county has established a new institutional framework to define, implement and monitor the impact o f innovation policies. The modifications to the investment promotion system introduced inNovember 2007 support the innovation agenda bypromoting the use o f clean technologies, increasing investment in research and development, and including further incentives for investorsto target increased value-added production andto generate o fjobs o fhighquality. 10 Table 2. Uruguay: Selected Social Indicators, 2001-2008 2001 2002 2003 2004 2005 2006 2007 200821 Poverty Incidence % 18.8 23.6 31.3 31.9 29.2 26.8 25.5 21.7 Extreme Poverty Incidence % 1.3 1.9 3.0 3.9 3.4 2.1 2.1 1.7 Unemployment Rate (INE)% 15.3 17.0 16.9 13.1 12.2 11.4 9.6 7.8 Share of Labor Force inInformal Sector % 41.7 42.8 43.6 42.4 41.6 nla nla nla Income Distribution (Gini) 1/ 0.45 0.45 0.46 0.47 0.45 0.46 nla nla Real GDP Growth% -3.4 -11.0 2.2 11.8 6.6 6.8 7.4 10.6 Source. CentralBank of Uruguay; National Bureau of Statistics (INE) and World Bank staff calculations. Note. 11National level Gini index. 21Latest data available. 22. Social indicators have recovered substantially since the crisis. Poverty rates declined and remain one o f the lowest in the region. A more buoyant labor market has contributed to a significant reduction in poverty from 32 percent in 2004 to 22 percent in the first half o f 2008 (Table 2). Extreme poverty more the halved from 3.9 percent in 2004 to 1.7 percent in the first semester o f 2008. The social policies o f the government contributed to this decline, particularly the emergency social assistance program introduced by the government to tackle the high poverty rates that accompanied the 2002 crisis-Plan de Asistencia Nacional a la Emergencia Social (PANES). In 2008, PANES was replaced by a new permanent, social protection system, Plan de Equidad Social. Reforms by the government in the area o f social security have resulted in an increase in contributors to the social security system and improved coverage of family allowances for non-contributory beneficiaries, which is the core social transfer program for the - poor (Figure 6). Figure 6. BPS Contributors and Family Allowances Beneficiaries, 1995-2007 (thousands of individuals) The number of BPS contributors has been increasing. Family allowances beneficiaries have been increasing due to the rise inthe numberof non-contributory beneficiaries. 600 I 1 1400 1200 1000 800 600 400 200 0 1995 1997 1999 2001 2003 2005 2007 1995 1997 1999 2001 2003 2005 2007 Source: Banco de PrevisionSocial (BPS). 11 23. Despite Uruguay's considerable economic and social successes, vulnerabilities do, however, remain. Dollarization throughout the economy is high. For the banking sector, this implies substantial exposure to foreign currency risks due to corporate balance sheet mismatches. Public debt i s still substantial and largely denominated in foreign currency. Exports and FDI have been significant drivers o f growth performance. Thus, as a small, open and dollarized economy, Uruguay i s vulnerable to a severe deterioration in global and regional economic conditions. A deeper global credit crunch couldjeopardize planned foreign investments projects, which are mostly from Europe. While there has been diversification in the destination of Uruguay's exports, its exports are concentrated in products related to the agricultural primary sector-animal products, vegetable products, textiles and raw hides, furs and leather amounted to 42 percent of total exports o f goods and services in 2007. Therefore, a protracted and sharp drop in the prices of agricultural products due to the global slowdown would impact negatively on economic performance. Regional conditions remain important and a crisis in a neighboring country would still have a strong impact on Uruguay, although perhaps not as catastrophic as in 2002. 11.3. MACROECONOMICOUTLOOKAND DEBTSUSTAINABILITY 24. The baseline macroeconomic projections used in the debt sustainability analysis assume a slowdown in growth from 2008 onwards.The government's projections are usedfor 2008-2009-reflecting the remaining two years o f this administration's term o f office-and World Bank and IMF staff projections are used thereafter (Table 3). Already included in the government's projections i s a depreciation inthe value o f the Uruguayan peso, which leads to a decrease in the U.S. dollar value o f nominal GDP in 2009. Output growth has been exceptional in2008, with the one-off effect of the commencement of Botnia operations boosting growth by over 2 percentage points in2008. Table3. Uruguay:BaselineMacroeconomicProjections,2008-2011 Projections 2008 2009 2010 2011 National Accounts (real growth, YO) Real GDP growth 10.6 3.0 4.3 3.8 Consumption 11.9 4.3 4.0 3.8 Investment 25.0 13.3 6.6 5.0 Exports 12.0 1.3 2.7 5.0 Imports 20.0 3.9 2.4 4.8 Prices CPI (YOchange, period average) 7.8 6.9 7.0 6.0 Current account balance (% of GDP) 1/ -2.7 -1.o -2.0 -1.3 Fiscal (% of GDP) Revenues 21 27.1 28.8 29.1 29.1 Primary expenditures21 25.5 26.5 26.5 26.5 Primary balance31 1.9 2.4 2.1 2.7 Interest 3.1 3.4 3.1 2.8 Overall fiscal balance -1.2 -1.0 -0.4 -0.1 Sources: Ministryo f Finance and Economy and World Bank staff estimates. Notes. The table uses MEF (projections to 2009 and, IMFand World Bank staff estimates thereafter. 1/ Includes pulp millprojects. 21 Covers the central government and public sector enterprises. 31 Covers consolidated public sector, including the central bank. 12 25. A contractionin externaldemandis expectedto leadto a substantialdecrease in the growthof exports,investmentandconsumptionin 2009. Real GDP growthis estimated to fall sharply to 3 percent in2009, before recovering somewhat to 4.3 percent in 2010. A 3.8 percent growth rate is assumed in the medium-term. Exports growth is expected to slowly recover after reaching a low in 2009, but is assumed to remain at under half its 2008 rate by 2011. The rise in the import bill is expected to decelerate in 2009 due to falling oil prices. The current account deficit is estimated to remain modest in the range o f 1-2 percent o f GDP from 2009 onwards. These deficits are expected to be financed by FDI inflows. The medium-term baseline scenario assumes continued strong levels o f investment in the tradable sector. Public investment, includingthe public sector enterprises, is also expected to strengthenfrom 3.2 percent of GDP in 2008 to 3.5 percent of GDP from 2009 onwards. While above historical average growth rates, the medium-tern framework growth projections are in line with those o f the IMF. However, given the role o f exports inthe economy and the lower prospects for continued large commodity-based FDI inflows, there are significant uncertainties and sizable downside risks to these growth projections depending on developments inthe global economy. 26. In December 2008, the government announced its policy stance to counter the contraction in external demand. The government stated that conditions in Uruguay do not allow for the adoption o f expansionary fiscal measures that would result in a generalized spendingincrease and tax reduction, without threatening macroeconomic stability. However, the aim is to avoid a contractionary fiscal stance. As a middle ground, the government intends to raise public investment by 0.3 percentage points o f GDP, to implement a series o f measures to help exporters and facilitate access to credit, and to continue efforts to strengthen social protection. The overall surplus o f the public sector enterprises is expected to improve in2009, as the costs o f electricity generation fall from the high levels o f 2008 for UTE. However, in response to the worsening external conditions, the government revised down central government revenue projections for 2009. Compared to the budget target o f 0.4 percent o f GDP, an overall fiscal deficit of 1percent o f GDP is now expected in 2009, with the primary surplus equal to 2.4 percent o f GDP. While it i s still premature to predict the consequences o f a worsening of the current crisis, the government has outlined its commitment to maintain fiscal discipline should decreased economic activity and falling exports prices exert a downward pressure on fiscal revenues. 27. Medium-termgovernment borrowing requirements are manageable. Due to the re- profiling o f public sector debt and better-than-expected growth and fiscal outcomes, gross borrowing requirements are projected to be 3.2 percent and 3.3 of GDP in 2009 and 2010, respectively (Table 4). Financing needs through 2009 and early 2010 are assured as the public sector has built up over US$1 billion in public sector deposits held in domestic banks. Nevertheless, the government i s in the process of securing contingent financing, including the PRIDPL I1operation, as insurance against possible external shocks (Box 1). Additional credit lines are available from the Corporacibn Andina de Foment0 (CAI?) (US$400 million), and possibly also from the Fondo Latinoamericano de Resewas (FLAR) (US$586 million). The Inter-American Development Bank (IDB) is expected to provide US$600 million in resources over 2009-2010. The government announced in December 2008 that it i s planning to use resources from multilateral creditors-the World Bank and the IDB-and reserves held in the banking system to cover its financing needs in2009 and2010. 13 Table 4. Uruguay:PublicSector FinancingRequirements,2008-2011 Projections 2008 2009 2010 2011 Gross borrowingrequirements (% GDP) 1/ 4.0 3.2 3.3 3.6 Overall balance (deficit (-)/surplus (f)) (% GDP) 2/ -1.2 -1.o -0.4 -0.1 Amortization (% GDP) 2.8 2.2 2.9 3.5 Gross borrowingrequirements (US$million) 1/ 1,232 918 1,077 1,292 Overall balance (deficit (-)/surplus (+)) (US$ million -376 -285 -121 -34 Amortization (US$ million) 856 633 956 1,258 Memorandum items: Real GDP growth assumption 10.6 3.O 4.3 3.8 Nominal GDP (US$ million) 30,449 29,126 32,417 35,918 Source: Central Bank ofUruguay,and MEF, Uruguay; and World Bank. Notes: I/Defined as primary balance plus amortization of overall public sector. Public sector amortization projections are as of June 2008. 2/ Primarybalance of overallpublic sector (NFPS and centralbank). 31Covers debt ofthe NFPS and the centralbank (excludingmonetary policy instruments and free reserves). Box 1. Debt Management Strategy 2008 The Debt Management Unit inthe Ministry of Economy and Finance (MEF) outlined the 2008 debt strategy in the May 2008 budget document (Rendicidn de Cuentus 2007). The primary objectives remain the same as those that guided debt management in2007: a) Fortify the financial position o f the central government by obtaining pre-financing for hture debt obligations; b) Smooththe debtrepayment profile inorder to mitigate refinancing risks; c) Continue to extend the average maturity o f central government debt; d) Deepenthe process of dedollarization o fthe central government debt; and e) Invigorate the domestic debt market. While the main features that guide the financing strategy for 2008 are basically the same as those that oriented debt management in 2007, there is a shift toward obtaining contingent credit lines with multilateral agencies in order to prevent refinancing risks due to the uncertainty surrounding the international credit situation. During 2007, the necessary financing for 2008 was secured. The aim now i s to build on this by securing a pool o f precautionary resources in2008. In its 2008 budget document, the government has identified the World Bank's DPL DDO as an appropriate instrument for its precautionary financing strategy. Another potential source of contingency financing is Corporacidn Andina de Foment0 (CAF). Following the incorporation o f Uruguay as a special member inDecember 2007, Uruguay has access to CAF resources following payment o f its quota inJuly 2008. The approval o f the new line o f precautionary credit with CAF is valid for one year and automatically renewable. Source: Debt Management Unit, Ministry o f Economy and Finance (Rendicidn de Cuentas 2007). 28. Sustained fiscal adjustment and economic growth are critical for continued improvement in public debt indicators. The baseline scenario calls for growth to gradually decelerate to a steady state of 3.8 percent per annum, and convergence to an almost balance overall fiscal position by 2011. Under these assumptions, there i s a modest decline in the global public sector debt ratio from 62 percent o f GDP in2008 to 61 percent o f GDP in2011 (Table 5). 14 The relatively low decline inthe public debt ratio compared to recent years is due to projections already factoring in a fall in the value o f the peso over 2008-09, declining growth rates and a decrease in the primary surplus. The baseline outcome depends on having a primary surplus o f on average 2.6 percent over 2009-2011. Ifthe primary surplus were to disappear, the public debt ratio would growth to 68 percent by 2011. The public debt position is vulnerable to a currency shock that might ensue from a sharp drop in commodity prices or a sudden fall in domestic confidence. An exchange rate devaluation o f 30 percent would lead to a rise inthe projected debt burden to 70 percent o f GDP in 2011, even if the primary surplus was maintained at the historically high baseline level. If real GDP growth and the primary balance were instead to equal historical averages, then the projected public sector debt ratio would be an estimated 2 percentage points higher than in the baseline case by 2011. A low case scenario is also considered with a combined shock consisting o f zero growth, a zero primary surplus to GDP and a 30 percent peso devaluation. Projected debt ratios increase substantially to 76 percent o f GDP in 2011. This is a note of caution that underscores the importance of sustaining tight macroeconomic policies. Table 5. Uruguay: PublicSector Debt Sustainability Indicators, 2008-2011 Est. Projections 2008 2009 2010 2011 Baseline Scenario Real GDP Growth (in%) 10.6 3.O 4.3 3.8 Primary Surplus (in% of GDP) 1/ 1.9 2.4 2.7 2.7 Gross Financing Need (% of GDP) 2/ 4.0 3.2 3.3 3.6 Public Sector Debt (% of GDP) 3/ 62 67 63 61 Alternative: Primary balance-to-GDP at 0% Public Sector Debt (% of GDP) 3/ 62 69 68 68 Alternative: 30% depreciation in the exchange rate 41 Public Sector Debt (% of GDP) 3/ 62 76 72 70 Alternative: Key Variables at their historical averages 51 Public Sector Debt (% of GDP) 3/ 62 67 66 63 Alternative: Combined shock 61 Public Sector Debt ("9 of GDP) 3/ 62 78 78 76 Source: Ministry of Economyand Finance, andWorld Bank staffprojections. Notes: 1/ Definedas globalpublic sector. 2/ Defined as primary balance plus amortization of overall public sector. Public sector amortization projections are as of June 2008. 3/ Overall public sector debt, net of free reservesof the CentralBank of Uruguay. 4/ Defined as a one-off30 percentexchange rate depreciationin 2009. 5/ Historical average over 1998-2007:real GDP growth is set to equal 1.8 percent, and primary balance 1.5 percent for the period 2009-2010. Baselineassumptionsfor 2011. 6/ Growth of 0 percent, primary balance of 0 percent and a 30 percent peso depreciation for the period 2009-2010. Baseline assumptions for 2011. 29. The assessment of Bank staff is that the macroeconomic framework is satisfactory relative to global circumstances. The government is not in a position to have a strongly countercyclical fiscal policy. However, the government does intendto increase public investment and social sector spending to confront the contraction in external demand. While this i s to be partly financed by redirecting resources away from less productive spending programs, the net 15 result will be an increase in expenditures in GDP terms. The Bank staff view is that the rise in the overall fiscal deficit from 0.4 percent to 1percent o f GDP in 2009 i s manageable given the government's cash reserves and the planned levels o f multilateral financing. However, a tightening o f fiscal policy may be needed at some point to underpin debt sustainability should global conditions worsen. Were such a fiscal tightening to be required, the expectation i s that the government would take the required measures. Bank staff agree that with the central bank decision to maintain reference rates in November 2008 given still high inflationary underlying pressures. This follows a further tightening o fmonetarypolicy inOctober 2008. 111. THE GOVERNMENT'S PROGRAM 30. The government outlined its overall program in its electoral manifesto, La Transicidn Responsable, aiming at a broad continuity of macroeconomic policies with increasedemphasison social programsand confirmationof a central role for the state. The document proposes a new national development strategy for the country articulated along six key themes: enhancing productivity (Uruguay Productivo), fostering social development (Uruguay Social), promoting innovation (Uruguay Innovador), strengthening democracy (Uruguay Democrutico), enhancing regional and global integration (Uruguay Integrado) and promoting policies which consolidate and promote Uruguayan culture (Uruguay Cultural). In December 2006, the Minister o f Finance, Danilo Astori, summarized the economic policy objective o f the government as sustained growth at higher than the historical rates, the combating o f extreme poverty, poverty and exclusion, and ensuring equitable access to opportunities for human progress. 31. The government is committed to a sequenced program of reforms, which aim at maintainingmacroeconomic stability and growth.Macroeconomic stabilizationremains at the core o f the government policy program, with a focus on fiscal responsibility and active debt management policy to reduce public debt vulnerabilities. The government aims to sustain growth at a rate substantially higher than the average annual GDP growth o f 2.3 percent in the twenty years prior to the 2002 crisis. That, in turn, can only be achieved by improving the investment climate so that investment may increase from historically low levels. Since 2002, investment has risen from 14percent to 17 percent o f GDP, which still falls well short o f the average for middle income countries. The government has prioritized investment climate policies to increase firm- level productivity, by enhancing innovation and through training worker capacity. The other critical investment climate policies the government has focused on at this stage have been the tax reform, investment promotion, new competition and insolvency and enterprise reorganization (bankruptcy) laws, and policies aimed at increasing international insertion. The government i s additionally working on other actions to improve the investment climate and enhance financial intermediation, notably in the area o f capital markets reform. The reform agenda o f the government inits first term o f office has, while ambitious, met with some success. This i s inpart attributable to the sequenced approach taken by the government in prioritizing key reforms, gaining consensus on them and then moving forward with their implementation. While the government i s committed to reforms, the traditional consensus approach in Uruguay will determine the pace o fprogress with the remaining reform program. 16 IV. BANKSUPPORTTO THE GOVERNMENT'S PROGRAM IV.1. LINKTO CAS 32. The PRIDPL I1would bring total policy lending under the FY2005-2010 Uruguay CAS (Report no. 31804-UY) to US$575 million, compared to the US$275 million initially envisaged. An increase in the CAS lending envelope o f US$60 million was included in the Uruguay: Country Assistance Strategy Progress Report in order to accommodate a PRIDPL I1 loan amount o fUS$300 million. The background discussionwith the authorities and the decision to increase the loan amount to US$300 million are discussed in more detail in the Uruguay: Country Assistance Strategy Progress Report (Section V and Annex 5) sent to the board on a no- objection basis on April 1, 2008 (Report No. 42789-UY). The Uruguayan authorities requested that the loan amount be further increased to US$400 million following recent financial turbulence. However, lending to Uruguay will remain within the CAS envelope, as planned investment lending o f an equivalent amount i s being postponed to accommodate the increase in the PRIDPL I1loan amount. The increased loan amount and DDO feature for the PRIDPL I1 operation are a response to the request o f the government for contingent financing. The loan terms would be those agreed under the new DDO pricing framework approved by the Executive Board in early 2008. 33. The PRIDPL operations are a cornerstone of the Uruguay CAS. The proposed PRIDPL I1would be the second of two programmatic operations to support implementation o f priority economic and social sector reforms as determined by the government. The first operation inthe series was the PRIDPL Iapproved inMay 2007. Development policy lending under the CAS is intended to support government policies in public sector management, financial sector reform and social programs reform. The Social Program Development Policy Loan (SPDPL) that accompanied the CAS to the Board in June 2005 supported structural and administrative reform progress inthe health, education, and social protection sectors since the crisis; included the early activities o fthe new administration inthese areas. 34. The proposedPRIDPL I1 operation is consistent with the CAS objectives (Table 1). The CAS'S three main objectives are to (i) vulnerability o f Uruguay's economy; (ii) reduce sustain economic growth; and (iii) improve living standards. As the centerpiece of the CAS lending program, the PRIDPL program targets all three objectives. Interms o f specific actions, the proposed PRIDPL I1focuses on three areas: (i) implementation o f the tax reform; (ii) first a set o f measures to improve the business climate and initiate the design o f a program to promote capital markets development; and (iii)implementation o f on-going measures to improve the social security system. These three areas are consistent with the broader reform agenda set out in the CAS. The tax reform supported by PRIDPL I1is the cornerstone o f the government's tax administration and tax policy reforms. The measures identified to improve the business climate and promote capital markets are aligned with the financial sector and capital market reform goals set out in the CAS. Finally, the social protection component builds on the SPDPL presented to the Board with the CAS. 17 Table 1.Link betweenPFUDPLI1ComDonentsand CAS Outcomes PRIDPLI1Component I Corresponding CAS Outcomes I/ and Milestones Reforming the Tax System. Create a simpler, more Primary surplus i s sustained at the level o f efficient and equitable tax structure 2004 or somewhat higher. Personal income tax is introduced. Number o f taxes is reduced. Market Promotion and Regulatory Framework. Measures introducedto promote capital Establishment o f an institutional, legal and regulatory, and markets and development o fpeso based infrastructure framework that provides for a safe and financial services. efficient market infrastructure. Bankruptcy Law. Modernize legal framework for Enactment o f new bankruptcy legislation bankruptcy inorder to provide for efficient and timely and 50% o f cases resolved under new law. resolution o fproblem enterprises. Information Transparency and Disclosure. Improve Enabling environment for the private sector. informationtransparency inthe corporate and financial sector (public and private). Payments System Reform. Reform o fpayments system Enabling environment for the private sector. to improve efficiency and security I Strengthening Social Protection. Expand and consolidatel Social emergency program (PANES) the social protection system, reinforcing the protection o f implemented, reaches 200,000 beneficiaries the poor and vulnerable. by 2006, andis largely phased out by 2009. Family allowances program has at least 60 percent o f take-up among the poor by 2009. Strengthening Social Protection. Increase efficiency, Pension system becomes more sustainable transparency and accountability o f social protection financially with more flexibility to include institutions. workers. Pension spending not to exceed 17% o f GDP by 2009. Pension coverage o fpeople inold age increases to at least 90%. I 35. The PRIDPLprogramis fully consistentwith the reformagenda set out inthe CAS. Inthe areaofpublic sectormanagement, the CASnotedthree priorityareasfor reformincluding tax administration and tax policy, expenditure management, and institutional reform. On the tax front, the stated aim o f the CAS was to improve equity o f the tax system, while on the administrative side the focus was on improving tax collection which i s essential to maintain the primary surplus. On expenditure management, the reform o f social transfer schemes was seen to be critical. Potential was also seen for the support o f broader institutional reforms. In the financial sector, the emphasis was expected to be on strengthening the institutional framework for supervision, on continuing state bank restructuring, and on policies to promote the deepening o f capital markets. The social context was to be on health and pension reforms where efficiency improvements could improve overall social welfare, while contributing to fiscal stability and expenditure switching policies. 18 36. The framework is in place for policy based lending as set out under the CAS. Uruguay's macroeconomic framework is satisfactory with higher-than-projected growth and strong fiscal performance; inflation is at manageable levels. Public debt sustainability has improved faster than projected under the CAS. Structural reforms are being implemented in the areas o fpublic sector management, financial sector and social programs. IV.2. ANALYTICAL UNDERPINNINGS 37. Since the PRIDPL Iwas approved in May 2007, three additionalstudies relevantto the PRIDPL programhavebeencarriedout. Povertyand Social ImpactAssessment (2008) 38. The Poverty and Social Impact Assessment (PSIA) analyzes the impact o f the tax reform package, which came into effect in July 2007, on tax incidence and poverty in Uruguay. The analysis employs a static "arithmetic" micro simulation model using household data to calculate for each household the total amount o f direct and indirect taxes paid before the reform and the total paid after the reform. The study focuses on the impact o f eliminating the personal receipts tax or wage tax (Impuesto a las Retribuciones Personales, IRP) and the implementation o f the dual personal income tax (Impuesto a la Renta de la Personas Fisicas, IRPF), as well as the effects o f reducing the VAT rate and eliminating the social security financing contribution tax (Contribucibn a1 Financiamiento de la Seguridad Social, COFIS). Results indicate that the replacement o f the IRPwith the IRPFresults in an improved situation for the bottom 80 percent o f income earners, for whom the mean tax rate falls. The mean direct tax rate increases for the top 20 percent o f taxpayers. Ifthe impact on households is considered, the reform represents a moderately redistributive change. Taking into account changes to VAT, COFIS and the new IRPF, along every measure considered the tax reform has a small, but positive impact on equity. This study is the first in a programmatic series. It is intended to follow-up with a further study, which will explore the modifications in individuals' behavior in response to changes in the tax structure. InvestmentClimateAssessment (2008) 39. The investment climate assessment (ICA) aims to help Uruguay identify and craft solutions for its binding microeconomic constraints to growth and employment generation. Multiple and complementary sources are used to analyze the investment climate. The report benchmarks Uruguay's performance against survey data from comparator countries within and beyond Latin America, mainly upper middle income countries, to identify the shortcomings and reform priorities. The primary data source for the report i s an investment climate survey undertaken in 2006 that covers 617 small, medium, and large Uruguayan firms in a range o f sectors. Data from the investment climate survey is complemented by other cross-country databases such as the World Competitiveness Report and the Cost o f Doing Business. In addition, the Uruguay's Expanded National Household Survey (2006) is used, which includes a specific and comprehensive module on training. Focus groups with workers and with entrepreneurs were conducted in April 2007 to understand better the functioning o f the labor market and the dynamics o f labor relations and identify opportunities for renewing a constructive dialogue. Workers are critical partners and stakeholders in the investment climate and listening to their voices i s important. The Foro Consultivo Econbmico Social del MERCOSUR led the focus group, and the World Bank participated as an independent observer. 19 40. According to ICA, Uruguay performs well in selected investment climate areas, such as public integrity. However, the investment climate needs further improvements to allow sustained growth and enhance productivity inUruguay. Inparticular, the assessment points out the need to improve labor regulations, access to finance, and the regulatory and institutional quality o f governance. Uruguay's investment climate showed important constraints on growth and employment generation and a need to improve several aspects was evidenced. The analysis points out the following areas where future reforms would be beneficial for growth. Labor regulations and skills. There are some regulations that could increase the likelihood o f informality incertain sectors. Uruguay ranks highinworking hours' rigidity and introducing a more flexible regime and easing the severance payments for hiring and firing could be welfare enhancing. It was also found that Uruguay under invests in training relative to other countries, when evidence has shown that training has a positive impact on workers' earnings and firm productivity inthe country. Technology. The government has developed a strategy comprising four key pillars. The first envisions a strengthening o f the policy and institutional framework. The second focuses on investments in human capital and high-quality research teams, the third supports the productive sector, stimulating private sector demand for innovation, developing and strengthening technology transfer institutions for priority sectors, and fostering overall linkages between supply and demand for research and technology transfer. The fourth pillar supports pro-poor innovation. International agencies are supporting the government in these efforts. Access tofinance. The survey found that external financing for local firms is very limited when compared to other countries, and the reasons appear to be both low demand and supply constraints. Furthermore, capital markets play a minimal role in investment financing, since public securities represent most o f the traded value on the stock exchanges. Pension funds will play a determinant role in developing capital markets since they are a large and stable source o f long term funding. Low investment demand appears to be due to three main factors: macroeconomic instability, trade integration, and investment climate constraints. Parliament i s considering a new Insolvency and enterprise reorganization Bill which i s critical to facilitate the exit o f non-viable firms and the financial restructuring o f those with a potential. Also, the authorities are drafting a new Capital Markets law that would strengthen investors' protection, corporate governance, and the powers o f the regulator. A number o f initiatives to enhance the reliability o f information are inprogress based on the development o f new accounting and auditing procedures. Additional reforms may need to be implemented for SMEs, which form the bulk o f enterprises. It is key to recover market confidence, and government intervention will be necessary to achieve it. Regulation and governance. The survey detected scope for improvement in two main government fronts: regulatory and institutional quality. Uruguay should focus on reducing red tape, which encourages informality, and improve government efficiency. The tax reform was a start, but further work is neededto attain a friendly business environment. 41. The ICA discussions took place in June 2008, by which time the preparation of the Uruguay PRIDPL I1operation was well-advanced. While productive, the ICA discussions are 20 more likely to inform policy content in subsequent World Bank operations. The key findings o f the World Bank's I C A were presented and discussed at a Uruguay Investment Climate seminar held on June 11, 2008, in Montevideo. The seminar was prepared in coordination with the Ministry of Economy and Finance; the National Chamber o f Commerce and Services and three other chambers; and a leading Trade Union (Central Nacional de Trabajadores). Participants included representatives from the government, the private sector, workers' associations and universities. The government's office o f private sector development has recently contracted an expert from Colombia to devise a strategy for enhancing regulation and administrative procedures. The implementation o f the proposals that might emerge from this review would buildon the ICA and could possiblyrequire Bank assistance inthe future. Income Transfers Policy Study (Report No. 40084-UY) 42. The report was prepared to provide information for Uruguay's government for the analysis o f several social sector reform strategies. The purpose o f the report i s to contribute to the debate around the design o f the income transfer policies for the medium and long term. The report is divided into five sections. Section two presents the conceptual discussion; section three describes the current policies, including an assessment o f coverage, impacts, and fiscal effects. The fourth section presents a simulation to assess the potential impacts o f the new Plan de Equidad Social, and the fifth section discusses conclusions and the central challenges for the future. 43. This report considers the rationale, coverage, impact, and costs o f (pre-Plan de Equidad Social) the four main income transfer programs, including the pension system, unemployment insurance, family allowances, and citizen income. Analyzing the coverage and impacts of these programs with micro data from the first semester o f 2006 national household survey, the report identifies significant coverage gaps and program overlaps, discusses the underlying rationale that guides their design, and simulates the impacts that several alternative strategies could have on poverty, equity, and financial sustainability o f these programs. The main goal o f this report is to present a detailed discussion o f policy options and implications in the area o f income transfers, aiming at facilitating abetter-informed policy makingprocess inUruguay. 44. Findings show that while family allowances and citizen income are clearly the best targeted programs; their impact on poverty i s small, due to the estimated benefit amounts. Simulations are given for the impact o f a new income transfer program based on provisional information for the Plan de Equidad (which had not yet been finalized at the time the study was prepared). It is assumed that the new family allowances system would significantly increase the size and coverage o f benefits. Another assumption is that the coverage o f the non-contributory pension scheme is expanded to include those who already qualify for it and, possibly, to anticipate access from the current 70 years o f age to 65 years old. Simulating the impacts o f these proposals, the report estimates that, if all are successfully applied, poverty would decline by three percentage points, while extreme poverty could be reduced by more than 50 percent. The report conclude that the biggest obstacle to advance further inthe income transfers system reform i s fiscal: if, inaddition to what was included inthe simulations, the Plan de Equidad were to include a component for working age adults and increase benefits, how could the Government finance these additional expenditures? The report considers three options: collect additional taxes/contributions; redistribute resources currently spent on income transfer schemes; or redistribute resources currently spent on other areas. 21 IV.3.COLLABORATIONWITHTHE IMFAND IDB 45. Uruguay benefitedfrom strong support by the IMF in response to the 2002 crisis. The Fund extended exceptional financing, augmenting twice its existing program, making it the largest Fund arrangement ever as a share o f a country's GDP, and providing a follow-up Stand- by Arrangement in 2005. Total drawings under the two programs were equivalent to about US$3.35 billion. InNovember 2006, the government announced its intention to pre-pay the IMF and cancel the SBA upon completion o f the combined fifth and sixth review. The pre-payment o f US$1.lbillion was made on November 30, 2006 and the final combined review was completed on December 22, 2006. The conclusion o f the final review was that early exit from IMF financial support signaled impressive progress since the crisis, but it would be important to continue to entrench macroeconomic stability and deepen structural reforms. The IMF Board called for continued fiscal discipline to reduce the debt burden and anchor policy credibility, and prudent monetary policy, as well as reserve buildup consistent with exchange rate flexibility and the inflation objective. 46. The October 2008 Article IV consultations for Uruguay concluded that vulnerabilitieshave declined considerably and the country is better prepared than in the past to withstand externalshocks. However, the Fundstressed that vulnerabilities remain, and that the situation warrants monitoring. Important medium-term vulnerabilities were reported as the still relatively high and dollarized public debt, and the dollarized financial system. The main short-term challenge would be to address the rise in inflation that accompanied increased domestic demand and capital inflows. The Fund recommended a tightening o f monetary and fiscal policy at the time o f writing the Article lV review. Since this time, the central bank has raised the policy rate by 50 basis points. A tightening o f the fiscal stance, as recommended by the IMF, has not however taken place. There i s to date no intention on the part o f the Uruguayan authorities to request IMF financial support. 47. Support for the tax reform is also being provided by the IDB. A clear division o f labor has been agreed between the Bank and the IDB on support for the tax reform agenda. In October 2006, the IDB approved the first operation for US$50 million o f a series o f three programmatic operations to support public sector reform in Uruguay. The first IDB operation included as a condition the submission o f the tax reform package to Parliament. The second IDB operation in this series includes parliamentary approval o f the tax reform as one o f its public sector reform triggers, while the third loan inthe programmatic series is tied to preparation o f an implementation plan for the tax reform. The policy focus o f the IDB is on the implementation o f the VAT component o f the tax reform, while the PRIDPL program focuses on implementation o f the personal income tax (PIT) which i s at the heart o f the reform. The IDB also approved a programmatic competitiveness loan in January 2007, which includes the submission o f the drafl insolvency and enterprise reorganization (bankruptcy) legislation to Parliament as a prior action for the first operation inthis series, as well as the establishment o f the private sector support unit in the Ministry o f Economy. The IDB programmatic series does not involve actions aimed at assisting in the implementation o f the bankruptcy reform framework which i s the focus o f the proposed PRIDPL I1 operation. A small technical cooperation loan, related to the social protection component o f the PRIDPL I1operation, was approved by the IDB in October 2008 with the objective o f financing the execution o f the first two rounds o f the social protection survey. A conditional credit line o f $200 million was approved to finance multi-sector projects 22 that will be developed under Uruguay's National Strategy for Children and Adolescents Support Program, part o f a long-term government effort to increase safety nets for poor children and teenagers. Uruguay's Ministry o f Social Development will be the executing agency for the conditional credit line, which will be used to finance projects in social safety nets, health, education, labor, sports and culture. IV.4. RELATIONSHIPTO OTHERBANKOPERATIONS 48. The Social Protectioncomponent of the PRIDPL programbuilds on improvements supported by SPDPL. The US$75 million SPDPL supported the initial steps taken by the Vasquez administration to improve priority social programs in health, education and social protection. It also recognized reform progress in social policies over the last two years o f the previous administration-replacing in that regard the last tranche of the Public Services and Social Sectors Special Structural Loan (SSAL II), approved in April 2003 and cancelled at the authorities' request in May 2005. The SPDPL was disbursed in a single tranche upon effectiveness in mid-2005 and implementation was satisfactory. The social component o f the PRIDPL program builds on progress achieved under the SPDPL in two important aspects. First, the program continues Bank support for the expansion and consolidation o f the non-contributory family allowances system, a core component o f the strategy to provide social protection to poor families operating inthe informal sector. Second the PRIDPL program continues support for the efforts to increase transparency and accountability in BPS initiated under the SPDPL. These efforts form part o f the broader strategy to improve coverage and revenue collection in the formal social security system. Table7. PRIDPL11-supportedPolicy ReformsandIBTALInstitutionalSupport PolicyReform InstitutionalSupport Tax reform, to reduce distortions andrender the tax Institutionalstrengthening o fthe Asesoria Tributariay system more equitable, while maintaining requisite Recaudacidn (ATyR), the tax administrationarea o f the government revenues to meet the primary surplus target BPS, including the areas o f humanresources, necessary for macroeconomic stability. information systems, auditing, business intelligence, collections, taxpayer risk management, outreach, and taxpayer services. BusinessClimate and CapitalMarketsDevelopment, (i) Support for capital markets development including to increase investment, improve the business climate and market promotion activities, institutional strengthening increase the overall transparency o f the corporate and o f the regulator, development o f the regulatory financial sectors. framework, andprovision o f information technology; (ii) forenhancingcorporatetransparency support through updating and strengthening o fthe regulatory and institutional framework and implementationo f reporting standards and control processes; and (iii) support for bankruptcy legal reforms through regulatory development, logistical support for courts, and outreach and dissemination. Policiesaimed at strengtheningsocial protection, to Data processing equipment, systems development expand and consolidate the social protection system, services, institutional strengthening activities, and reinforce the protectiono f the poor and vulnerable, and operational costs associated with the logical and an increase inthe efficiency, transparency and physical design and implementation o f an integrated, accountability o f social protectioninstitutions. inter-institutional information system that brings together data on the characteristics and beneficiaries o f social programs from various entities. 23 49. An advantage of includingthe payments and securitiessettlement system reformis existing involvement in the area. The World Bank's financial experts have been providing technical assistance with regard to the implementation o f the new payments and securities settlement systems under the Uruguay Payments System Fee-Based Service, which is due to be completed in2009. 50. An Institution-buildingtechnical assistance loan (IBTAL) supports the PRIDPL program. The IBTAL is structured to support core elements o f the government's public administration modernization agenda, as well as institutional needs arising from the reform program supported by the PRIDPL program. The IBTAL was approved by the Board together with the PRIDPL I.It includes assistance with the design and implementation o fmeasures inthe fiscal, financial and social areas. The linkages between the reforms supported by the PRIDPL I1 and the institutional support provided by IBTAL are given in Table 7. As with the PRIDPL program, the IBTALhas been prepared inclose collaboration with IDB. IV.5. LESSONSLEARNED 51. The Bank has learned important lessons from its recent experience in Uruguay. First, the experience underscores the consensual nature o f Uruguay's policy-making environment. In Uruguay, reforms generally take a long time to mature, but then tend to be sustained once implemented. In several high profile cases in the recent past involving privatization and market liberalization, relatively less attention was paid to political consensus in an effort to speed reform preparation. However, this led to policy reversals. Second, country ownership o f the reform program is critical, with the role o f the Bank focused on suggesting policy options and, where appropriate, supporting reform implementation in priority areas as determinedby the government. Third, while Uruguay has made substantial progress since the 2002 crisis, it continues to be vulnerable to a substantial and persistent external shock. The 2002 crisis showed how painstaking development progress can be brutally set back inUruguay due to external shocks. Prior to the crisis, the Bank had envisaged a scaling down o f IBRD funding activities inUruguay, but the subsequent crisis fundamentally altered this assessment. 52. The design of the PRIDPL program reflects these lessons learned. First, the programmatic structure takes into account the time needed for reforms to come to fruition, and the focus is largely on the implementation o f measures for which the government has either already obtained approval or at least submitted legislation to the Parliament. Second, the PRIDPLprogram focuses on areas that the government has itselfdeemed as priority, while at the same time incorporating the results o f the Bank's analytical work and the on-going consultation process with the government. Third, it is important to continue supporting government efforts to reduce vulnerability to external shocks and spur growth through policy reform. With regard to program risks, substantial analytical work carried out by the government, the Bank and other organizations underliesthe reform program. 24 V. THE PROPOSEDOPERATION V.l. OPERATIONDESCRIPTION 53. The PRIDPL I1 would continue World Bank support implementation of priority economic and social sector reforms as determinedby the government. The program content reflects the government's sequenced approach to reform. The program aims to provide the government with a framework for the implementation o f the reforms that it has identified to move towards its ultimate goal o f obtaining sustained growth at higher than historical rates, while combating poverty and exclusion and ensuring equitable access to opportunities. The operation would be the second o f the PRIDPL series and final under the FY2005-2010 Uruguay CAS. The specific development objective relates to three areas: (i) Tax reform. The development objective o fthis reform is to improve the efficiency and equity o f the tax system, while maintaining government revenues at the level to meet the overall balance target necessary for macroeconomic stability; (ii)Business climate and capital markets development. The development objective o f these reforms is to increase the quality and quantity o f investment, and thereby contribute to growth; and (iii)Improvingthesocialprotectionsystem.Thedevelopmentobjectiveofthesocial reforms i s to promote social inclusion so that all individuals in society benefit from development and government programs. 54. The government has made good progress in implementingthe PRIDPL program. Five o f the triggers for the second operation have been fully met: (i) implementation targets the for the tax reform; (ii) the relevant information transparency and disclosure legislation has been presented to parliament; (iii) the implementation o f the new family allowances system; (iv) the reduction o f exemptions and adoption o f a new unified social contribution rate for employers; and (v) the submission o f the draft capital markets law by the executive to Parliament. The remaining trigger-the formulation and putting into effect o f the action plan for implementing insolvency reform-is set to be fulfilled soon. The bankruptcy law was passed by the House o f Representatives on July 1, 2008, approved by the Senate on October 23, 2008 and came into effect on November 3, 2008. Annex 2 provides a detailed discussion o f progress under the six program triggers, including the status o f each o f the monitoring indicators. 55. The PRIPDL I1 would sustain support for existing components of the program, while addingsupport for modernizationof the paymentssystem. The prior actions for Board presentation together with progress under the original triggers for PRIDPL I1are summarized in Table 8. The prior actions reflect full achievement o f the PRLDPL program triggers outlined in the PRIDPL Idocument for five o f the six policy actions. The action for bankruptcy reform was changed to approval o f the draft law by House o f Representatives (Ccirnara de Diputados) as a key milestone toward full parliamentary approval and subsequent implementation, which was the original trigger. The law has now attained full parliamentary approval and became effective as o f November 3, 2008. The program under the capital markets and business climate area has been expanded to include the reform o f payments and securities settlement systems for which a new prior action has been added. N o triggers are proposed for a subsequent operation as this is the final PRIDPL operation envisaged under the FY2005-2010 Uruguay CAS. Box 2 shows how the 25 operation seeks to meet the good practice principles on conditionality. The policy matrix for the Program, including the prior actions for PRIDPL 11, i s presented inAnnex 1. able 8. Status of Triggers and Prior Actions for PRIDPL I1 TriggersPFUDPLI1 IPrior ActionPRIDPLII Istatus System Create a simpler, DGI leads and coordinates D G I i s leading and coordinating the The DGI is more efficient and personal income tax (IRPF) personal income tax (IRPF) collection effectively leading equitable tax collection efforts o f different efforts o f different collection-retention and coordinating the structure collection-retention agencies agencies as provided in Article 8 o f the IRPFtax collection, (BPS, Cajas Notarial, banks, Tax Reform Law (which amends as evidenced by the Ministries o f Defense and Article 1 o f Chapter Io f Title 7 o f the meeting o f all the Interior, etc.). The following Texto Ordenado 1996). The following implementation implementationtargets are in implementationtargets are inplace: targets set out as place: (I) DGI and BPS inspectors have been triggers for the (i)Training o f DGI and BPS trained inthe skills required for their second operation in inspectors complete by June jobs; PRIDPL I. 2007; (ii)Establishmentof210DGIposts (ii)Establishmentof210DGI outside DGI and a tax call center for posts outside DGI and a tax call consultations; center for consultations; (iii)ASingleTaxRegistryisin (iii)EstablishmentofaSingle operation; Tax Registry; (iv) IRPFtax files are being transferred (iv) IRPFtax files are transferred monthly from BPS to DGI; and monthly from BPS to DGI; and (v) DGI has consolidated taxpayer (v) DGIperforms taxpayer information into a single IRPFtax file consolidation into a single IRPF combining income from different tax file combining income from sources for each multi-employed different sources for each multi- contributor. employed contributor by October 111.1MarketPromo1 1and Regulatory Framework Establishment o f an Presentation to Parliament of a The Executive has presented to A draft o f the new institutional, legal new Capital Markets Law. Parliament for approval a draft capital Capital Markets Law and regulatory, and markets law. was sent by the infrastructure executive to framework that Parliament on provides for a safe November 19,2008. and efficient market infrastructure I C Reform of payments INot a trigger, but included as (i) BoardofDirectorsofBCU The The payments and and securities part o f the overall strategy and (central bank) has approved a planthat securities settlement settlement systems to implementation plan for capital system reform improve safety and markets reform. strategy and efficiency implementation plan have been approved and communicated to the private sector. I The payments system law has been drafted and submitted to MEF. 111.3 Bankruptcy Law Modernize legal MEF has formulated and is The House o f Representatives (Camara OnJuly 1, 2008, the framework for carrying out the action plan for de Diputados) has approved a draft House o f bankruptcy in order implementing insolvency reform. Insolvency and Enterprise Representatives, and to provide for The action plan includes Reorganization Law (Ley de Concursos on October 23,2008, efficient and timely benchmarks and a chronogram o f y Reorganizacidn Empresarial). the Senate approved 26 problem enterprises (ii) training and educating o f The law iskfiective stakeholders. as o f November 3, 2008. Improve information Amendments to the Corporate (i)TheExecutivehasissuedadecree The information transparency in the Law and draft legislation for the establishing as obligatory from January transparency and corporate and strengthening o f the CPNCA 1,2009 the International Financial disclosure prior financial sector have been presentedto Reporting Standards (Normas action reflects the (public and private) Parliament, including: Internacionales de Inforrnacibn steps taken to (i)Requirement for enterprises to Financiera), which include: (a) the implement the agreed consolidate financial statements, requirement for enterprises to trigger for PRIDPL and when applicable have them consolidate financial statements; and 11. In order to meet its audited; (b) the requirement that enterprises objectives o f (ii)Requirement that enterprises provide information about related party strengthening provide information about transactions. information ownership and related party (ii) HouseofRepresentatives The transparency and (Camara de Diputados) has approved disclosure, the amendments to Law number 16.060o f government decided September 4, 1989,published in the to establish a new Official Gazette on November 1, 1989 entityincharge o f (Ley de Sociedades Comerciales)to accounting standards eliminate inconsistencies with the (Entede Emisor accounting standards referred to in Normas Contables), paragraph (i) above. which would have (iii)TheExecutivehasadopteda the technical and resolution that strengthens the financial capacity, composition o f the CPNCA by adding and independence to representatives o f BCU, DGI, private lead the process in universities and the Association o f ensuring the latest Private Banks o f Uruguay (Asociacibn accounting norms are de Bancos Privados del Uruguay). adopted. The (iv) The Executive has presented to CPNCA is to act as a Parliament draft legislation establishing formal advisory body a system o f independent accounting for the new entity. In oversight. order to adopt the latest International I Financial Reporting Standards, relevant enterprises are to be required to provide consolidated financial statements, necessitating amendments to the Corporate Law, which were sent to parliament inJune 2008. IV. Strengthening Sc ial Protection Expand and Plan de Equidad, the new The government is implementingthe On December 22, consolidate the social structural income transfer policy new structural income transfer policy 2007, legislation was protection system, has beenadopted and is under (Plan de Equidad Social), which approved by reinforcing the implementation. This program includes as a core component the new Parliament on the protection o f the replaces the emergency plan family allowances system. core component o f poor and vulnerable PANES. Plan de Equidad Social-the new family allowances system- which is to be the main 27 Component f Triggers PRIDPL11 1PriorActionPRIDPLI Istatus Iinstrument used to make income transfers to poor families (Law 18.227). The new family allowances program was introduced on January 1,2008 and immediately replaced the benefit received under the Citizen's Incomeprogram (PANES income transfer component). Increaseefficiency, Implementationof tax reform The government is implementing The measure has transparencyand legislation to reduceexemptions legislation (Law 18.083 of December beenimplementedas accountability of and to adopt the new unified 27,2006) to eliminate exemptions to part of the tax reform social protection social contribution rate of selected sectors and industries and to package put into institutions employers (7.5% ofwages). adopt a new unifiedsocial contribution effect on July 1, rate of employers (7.5% ofwages) 2007. Box 2. GoodPracticePrinciples on Conditionality Principle 1:Reinforce Country Ownership There is strong government ownership o f the proposed operation as the reform areas included are those identified by the government as priority areas for Bank support. These include reforms that have been central to the government reform agenda since taking office, such as the tax reform and improving social protection. The programmatic structure o f the operation also allows for the support o f nascent reform efforts in the capital markets, a component not as advanced as the others, but where the government has requested support under the program. The PRIDPL I1operation supports the implementation o f reforms, which have been based on strong consensus-building process put in place by the government. Many o f the reforms supported have already been presented or passed through Parliament. Uruguay's track record o f solid macroeconomic performance and success in advancing key structural reforms-particularly the tax r e f o m u n d e r l i e s the proposed operation. A substantialbody o f analytical work assisted inthe formulation o fpolicies supported by the operation. Principle2: Agree upfront with thegovernment and otherfinancingpartners on a clear division of labor A summary o f the policies to be supported by the Bank is given inthe policy matrix. The main area o f cross-over with other financing partners is tax reform, where support is also being provided by the IDB.A clear division o f labor has been agreed on the tax reform agenda among the government, the World Bank and the IDB. The IDB will concentrate on the institutional preparedness to cany out the VAT component o f the reform. The World Bank proposes to focus on implementation o f the tax reform, particularly the new personal income tax (PIT) which will be administered bythe social security institution (BPS). Principle3: Customize the components and structure of the operation to country circumstances By nature, policy-making in Uruguay is done by consensus, which can often make reform a time- consuming process, but helps ensure that agreed reforms are sustained. The very nature o f the challenges faced by the government inthe areas o ftax reform implementation, business climate and capital markets development and improvements to social protection, mean that the reform process i s likely to be lengthy and the results longer-term in nature. One o f the prior actions for PRIDPL I1was an amended versions o f the original triggers included for the operation. The PRIDPL I1prior action in this area has been designed to take into account the shiftingtimetable due to the need for further stakeholder consultation to reach consensus on the reformprogram. This illustrates the appropriateness o f the programmatic structure o f the PRIDPL as it allows Bank support to reflect the changing nature on an ongoing reformprocess and the longer-term nature o f the expected results. Principle4: Choose only actions criticalfor achieving results as conditionsfor disbursement 28 The Bank's policy matrix uses a limited set o f conditions as prior actions for PRIDPL I1(7 in total). These were identified as critical actions for reform implementation in each o f the policy areas. The PRIDPL I1 prior actions reflect indicators of implementationprogress in the chosen policy areas since the first operation in the series and are not stand-alone conditions. These benchmarks have been provided by government counterparts and are the policy actions contained in their own reform implementation plans. Expected medium-term indicators included inthe policy matrix are intended to measure outcomes achieved under the program. Principle5: Conduct transparentprogress reviews conducivetopredictable andperformance-basedfinancial support All ofthe triggers for PRIDPL I1and medium-term outcome indicators for the programfocus onthe results o f implementation o f the supported reforms. The programmatic structure o f the PRIDPLprogram allows for a time period inwhich these outcomes can be observed. 56. The operation is designed to contribute to the debt management strategy of the government.The PRIDPL I1is intended to provide Uruguay with a risk management tool inthe event that market borrowing is interrupted and a public sector financing shortfall arises. A DPL DDO provides the option o f deferring loan disbursement for up to three years from loan signing and is renewable for an additional three years, thereby creating a contingency form o f financing for Uruguay over an extended period of time. The PRIDPL I1 would support the debt management efforts o f the government. The PRIDPL I1 loan funds would provide alternative financing resources to meet maturing public sector debt obligations in case o f reduced market access or increased sovereign risk spreads. In keepingwith the government's aim o f increasing the proportion o f public debt denominated in local currency, the DPL DDO could be used for disbursements in local currency during the three-year draw-down period from loan signing depending on market conditions. 57. The Uruguayanauthoritiescould elect to draw on the PRIDPL I1loan proceeds,at any time during the three-year draw-down period, provided that: (i) the macroeconomic framework remains satisfactory; and (ii) Uruguay continues to adhere to the overall program set out in the Letter o f Development Policy (LDP). These two draw-down conditions would be continually monitored as part o f regular loan supervision. The entire amount o f the loan, less any premia capitalized for exercising the option o f caps and collars, would be made available for disbursement upon effectiveness. 29 V.2. POLICYAREAS REFORMINGTHE TAX SYSTEM- COMPONENT I1 58. The implementationtargets for the tax reform-the tax reformprior action for the PRIDPL 11-have all been met. The tax reform bill came into effect on August 1, 2007. The essence o fthe reform is the introduction o f a dual personal income tax, which taxes labor income at progressive rates and capital income at lower, proportional rates. A further modification is the reduction in the revenue share o f indirect taxes. Implementation to date has been on track. The current data management system o f the BPS and the DGI hnctions a single tax registry, with (i) a unique data entry form accessible through a single window, (ii) transmission of the same date to DGI and BPS databases at the moment o f inscription, and (iii) mandatory use o f a unique taxpayer identifier number (Registro Unico de Ciududaniu, RUC). The current system is not best internationalpractice inthat it is not based on an online, real time single database. Tax collection efforts are in line with medium-term targets. Indications are that collection for the dual personal income tax (Impuesto u la Renta de las Personas Fisicas, IRPF) introduced by the reform is close to the medium-term target for 2009 o f 2.1 percent o f GDP. Collection for the five-month period o f August to December 2007 was equivalent to 2.1 percent o f GDP on an annualized basis. Box 3. Reformingthe Tax System Actions taken prior to Board presentationof PRTDPLI Parliament has approved the tax reform law (law no. 18.083 dated December 27, 2006). Prior actionfor Boardpresentationof PRIDPL I1 DGI is leading and coordinating the personal income tax (IRPF) collection efforts o f different collection- retention agencies as provided inArticle 8 o f the Tax Reform L a w (which amends Article 1 o f Chapter Io f Title 7 o f the Texto Urdenado 1996). The following implementation targets are inplace: (i)DGIandBPSinspectorshavebeentrainedintheskillsrequiredfortheirjobs; (ii)Establishmentof210DGIpostsoutsideDGIandataxcallcenterforconsultations; (iii)SingleTaxRegistryisinoperation; A (iv) IRPFtax files are being transferred monthly fromBPS to DGI; and (v) DGI has consolidated taxpayer information into a single IRPF tax file combining income from different sources for each multi-employed contributor.* Medium-TermIndicators (2009) Total tax revenue-to-GDP ratios are at least equal to the 2005 value o f 22.5 percent o f GDP for 2008 and 2009. Effective IRPF and IASS tax contributors increase. Target isfor IRPF and IASS tax contributors to risefrom a baseline of around 200,000 in 2006. IRPFrevenue collection is sufficient. Target is that IRPF revenue is greater than or equal to 2.1 percent of GDP in 2009. Cost o f total tax collection decreases. Target is that the ratio of tax collection costs to tax revenuespeaks (at 1.5percent) in 2007 in view of the sizablefixed investment and human capital requirements to implement the reform. Total tax administration costs areprojected to decline to at most 1.3percent of revenue in 2009. 30 59. The recentlyannouncedchange to the tax reformlegislationfor pensionersdoes not constitute a reversal that would adversely affect the achievements of the objectives of the PRIDPL program. For pension income, the change will replace the IRPF and the non-resident income tax (Renta de No Residentes, IRNR) with a new social security tax (Impuesto de Asistencia a la Seguridad Social, IASS). The IRPF will remain in effect for all non-pension income. The Government is introducing the IASS in response to a Supreme Court decision earlier this year that application o f the IRPF to pensions was unconstitutional. This ruling affected some 1,500 individual pensioners. Following a change in one o f the five justices, the Court subsequently ruled that taxation o f pensions under the IRPF is in fact constitutional. To resolve the issue, Parliament approved the new IASS on July 4, 2008 (Law 18.314), in time for the new tax to become effective on August 1, 2008. There is estimated to be an annual shortfall inthe IASS collection vis-a-vis that collected from pensioners under the IRPFof about US$40 million (about 0.2 percent o f 2007 GDP). BUSINESSCLIMATE AND CAPITAL MARKETS REFORM- COMPONENT I11 CAPITAL MARKETS PROMOTIONAND REGULATORY FRAMEWORK 60. The final draft of the new Capital Markets Law was sent to Parliament in November 2008. The consultation process with private sector stakeholders included the discussions opened by MEF at the Securities Market Annual Seminar held at the central bank in April 2008. Expert opinion has been sought (including the input of World Bank specialists) on the draft law and the draft was adapted to take into account both expert advice and to meet the concerns o f the private sector. The new draft law i s an important advance over the current existing legal framework and it will provide an improved legal basis for capital markets development. As in many other countries, changes to the legal framework are introduced gradually and new adjustments may be required in the future as capital markets further develop inUruguay, butthe new draft is proportionatewith the current development ofcapitalmarkets in the country. The new legal framework introduces important improvements in the areas o f corporate governance, minority investor protection and information disclosure. It also includes initial steps for improved markets and intermediaries (including, for example, a demutualization option for the stock exchanges, and initial steps towards conversion o f individual broker-dealers into joint stock companies) and simplification o f procedures. The law opts for a regulatory approach, versus a self-regulatory approach, as with other jurisdictions around the world, but has introduced a formal consultation process for market promotion through a Market Promotion Committee (Comisidn de PromociBn del Mercado de Valores). 61. There has been progress in terms of other legal and regulatory changes under the capital reform implementation plan, and the implementation of the securities market promotion and regulatory framework. The pension funds (Administradoras de Fondos de Pensiones, AFPs) investment regime was opened up somewhat in May 2007 through changes (Law 18.127 o f May 12, 2007) to the Social Security Law (Law 16.713 o f September 3, 1995, articles 123 and 124) to allow for investments by AFPs in securities issued by international organizations. On August 31, 2007, a law (Law 18.172) was passed that included a tax exemption regime for certain trust funds (Fideicomisos Financieros, FF), namely those under the Multi-Sector Global Credit Program to provide a common tax treatment for different financing instruments. There have been certain improvements in the organization and human resources o f 31 the Securities Market Regulator (Departamento de Mercado de Valores, DMV) at the BCU. The implementation o f risk-based supervision has begun, with B C U preparing to build new IT systems. New regulations have been issued by the B C U to follow-up on some o f the recommendations included in the International Organization of Securities Commissions (IOSCO) Principles assessment o f 2007. Interms o f market activity, there has been a significant increase o f 69 percent in primary market activity on the stock exchanges in2007 compared with 2006. The DVMhas designed a new plan for the oversight o f the settlement activity o f the stock exchanges, Montevideo Stock Exchange (Bolsa de Valores de Montevideo, BVM,) and Electronic Stock Exchange (Bolsa Electrbnica de Valores del Uruguay, BEVSA). More importantly, the B C U Board has decided to implement a new large value payments system that includes a securities depository for both public and private securities. These reforms to the payments and securities settlement systems have been included as a separate prior action under PRIDPL 11. Box 4. CapitalM a r k e t s Promotion and Regulatory F r a m e w o r k Actions taken prior to Board presentation of PRIDPL I MEF incollaboration withthe BCU's (Banco Central del Uruguay) securities regulator (DMY) produces an overall strategy and implementation plan for capital markets reform. Prior action for Board presentation o f PRIDPL I1 The Executive has presentedto Parliament for approval a draft capital markets law. Medium-Term Indicators (2009) Increased capital markets depth, as measured by: (i)Riseinmarketcapitalization(currentlybelowUS$20million); and (ii)Increaseinstockexchangeactivityforboththeprimaryandthesecondarymarket(in2006about US$4,500 million for both stock exchanges, about US$3,500 million primary market and about US$l,OOO million for the secondary market). Improvement in compliance with IOSCO Principles on Securities Regulation and CPSS-IOSCO Recommendations on Securities Settlement Systems (staff assessment on progress from baseline as set out in the 2007 assessment). REFORMINGTHE PAYMENTS SYSTEM 62. Business climate and capital markets developmentdepends on a safe and efficient financialinfrastructure.The reform o f the overall payments and securities settlement is one o f the set o f actions identified by the government as promoting capital markets development and was part o f the original capital markets reform plan included in the PRIDPL Ioperation. Authorities and the private sector in Uruguay are engaged on a comprehensive reform o f payments and security settlement systems. The main objective o f this reform is to develop safe, efficient and reliable systems for the clearance and settlement o f securities and funds transactions. 63. These reforms require not only upgradingof the operational systems, but also the improvement of the legal and oversight framework. The central bank is playing a coordinating role in this reform and a strategy document has been discussed and agreed with other authorities and the private sector. The central bank i s currently undertaking the implementationphase o f the reform that includes four main components: (i) the acquisition o f an 32 external provider o f a real time gross settlements system and a securities depository and related applications; (ii) the improvement o f the legal and regulatory framework through the drafting o f a payments system law; (iii) the improvement o f the retail payments system; and (iv) the establishment o f a formal B C U oversight function over payments and securities settlement systems and coordination with other authorities. 64. The first steps in implementingthe new payments system have been achieved. The payments system reform strategy plan and implementation plan have been approved by the central bank (BCU) and communicated to the private sector. In addition, the legislation necessary to put inplace the new payments system has been drafted and sent by the B C U to the MEF inMay 2008. This begins the progress o fthe draft law to parliament later in2008/09. The prior action for PRIDPL I1Board presentation comprises the approval o f the strategy plan and implementationplan and the drafting o f the new payments systems law. Box 5. Reform of Payments and Securities Settlement Systems Actions taken prior to Boardpresentationof PFUDPLI Included as part o f the overall strategy and implementation plan for capital markets reform. Prior action for Board presentationof PRIDPL I1 (i)TheBoardofDirectorsofBCU(centralbank)hasapprovedaplanthatissatisfactorytotheBankforthe implementation o f an overall payments and securities settlement system reform; and (ii)TheBoardofDirectorsofBCUhassubmittedtoMEFforapprovalbytheExecutiveanewdraft payments system law (Anteproyecto de Ley sobre Compensacidn y Liguidacion de Pagos y Valores). Medium-TermIndicators (2009) Real Time Gross Settlement (RTGS) system in operation and in compliance with the Committee o n Payment and Settlement Systems (CPSS) o f the Bank for International Settlements (BIS) core principles for systematically important payment systems (staff assessment on progress from baseline as set out in the 2007 Report on the Observance o f Standards and Codes (ROSC)). (Payments system will be hnctioningin2010). 65. The new payments and securities settlement systemwill becomefunctional in 2010, so an assessment of the new payments and securities settlement system will be possible thereafter. Once the system is inplace and it has been functioning for an appropriate length o f time (to be decided by the sector specialists in this area), a update o f the 2007 Report on the Observance o f Standards and Codes (ROSC) is expected to be carried out to assess whether the Real Time Gross Settlement (RTGS) system i s in operation and in compliance with the Committee on Payment and Settlement Systems (CPSS) o f the Bank for International Settlements (BIS) core principles for systematically important payment systems REFORMOF THE LEGAL AND INSTITUTIONAL FRAMEWORKFOR CORPORATE INSOLVENCY 66. The insolvency and enterprise reorganization(bankruptcy) law has been approved by parliament. In June 2008, a parliamentary commission (Comisiones Permanentes de Constitucidn, Cddigos, Legislacidn General y Administracidn de la Camara de Representantes) completed reviewing the draft law and consulting with key stakeholders. On July 1, 2008, the law was approved by the House o f Representatives (Cdmara de Diputados) and next approved 33 by the Senate on October 23, 2008. The Bankruptcy Law was due to be effective as o f April 2009, but an amendment approved on November 14made it effective from November 3,2008. , but a proposal has been put forward to parliament to make the law immediately effective. Pending approval o f the law, the MEF representatives had already started training and dissemination activities included under the implementation plan. The new legal framework has been discussed and disseminated in key universities (e.g., Universidad Publica, Universidad Catdlica, Universidad de Montevideo). Training activities on the specific workings o f the law are due now to beginfollowing the recent approval o f the law by Parliament. 67. Progresswith the medium-termindicatorsfor the bankruptcylaw is to be based on a joint assessment of qualitative and quantitative indicators. To measure progress the assessment would focus both on the Insolvency and Creditor Rights ROSC update and the following quantitative indicators: (i) an increase in the number o f insolvency cases presented; and (ii) an increase inthe number o f insolvency cases satisfactorily resolved and reduction inthe time required to do so. A joint assessment is necessary as quantitative indicators alone are an insufficient gauge o f progress. The quantitative indicators could be influenced by factors exogenous to the implementation o f the new legal framework, such as the economic cycle. Therefore, a more coherent assessment would use both the quantitative and qualitative indicators to take into account all relevant factors with regard to the bankruptcy reform implementation. The MEFis planningto carry out a study incooperationwith the Supreme Court (Suprema Corte de Justicia) to determine the 2004-06 baseline for the quantitative indicator on the number o f insolvency cases satisfactorily resolved and the time required for resolution. It will be necessary for the government, with the assistance o f the World Bank sector specialist, to agree on a definition o f "cases satisfactory resolved". As the new bankruptcy framework is not going to come into effect until at the earliest 2009, the final performance under this component would not properly be reviewed until after 2009. Box 6. BankruptcyReform Actions taken prior to Board presentationof PRIDPL I The Executive has submitted to Parliament a Bill on Insolvency and Enterprise Reorganization (Bankruptcy Law), which includes liquidationandreorganizationprocedures. Prior action for Boardpresentationof PRIDPL I1 The House o f Representatives (Camara de Diputados) has approved a draft Insolvency and Enterprise Reorganization Law (Ley de Concursosy ReorganizacidnEmpresarial). Medium-TermIndicators (2009) Insolvency and Creditor Rights ROSC update shows compliance improvement to be jointly assessed with the quantitative indicators below: (i)Increaseinthenumberofinsolvencycasespresented(baselineisanaverageof56perannumover 2004-06); and (ii)Increaseinthenumberofinsolvencycasessatisfactorilyresolvedandreductioninthetimerequiredto do so (baselines for 2004-06 to be determined ina study to be camed out by MEF incooperation with Supreme Court). 34 INFORMATION TRANSPARENCY AND DISCLOSUREREFORM 68. Significant progress has been made in improving the information transparency framework. This activity is focused on improving the institutional framework for accounting standards, including the establishment o f a system o f independent accounting over~ight.~ InJuly 2007, the Executive issued Decree 266/07 establishing as obligatory from January 1, 2009, the International Financial Reporting Standards (IFRS) adopted by the International Accounting Standards Board as o f the date o f publication o f the decree. The IFRS include: (a) the requirement for enterprises to consolidate financial statements when a group o f enterprises comes together under one company (International Accounting Standard (IAS) 27); and (b) the requirement that enterprises provide information about related party transactions (IAS 24). A resolution o f the Executive o f September 2007 strengthened the composition o f the accounting norms commission (ComisiBn Permanente de Normas Contables Adecuadas, CPNCA) adding representatives from the central bank (BCU), la Direccidn General Impositiva (DGI) and a representative o f the private universities. The reinforced CPNCA worked intensively on the drafting o f new accounting standards legislation. The draft law establishing a new entity in charge o f accounting standards (Ente de Emisor Normas Contables)was submitted to parliament inJuly 2008. The new entity would have the technical and financial capacity, andindependence to lead the process in ensuring the latest accounting norms are adopted. The new entity will be responsible for the application o f the IFRS, which includes the presentation o f consolidated financial statements and the requirement that information on related party transactions is provided by enterprises. Under the new law, the role o f the existing accounting norms commission (CPNCA) will be institutionalized as a formal advisory body for the new entity. Amendments to the corporate law required to ensure the consistency o f the new legislation with the legal framework were sent to parliament inJune 2008 together with the government's budget (Rendicion de Cuentas). Once the IFRS standards come into force inJanuary 2009, consolidated accounts will be audited, where applicable, through the requirement that auditors verify that the accounts have been prepared according to the accounting standards ineffect. 69. The next steps will be to improve the audit framework. Plans are already inplace to establish an entity responsible for independent oversight o f statutory audits. Draft audit legislation has been prepared, but discussion has not taken place to reach agreement on the final version o f the law to be sent to Parliament. A key obstacle to be settled prior to the audit law presentation is agreement on the separation o f audit and consultancy services. 4. The expression "system o f independent oversight' is normally used to describe a system o f regulations and supervisory mechanisms aimed at ensuring that auditors comply with their professional obligations and are accountable for any errant behavior. In this particular case, the intent was instead to describe a system whereby the government oversees the accounting standard-settingprocess, through the establishment of the new entity in charge of accounting standards under the MEF and the strengthening of the accounting norms commission (CPNCA). 35 Box 7. InformationTransparency and Disclosure Actions taken prior to Board presentationof PRIDPLI MEF, in collaboration with BCU, AIN (Auditoria Interna de la Nacidn), TCR (Tribunal de Cuentas de la Repziblica) and the CPNCA (Permanent Commission on Accounting Standards), produces an Implementation Plan for improving information transparency. Prior action for Board presentationof PRIDPL I1 (i)TheExecutivehasissuedDecree266/07establishingasobligatoryfromJanuary1,2009theInternational FinancialReporting Standards (Normas Internacionales de Informacidn Financiera) adopted by the International Accounting Standards Board as o f the date o f publication o f said Executive Decree, which include: (a) the requirement for enterprises to consolidate financial statements; and (b) the requirement that enterprises provide information about related party transactions. (ii) HouseofRepresentatives(CbmaradeDiputados)hasapprovedamendmentstotheLawnumber16.060 The o f September 4, 1989,published inthe Official Gazette on November 1, 1989 (Ley de Sociedades Comerciales) to eliminate inconsistencies with the accounting standards referred to inparagraph (i)(a) above. (5)TheExecutivehasadoptedaresolution(Resolucidn delPoderEjecutivo 598/07)thatstrengthensthe composition of the CPNCA by adding representatives o f BCU, DGI, private universities and the Association o f Private Banks o f Uruguay (Asociacidn de Bancos Privados del Uruguay). (iv) The Executive has presentedto Parliament draft legislation establishing a system o f independent accounting oversight. Medium-TermIndicators (2009) Most recent version of IFRS implementedby all corporate companies. Availability o f large and medium enterprises financial statements inthe companies' registry on-line. Public enterprises (UTE, OSE, ANCAP and ANTEL) make public timely their audit reports and financial statements with improved quality o f information (including management indicators) following the same standards as private companies. SOCIAL PROTECTION-COMPONENT IV STRENGTHENINGTHE SOCIAL PROTECTION SYSTEM 70. The government's social protection reforms are fully on track. Legislation was approved in December 2007 for a new system o f family allowances, which is to be the main instrument for income transfers to poor families under the new, permanent social safety net (Plan de Equidad SociaZ) (Box 9). The new family allowances program was introduced on January 1, 2008 and immediately replaced the Citizen's Income benefit (Ingreso Ciudadano), the income transfer program under the emergency social plan PANES introduced in 2005. In parallel, the government has taken effective action to reduce social contribution tax exemptions and adopt a new unified social contribution rate for employers o f 7.5 percent. This was implemented as part o f the tax reform package put into effect on July 1, 2007. Data i s not yet available to assess the impact o f this measure on the coverage o f active workers by the social security system. 36 Box 8. Strengthening Social Protection Actions to be taken prior to Board presentationof PRIDPL I Implementation o f Laws 17139 and 17758 has resulted in increased coverage o f non-contributory family allowances program o f children o f unemployed individuals and informal workers (Coverage reached 210,258 by October 2006 compared to 184,252 at the end-2004). Implementation o f policy to increase coverage and revenue collection o f the formal social security system, through: (i)BPSBoardeliminatedexceptionregimes; (ii)BPSintroducedenhancementsinenforcementpolicies;and (iii) 17.963promotedregularizationofemployersindebtedtothesystem. Law Prior action for Board presentationof PRIDPL I1 The government i s implementing the new structural income transfer policy (Plan de Equidad Social), which includes as a core component the new family allowances system establishedby Law 18.227 dated December 22,2007 andpublishedinthe Official Gazette on January 9,2008. The government is implementing tax reform legislation (Law 18.083 o f December 27, 2006) to eliminate exemptions to selected sectors and industries and to adopt a new unified social contribution rate of employers (7.5% o f wages) (Articles 87-94 o f the Tax ReformLaw). Medium-TermIndicators (2009) By 2009, at least 70% o f the poorest quintile households are covered by Plan de Equidad (as o f 2006, 61% o f the poorest quintile households were covered by PANES or Family Allowances Program). Coverage o f active workers by social security system continues to grow. By 2009, at least 70% o f the occupied labor force contributes to social security (as o f 2006, 65% o f occupied labor force contributed). Box 9. Family Allowance System in Uruguay The family allowances program (FA) in Uruguay was, in its origin, a contributory scheme, financed with workers and employers contributions and restricted to salaried formal workers. In 1980, a reform eliminated the earmarked contributions. Since 1999 the system o f FA experienced three reforms that transformed it into a dual scheme where non-contributory benefits are paid inparallel to contributory ones. According to Law 16.697, "contributory" FA can be claimed for children younger than 18 years old by salaried workers inthe private sector, civil servants, retirees and unemployment insurance beneficiaries. Benefits are paid per child, and there are two levels, depending o n workers' income. Children o f workers earning less than six BPC (Base de Prestaciones Contributivas, an index used to adjust all social security variables, valued at UR$1636 in early 2007) receive an allowance o f 16 percent o f that value, while the children o f workers earning between six and ten BPC receive 8 percent o f that value. Children o f workers earning more than 10 BCP receive no benefit, with a few exceptions. Benefits are paid by the BPS inthe case o fprivate sector employees, retirees and unemployment insurance beneficiaries, or directly by the State, inthe case o f civil servants. Family allowances coverage was extended to children o f poor, informally employed families in 1999. In a departure fromprevious practice, Law 17.139 granted FA to children living inl o w income households (less than 3 minimum salaries, later replaced by the BPC), if their father had been a beneficiary of the unemployment insurance and exhausted the six-month limit or they are solely supported by their mother. Benefits were set at the same level o f the contributory FA. Enrollment in this new program was slow until a reform introduced in late 2004 extended coverage to all children o f low income households, regardless o f the employment status o f their parents. As a result, by late 2007 nearly 215,000 children received this benefit. As part o fthe Plan de Equidad Social a major reformon the FA program was introduced inearly 2008 (Law 18.227). Duringthe first phase, the reform expects to reach 330,000 children by migrating beneficiaries from the old non-contributory system, plus those qualifying participants from the closing cash transfer program (Ingreso Ciudadano). Ina second phase (2009), authorities plan to add an extra 170,000 children, estimated to be eligible butnot yet enrolled inthe system. The new non-contributory FA increases the amount o fthe benefit, introducing 37 two payment scales that take into account the number o f children inthe household and their schooling level, the latter intendingto reduce drop-out rates at secondary schools. The impact o f the new scheme on social indicators i s expected to be significant. Once hlly implemented, the program should result in a reduction o f extreme poverty by nearly 20 percent, while total poverty would decline by 7 percent. In fiscal terms, the reform is expected to have a small impact in the first year, as the expanded benefits will be compensated by the closing o f PANES. The cost o f Ingreso Ciudadano in 2007 was 0.25 percent o f GDP, while non-contributory family allowances totaled another 0.07 percent of GDP. In 2008, with Ingreso Ciudadano replaced by an expansion of non-contributory family allowance, their cost increases to 0.34 percent of GDP. During the second phase expansion, the estimated additional cost could reach 0.47 percentage points o f GDP in2009. VI. OPERATION IMPLEMENTATION VI.l. POVERTY AND SOCIAL IMPACT 71. Overall, the policies supported by the PRIDPL program are expected to have a significantpositivesocial impact, includingfor the poorer groupsin society. The program is expected to have a positive impact by increasing equity in the tax system, encouraging investment and growth, and enhancing social protection for low-income households. The tax reform and social policies supported by this operation are estimated to have direct, positive distributional effects. These policies also are expected to bebeneficial for social cohesion. 72. The tax reformis estimatedto have a significantandpositiveimpacton equity and a small, but beneficial, impact on poverty.Estimates from an analysis carried out by the World Bank looking at the change in tax incidence due to the reform indicate that the replacement o f the former wage tax (Impuesto a las Retribuciones Personales, IRP) with the personal income tax (Impuesto a la Renta de la Personas Fisicas, IRPF) results in an improved situation for the bottom 80 percent o f labor income earners, for whom the mean tax rate falls (Annex 3). The mean direct tax rate increases' for the top 20 percent o f taxpayers. The mean tax rate here refers to the average IRP and IRPFpayments by decile as a share o f labor income, including any labor income from secondary occupations. Workers in the tenth decile are calculated to pay, on average, 7 percentage points more tax on their labor income, which implies an increase in their tax burdenby 150 percent. For the ninthdecile, the increase inthe mean tax rate is much lower at 0.3 percentage points. All households are estimated to benefit from a reduction inthe indirect tax rate due to the tax reform, which falls by on average over 2 percentage points over the different income groupings. An analysis o f the total impact o f the reform shows it to be progressive. The reform alters the relative neutrality o f the pre-reform tax system. Following the tax reform, there is a monotone increase inthe tax burdenfrom the median onwards. 73. For pensioners,the replacementof the IRPFwith the new social securitytax (IASS) will represent a progressive change. Whether the impact on equity will be significance or not has yet to be determined. Under the IRPF, the tax burden for pensioners was increased from the eighth decile onwards due to the introduction o f the IRPF. Pensioners paid little wage tax on pension income prior to the tax reform. With the new IASS, higher income pensioners will pay more than under the IRPF. The nontaxable minimum has been increased, income levels 38 previously taxed at the second lowest tax rate (15 percent) will be taxed at the lowest tax rate (10 percent) and the former highesttax rate kicks inat lower income levels. 74. The business climate and capital markets reforms are not expected to have an adverse poverty or social impact. Rather increasing investment due to the development o f the business climate and capital markets would be expected spur growth and employment generation, thereby reducing poverty. Relative to Latin America, the country has had relatively low per capita GDP growth rates over the last 40 years. Continued high and broad-based growth would raise average income and reduce poverty. To the extent that these measures will spur revenue growth and thereby support the government's ability to maintain social spending levels, their impact on incomes is expected to bepositive. 75. The strengthening of the social protection system is targeted toward increasing the welfare of low income groups and so i s expected to have a significant positive effect on poverty. The policies supported are aimed at expanding and consolidating the social protection system, reinforcing the protection o f the poor and vulnerable; and increasing efficiency, transparency and accountability o f social protection institutions. The impact o f the Plan de Equidad Social on social indicators is expected to be significant. Once fully implemented, the program should result ina reduction of extreme poverty by nearly 20 percent, while total poverty would decline by 7 percent. VI.2. ENVIRONMENT,FOREST,AND NATURALRESOURCES 76. The specific policies supported by the PRIDPL I1 operation are not expected to entail significant impacts on the environment, forests or other natural resources. However, to the extent that measures supported by the PRIDPL program are successful, over time, in attracting new investment (including in infrastructure), there will be a need to continue strengthening Uruguay's institutional capacity to identify and address environmental policy and regulatory issues. 77. Environmental policies and regulations are in place, and implementation is improving. The Ministry o f Housing, Planning and Environment (Ministerio de Vivienda, Ordenamiento Territorial y Medio Ambiente, MVOTMA), through the National Environment Directorate (Direccidn Nacional de Medio Ambiente, DINAMA) i s responsible for the formulation, execution, supervision, and evaluation of the national plan for environmental protection and for proposing and implementing national policy, harmonizing the needs o f environmental protection with sustainable development. Uruguay's large new foreign-financed investments in the pulp industry have elevated the public awareness of, and government commitment to, monitoring and compliance with environmental regulations. Uruguay was one o f the first countries in the region to complete its Second National Communication on Climate Change (in 2004), and has subsequently moved quickly to benefit from innovative financing through the carbon market. Carbon and GEF strategies are being implemented to improve solid waste management in its two largest cities, as well as initiate multiple investments inrenewable energy. 39 VI.3. PARTICIPATION 78. Inthe three policyareas supportedby the PRIDPL11, the governmenthasconsulted with the civil society and relevant actors. The proactive stance the government has taken in consulting with Uruguayan society on each o f the main policy reforms supported by the PRIDPL I1provide additional credibility and should advance the success o f the operation as a whole. Since the PRIDPL Ioperation, the following participatory activities have been conducted: Capitalmarkets. The MEF opened the consultation process on the draft capital markets law with private sector stakeholders at the Securities Market Annual Seminar held at the B C U on April 1-3, 2008. The seminar had sessions on international experience regarding demutualization and self-regulation; as well as major components o f the implementation strategy, including self-regulation, professionalization o f market operators and investor protection, and market transparency. Expert opinion was been sought on the draft law and the draft was modified to take into account both expert advice and to meet the concerns of the private sector. Payments system. A seminar took place over May 29-30, 2008 at the BCU with key actors and international experts to present the Implementation Plan and discuss it with domestic stakeholders and also present international experience in implementing payments and securities settlement system reforms. In addition, the central bank has established coordination arrangements to incorporate the points o f view and opinions of all interested parties. Inthis respect, the central bank has put together working groups to help implement the reform pillars and define the aspects o f concern. Bankruptcy Law. The review period by the parliamentary commission (Comisiones Permanentes de Constitucidn, Cddigos, Legislacidn General y Administracidn de la Cumara de Representantes), which is incharge o f reviewing the draft law and o f holding consultations with key stakeholders, was lengthy, lasting fi-om August 2006 to June 2008. Due to the consultations, a small amendment was put inplace to protect workers' rights inthe case where an owner declares bankruptcy, workers are the only creditors and there is no open liquidation process (proceso concursal abierto). Since the 2002 crisis, 12-15 firms have been recovered in these particular circumstances. Information Transparency and Disclosure. The accounting norms commission (CPNCA) drafted the amendments to the law now sent to parliament. The final legislation resulted fi-om a collaborative process in 2007 between the MEF, central bank (BCU), the general tax directorate (DGI), the court o f accounts (Tribunal de Cuentas, TCR), academics inthe field and representatives o fprofessional organizations. VI.4. IMPLEMENTATION, MONITORINGAND EVALUATION 79. The followingdata sources will be usedto assessprogressfor the PRIDPL program: Central and non-financial public sector budgetmonitoring from the Ministry o f Economy and Finance; B C Ureports and analysis; 40 DGIandBPS information systems; Investment climate surveys; 0 Reviews and analyses o f laws and implementingregulations from the World Bank and other stakeholders; Financial audits and follow up o f CFAA recommendations; 0 World Bank supervision missions and reports; and IMFArticle IV consultations. 80. The Uruguayan government and the Bank have agreed to monitor progressin the PRIDPL program regularly, including during periodic reviews of CAS progress. Discussions will be held with the Ministry o f Economy and Finance, the main counterpart agency for the loan, which is in charge o f monitoring and evaluation for the program and for collecting from the appropriate sources the data necessary to assess implementation progress. Other agencies that play an important role inthis process are the Central Bank (for capital market issues), DGIand BPS. The maintenance o f agreed triggers for continued policy-based lending, in particular, maintenance o f a satisfactory macroeconomic framework and progress with the overall structural program, was reviewed in the CAS Progress Report circulated to the Board in March2008. 81. The proposed PRIDPL I1 operation would feature the DDO disbursement option. Therefore, it has been agreed to maintain a continuous monitoring process over the 3-year period. The revised procedures for DDOs are intended to provide borrowers with greater certainty regarding the availability o f Bank funds. Under the new procedures for DDOs agreed by the Executive Board in 2008, throughout the draw-down period, the Borrower and the Bank maintain a close policy dialogue. During this period, Bank staff will continuously monitor the Borrower's macroeconomic policy framework and continued adherence to the overall program set out inthe Letter o f Development Policy. Following the request for withdrawal, the Borrower may draw down the loan funds unless it has received prior notification from the Bank that one or more draw-down conditions are not met and that a subsequent review is necessary. Monitoring o f the PRIDPL I1 operation will be based on the framework already established with the authorities under the PRIDPL program. For the program areas, a medium-term results monitoring framework is inplace through 2009, and this will be expanded to include the added focus on payments systems. Monitoring indicators for 2010-11 will be agreed with the incoming government after the 2009 elections to encompass the entire period o f the program. In the areas where the government policy agenda has moved is advanced, such as the tax reform, the medium-term indicators are very precise. Inother areas where progress is less advanced, such as the bankruptcy legislation, the medium-term indicators are more general and will be tightened as the program moves forward. VI.5. FIDUCIARYASPECTS 82. The conclusions of the Uruguay Country Financial Accountability Assessment (CFAA) is that Uruguay's PFM fiduciary risk is considered low due to the existing accountability policies and practices. Public financial management (PFM) in Uruguay is sound, reliable and with a good level o f transparency, despite the existence o f room for improvement, particularly with regards to flexibility and efficiency. Taking into account the 41 CFAA conclusions and assessment o f Uruguay PFM fiduciary risk, there i s no additional condition for the proposed operation. However, the Bank reserves the right to request an audit o f the deposit account inwhich loan proceeds are received. 83. The current foreign exchange control environment within the Central Bank is satisfactory. The conclusions o f 2002 IMF Safeguard Assessment were overall satisfactory. Another IMF Safeguard assessment was completed in September 2005 and IMF review under the 20065 and 20076 Article IV consultations confirmed that most o f the recommendations from the last safeguard assessment were already implemented. 84. The overall assessment of the procurementfunction in Uruguay is that the system is in need of improvement. The government procurement function in Uruguay has two key characteristics: on the one hand, the procurement function is generally considered to be free o f corruption, but on the other hand, the system i s slow and inefficient. Agencies often find ways out-mainly through exceptions and waivers to competition-to acquire goods and services thus reducing competition and business opportunities in a relatively small market. In Uruguay, the exceptions to the normal procedures appear to be the response o f the purchaser to a lengthy decision making process and cumbersome procedures that ifproperly followed would take many months to deliver. The Country Procurement Assessment Report (CPAR) 2000 and the 2005 update noted the limited commitment by the national authorities towards reform and modernization o f the procurement function. Among the main issues that need to be addressed in Uruguay are: a stronger policy making or regulatory body o f the procurement function; more specialization o f the law and regulations in respect to the procurement o f goods, works and consultant services; regulation o f the public audiences; better internal and external control mechanisms; merging and simplification o f registers; and to further strengthen the e- procurement. The Bank and IDB will be approaching the government to suggest the application o f the OECD benchmarking methodology within the next months in an effort to establish a dialogue with government and key stakeholders on government procurement that was not achieved duringthe CPAR update. The I B T A L is providing support to one procurement function that appears advancing in the correct direction: e-procurement by the Unidad Central de Aquisiciones (UCA). VI.6. DISBURSEMENTSAND AUDITING 85. The administrationofthis loanwill be the responsibilityof the Ministryof Economy and Finance. The proposed loan will follow the Bank's disbursement procedures for development policy loandcredits. The untied balance o f paymentshudget support will be disbursedagainst satisfactory implementation o f the development policy program and not tied to any specific purchases and no procurement requirements will be needed. Once the loan is approved by the Board and becomes effective, the borrower may submit a withdrawal application requesting the Bank deposit the proceeds o f the loan in an account designated by the Borrower and acceptable to the Bank at the Central Bank o f Uruguay at the request o f the Borrower. The Borrower shall ensure that upon the deposit o f the Loan into said account, an 5. 2006 Article IV consultation, Fourth Review under the Stand-By Arrangement, Appendix 11, page 53; IMF CountryReportNo 061425;December 2006. 6. 2007 Article I V consultation, Appendix 11,page 44; IMF Country Report No 071111; July 3 1, 2007. 42 equivalent amount i s credited in the Borrower's budget management system, in a manner acceptable to the Bank. The Borrower will report to the Bank on the amounts deposited in the foreign currency account and credited to the budget management system. Ifthe proceeds o f the loan are used for ineligible purposes as defined in the Development Policy Loan Agreement, IBRDwill require the Borrower to promptly, uponnotice from IBRD,refundan amount equal to the amount o f said payment to IBRD.Amounts refunded to the Bank upon such request shall be cancelled. While the whole amount o f the loan will be available upon effectiveness, there could be more than one disbursement o f loan proceeds. This is particularly relevant in case disbursements will take place in Uruguayan pesos, where the amount disbursed would be dependent on the market appetite for a local currency bond issuance. VI.7. RISKSANDRISKMITIGATION ECONOMIC, POLITICAL AND SOCIAL RISKS 86. The key economic risk remains public debt sustainability. Three factors have mitigated this risk in recent years. First, growth has been well over the 3 percent targeted under the base case. Second, the primary surplus over 2004-07 outperformed expectations as envisaged when the CAS was put together in 2005. Third, there have been additional gains in terms o f declining public debt ratios and debt servicing needs due to the depreciation o f the U.S. dollar prior to 2008. As mentioned above, the debt management efforts o f the government have further contributed to reduce medium-term public sector financing requirements. 87. The main risk to debt sustainabilityis the potentialimpact of a globalslowdown on Uruguay's economic growth. A small, open and dollarized economy, the implications o f a global slowdown could be substantial for the real sector inUruguay. The commodity-dependent export base i s vulnerable to a downturn in agricultural commodity prices and demand. While the country has diversified its export markets and the economy could well be robust to a modest decline in global demand, a significant and prolonged slowdown in global demand would likely entail more detrimental effects for growth and the fiscal situation. Regional conditions are a concern for Uruguay, given its small size relative to its neighbors andpartners inMERCOSUR. 88. Financial sector vulnerability is a second important source of economic risk. The main risks posed by the financial sector in the 2002 crisis were the high levels o f dollarization, the importance o f State Banks, and a combination o f inadequate supervision o f foreign banks and high levels o f non-resident deposits. While substantial progress has been made, some o f these factors still pose risks. The government continues to face large contingent liabilities arising from explicit and implicit guarantees to the state banks and non-banking financial institutions. Public banks represent more than 50 percent o ftotal banking system assets. 89. Financialsector vulnerability has diminishedbut the current internationalsituation raisessome uncertainties.There has beena steady improvement infinancial sector indicators in recent years. Solvency and liquidity ratios for the banking sector are better, and profitability has increased. However, a deep and protracted deterioration in international economic conditions may increase NPLs. Also, the current level o f unremunerated reserve requirements has negatively affectedbank profitability. 43 90. Recently, the interbank money market has shown high interest rates and increased volatility. This has been triggered by a change in behavior o f economic agents, who have been switching the currency denomination o f their banking deposits from pesos to U.S. dollars, forcing banks to buy U.S. dollars. Regional factors seem to have less potential to affect the financial sector in Uruguay than in the past as foreign deposits represent 18 percent o f total deposits, compared to 50 percent previous to the 2002 crisis. In addition, liquidity requirements on foreign deposits are high, at 30 percent. 91. A strengthened prudential regulatory and supervisory framework for the financial system would help to better contain risks. NPLs are low at below 1 percent and the level o f provisioning seems adequate following the adoption o f a conservative approach on prudential regulation after the 2002 crisis (e.g., anticyclical provisions, and the carrying out o f stress tests on foreign exchange position o f non-tradable sector). Currency mismatch has been better protected. Loans in foreign currency have been mainly targeted to the tradables sector. Most consumer and mortgage loans are now denominated in pesos or indexed units: the levels o f dollarization o f consumer loans and mortgages is only 14 percent. There may be an increasing exposure o f the corporate sector to exchange rate depreciation given a relatively long period o f peso appreciation that may have changed economic agents' appetite for dollars. This risk i s mitigated due to the central bank's prudential regulation policy. Provisioning requirements oblige banks to perform a stress test on loans for the non-tradable sector and take it into account for the credit category classification and, thus, provisioning. Also, the central bank applies capital requirements for net exposures on foreign currency. The central bank monitors closely this risk through the implicit foreign exchange risk indicator (non-tradable sector exposure). The new central bank Charter Law intends to enhance the institution's operational autonomy and accountability. The amendments to the charter unifying the banking, insurance, securities and pension regulation (Superintendencia de Sewicios Financieros) and separating from the central bank the administration o f the deposit insurance fund (Corporacibn de Proteccidn al Ahorro Bancario) are intended to strengthen the institutional framework and supervision o f financial institutions. In addition, World Bank support for the implementation plan for capital markets reform, including the strengthening o f the securities market promotion and regulatory framework, is intendedto further mitigate financial sector risks. 92. Political risks relate to the potential for a reversal of the current policies in the event of a substantial external shock or change of government following the 2009 elections. These risks are mitigated by Uruguay's track record o f strong commitment to fiscal prudence following the 2002 crisis and the efforts by the government to build support for its policy reforms, in line with Uruguay's tradition o f consensus building. In the area o f capital markets reforms, the sustainability risks are particularly substantial as the reforms are less developed and the timetable for the ,reform program is less clearly defined. The tax reform has also encountered some domestic opposition as witnessed by the initial Supreme Court rulings on its applicability to pension income. However, the government has responded appropriately and managed to keep the reform on track. 93. A risk to the business climate is posed by labor relations, particularly during an economic downturn. One issue o f conflict has been the new law that makes companies outsourcing work responsible for labor code violations by subcontractors. A second issue is the abolishment in 2006 o f a decree prohibiting occupation o f factories by employees leading to 44 about 35 such events over the past two years, often by a minority o f workers. For workers, the government has stressed its commitment to collective bargaining, combating inflation and increasing social spending through responsible fiscal management. For the business community, the government has reiterated its policies designed to create incentives to investment and employment and its pursuit o f sound macroeconomic management. 94. Another labor concern for long-term growth prospects is the tendency for young Uruguayans to emigrate. Estimates o f Uruguayans abroad are in the range o f 470,000 to 600,000, representing more than 15 percent o f the population. After a peak o f 52,000 people leaving the country over 2002-2003, about 15,000 people left annually in the past 3 years. According to National Bureau o f Statistics (NE) estimates, more than 50 percent o f these most recent emigrants were aged between 20 and 30 years, and their reasons for leaving were labor- related. Emigrants have a substantially higher-than-average educational level, indicating that the country is losing skilled labor. Increased employment opportunities-both in terms o f quantity andquality o fjobs-will be needed to counter the outflow o f youth. PROGRAMRISKS 95. Managerial risks for the PRIDPL I1 operation relate to potential difficulties in implementingnew programs, particularly implementationof the tax reform, and systems because of the potential shortage of trained human resources. This risk is mitigated by efforts o f the government inimplementing a program to strengthen capacity inthe implementing agencies and in the executive branch o f the civil service overall. The IBTAL operation that supports the PRIDPL series provides assistance for the improvement o f information systems and processes related to the implementation o fPRIDPL-supported policies. 96. Sustainability risks refer to the possibility that the reform process may lose momentumor be reversed. In the area o f capital markets reforms, the sustainability risks are particularly significant as the reforms are less developed and the timetable for the reform program i s less clearly defined. Inthe area o f tax reform, there is a residual risk that the reform may be reversed. However, the government has a track record o f coming up with policy solutions to meet controversy with regardto the tax reform. 97. Programoutcome risks come about when the supported actions may not suffice to bring the targeted results. There are significant outcome risks across the capital markets and business climate reform components o f the PRIDPL I1operation. The outcomes o f these reforms depend not only on the government, but also on the private sector response. For example, the implementation o f a new capital markets reform law may not be sufficient to induce a substantial rise in market activity on the part o f the private sector. In addition, further policy measures may be needed to encourage enterprises (such as the public sector enterprises) to make use o f domestic capital markets. 45 46 Dt) d 3 D 1 vi 0 0 hl ct: i e, Y m 2 .e 0 YE ee,a '? vi 3 3 -88 .M Y 0 e, e 3 3 *m c-" id 0 0 rJ e, 75 rcr 0 ANNEX 2. DESCRIPTION OF STATUS OFTRIGGERS FORPRIDPL I1 COMPONENT 11.REFORMINGTHE TAX SYSTEM Trigger: The revenue authority (Direccibn General Impositiva, DGI) leads and coordinates personal income tax (Impuesto a la Renta de la Personas Fisicas, IRPF) collection efforts of different collection-retention agencies (Banco de Prevision Social (BPS, Social Security Fund), Cajas Notarial, banks, Ministries of Defense and In.terior, etc.). The following implementation targets are in place: (i) Training of DGI and BPS inspectors complete by June 2007; (ii)Establishment of 210 DGI posts outside DGI and a tax call center for consultations; (iii) Establishment of a Single Tax Registry; (iv) IRPF tax files are transferred monthly from BPS to DGI; and (v) DGI performs taxpayer consolidation into a single IRPF tax file combining income from different sources for each multi- employed contributor by October 2007. 98. Policy Developments and Status. Based on the latest information received from the authorities, the tax reform triggers have been so far fulfilled. The tax reform bill came into effect on July 1,2007. Implementation to date has been on track. 99. Since its inception, the tax reform program has encountered opposition, as is to be expected for a structural reform o f this type. The MEF has been countering with a communications campaign and responded effectively to a summons by the opposition to Parliament to defend the tax reform in early September 2007. As the reform involves the imposition o f a new income tax regime, the public reaction in understandable. It will be important to continue to engage civil society on the issue o f the tax reform, inpart to emphasize the positive impact on equity and also to respond to criticisms that the reform is too complex. Central to the success o f the reform i s the need to resist pressures from interest groups to complicate the tax system byproviding further exemptions. 100. For pension income, the change will replace the IRPF and the non-resident income tax (Renta de No Residentes, IRNR) with a new social security tax (Impuesto de Asistencia a la Seguridad Social, IASS). The recently announced change to the tax reform legislation for pensioners does not constitute a reversal that would adversely affect the achievements o f the objectives o f the PFUDPLprogram (as per Section 4.01(c) o f the Loan Agreement). For pension income, the change will replace the IRPF personal income tax (Impuesto a la Renta de las Personas Fisicas, which law 18.083 introduced under the program as per Section 1.A o f Schedule 1 o f the Loan Agreement) and the non-resident income tax (Renta de No Residentes, IRNR)with a new social security tax (Impuesto deAsistencia a la Seguridad Social, IASS, also established under law 18.083). The IRPF will remain in effect for all non-pension income. The Government is introducing the IASS in response to a Supreme Court decision earlier this year that application o f the IRPF to pensions was unconstitutional. This ruling affected some 1,500 individual pensioners. Following a change in one o f the five justices, the Court subsequently ruled that taxation o f pensions under the IRPF is in fact constitutional. To resolve the issue, the Government approved the new IASS on May 26, 2008. To resolve the issue, Parliament approvedthe new IASS on June 18,2008, intime for the new tax to become effective on August 53 1, 2008. There is estimated to be an annual shortfall in the IASS collection vis-a-vis that collected from pensioners under the IRPF o f about US$40 million (about 0.2 percent o f GDP compared to the original medium-term target for total collection under the IRPF o f 2.1 percent o f GDP by 2009). The Minister o f Finance has proposed a further modification to the reform to increase the minimumnon-taxable income by 1BPC (equivalent to UR$1,775), bringingit from UR$8,875 to UR$10,650. This would only be applied for active workers. The MEF has estimated that the result would be to eliminate the tax for 20 percent o f the active workers (120,000 workers). The cost o f this has been put at US$35-40 million or about 0.2 percent o f GDP. ADD The followingimplementationtargets are inplace: (i) Trainingof DGIandBPSinspectorscompletebyJune2007 101. The initial training o f DGI and BPS tax inspectors is complete. Over the period March to end-July 2007, 2000 participants from BPS, DGI and other organizations involved in the implementation o f the reform received training. In total, 243 hours o f training were given by DGI, with 140 hours o f training specifically for those dealing with the new information technology (IT) system. (ii) Establishmentof 210DGIpostsoutsideDGIandataxcallcenterfor consultations 102. There have been 222 posts established, which are staffed by 300 interns. These posts are located at the DGImain office inMontevideo, all DGIoffices inthe interior, community centers, shopping centers, DGI main office, and include two mobile units. There also i s a call center staffed by 60 posts. The Montevideo posts have received 180,000 consultations to date, those outside Montevideo have received 120,000 consultations and the call center is gettingon average 2300 calls a day. A private market and opinion research firm, Equipos MORI, evaluated the quality, disposition and technical knowledge o f the public information service officials at the DGI posts. They found that consultations were dealt with 87 percent successfully. Three WebPages cover the IRPF, with one from DGI (www.d&Rub.uy), a second set up by BPS (www.bps.gub.uv), and a third government webpage specifically for the IPRF reform (www.uruguayavanza.g;ub.uy). Together these have registered 1.4 million webpage hits (some o f these are most likely to berepeat hits). (iii) Establishment of a Single Tax Registry 103. A new information system has been developed to incorporate a registry o f firms and resident and non-resident individuals, with unique identifying numbers for each taxpayer. For individual taxpayers, the tax identification number i s from a person's identify card (cedula de identidad) or the identification number for foreigners (numero de identzficacidn de extranjeros). The initial registration o f physical personshndividuals was put together using information received from BPS and other organizations, involving the inscription o f over 3 million people. A single form is used for enrolment or modification o f a registration. The registration procedure takes place using a single window (ventanzlla dnica) in DGI or BPS offices. Information on individual taxpayers from BPS is sent monthly and firm information periodically to DGI. When a registration is made in one organization, the two organizations communicate to ensure that the registration is incorporatedinthe registry. 54 104. The current data management system o f the BPS and the DGI functions a single tax registry, with (i) unique data entry form accessible through a single window, (ii) a transmission o f the same date to DGIand BPS databases at the moment o f inscription, and (iii) mandatoryuse o f a unique taxpayer identifier number (Registro Unico de Ciudadania, RUC). The current system i s not best international practice in that it is not based on an online, real time, single database. In order to reflect this actual situation, the trigger o f "Establishment o f a Single Tax Registry" was transformed into "A Single Tax Registry is in operation" to as the relevant prior action for PRIDPL 11. The single tax registry in operation meets the tax reform implementation objectives o f the original PRIDPL I1trigger. The establishment o f a single, real time tax database wouldbe a desirable longer-tern objective. (iv) IRPF tmJiles are transferred monthlyfrom BPS to DGI 105. The monthly transfer o f information from BPS to DGI takes place. The BPS transfers IRPFinformationandrevenues to DGIwithin 96 hours o fcollection. (v) DGIperforms taxpayer consolidation into a single IRPF taxfile combining incomefrom dflerent sourcesfor each multi-employed contributor by October 2007 106. The consolidation o f taxpayer information into a single IRPF tax registry file took place as expected in October 2007. BPS and DGI now maintain two databases with identical information. For BPS, targets have also been met (not formally part of the PRIDPL I1Trigger): (i) At least 80% ofpayrolls submitted byfirms are validated by BPS at end-2007 107. Based on monthly data for 2007, 99 percent o f payrolls submitted to the BPS were validated. Validation consisted o f passing the following criteria for data validation: consistency o f information inBPS databases, internal coherence, etc. (ii) IRPF taxpaid is at least 80% of amount calculated by BPS 108. The BPS is meeting this target. Over the period August 2007 to end-January 2008, the final IRPF amount collected by BPS was 83 percent of the payment amount calculated by BPS. The payment amount calculated by BPS corresponds to the retentions or adjustments IRPFthat the information systems calculated should be paid by companies. Calculations are only carried out for individuals declared on validated payroll lists. (iii)Sendsperiodically to DGIIRPF collection data referred both to the individual- discriminating deductions-and corporations 109. The first transfer o f information took place in August 2007. This involved data on payments by firms. The second transfer of information took place at the beginning o f October and comprised detailed data on individual tax contributors. Starting in October, multi-income earners had to choose which enterprise they want to nominate to use their tax-free minimum in IRPFcalculations. (iv) At least 90% ofpayrolls are submitted in an electronicformat 110. BPS has provided firms with software to submit payment data in an electronic format. In December 2007, 90 percent o f payrolls were submitted in electronic format (by Web, automatic payroll or diskette). 55 111. Advances on Medium-Term Indicators (2009). Preliminary estimates are that the total tax revenue-to-GDP ratio in 2007 was above the 2005 value o f 22.5 percent o f GDP (at just about 23 percent o f GDP).The total IRPF collection over August-December 2007 when annualized equals about 2.1 percent o f GDP, which i s the medium-term target for IRPF revenue collection by 2009. Due to the introduction o f the IASS, it will inthe future be more appropriate to use as the medium-term indicator the evolution o f both IASS and IPW contributions rather than IRPF alone. In addition, it is important to note that the increase in the minimum taxable amount will impact on the number o f IFFW contributors, as would a decline in economic circumstances. The baseline for the ratio o f DGI tax collection costs to tax revenue is 1.12 percent for 2006. The ratio remained the same in 2007 at 1.12 percent (including the amount o f the EUloan), thereby meeting the 1.3 percent medium-term results target. This i s despite the rise intax administration costs to take into account the sizable fixed investment and human capital requirements needed to implement the tax reform. COMPONENT111.BUSINESSCLIMATE AND CAPITAL MARKETSDEVELOPMENT 111.1Market Promotion and Regulatory Framework Trigger: Presentationto Parliamentof a new CapitalMarketsLaw 112. Policy Developments and Status. The final draft o f the new Capital Markets Law was sent to Parliament inNovember 2008. The consultation process with private sector stakeholders included the discussions opened by MEF at the Securities Market Annual Seminar held at the central bank in April 2008. Expert opinion has been sought (including the input o f World Bank specialists) on the draft law and the draft was adapted to take into account both expert advice and to meet the concerns o f the private sector. The new draft law is an important advance over the current existing legal framework and it will provide an improved legal basis for capital markets development. As in many other countries, changes to the legal framework are introduced gradually and new adjustments may be required in the future as capital markets further develop inUruguay, butthe new draft isproportionate withthe current development ofcapitalmarkets in the country. The new legal framework introduces important improvements in the areas o f corporate governance, minority investor protection and information disclosure. It also includes initial steps for improved markets and intermediaries (e.g., stock exchanges demutualization option, initial steps towards conversion o f individual broker-dealers into joint stock companies) and simplification o f procedures in some cases. The law opts for a regulatory approach, versus a self-regulatory approach, as with other jurisdictions around the world but has introduced a formal consultation process for market promotion through a Market Promotion Committee (Cornision de Promocion del Mercado de Valores). 113. There has been progress in terms o f legal and regulatory changes in this area. The Administradoras de Fondos de Pensiones (AFPs) investment regime was opened somewhat in May 2007 through changes (Law 18.127 o f May 12, 2007) to the Social Security Law (Law 16.713 o f September 3, 1995, articles 123 and 124) to allow for investments by AFPs in securities issued by international organizations. Law 18.127 also included a tax exemption regime for certain trust funds (Fideicomisos Financieros, FF), namely those under the Multi- 56 Sector Global Credit Program.' The regulatory framework for this law was put in place by a decree o f August 21, 2007 and a regulation o f the Banco Central de Uruguay (BCU, Central Bank o f Uruguay) (Comunicacidn 2006/293). 114. The Capital Markets Implementation Plan (securities market promotion and regulatory framework) is partially complete (not a formal PRIDPL I1 Trigger), key progressis as follows: 0 Improvements of the organization and human resources of the D M V (Departamento de Mercado de Valores) at the BCU. The DMV has incorporated a new IT specialist. Crucial human resources envisaged under the Implementation Plan are still pending (e.g., accountants, economists) due in part to a delay in the civil service recruitment competition. There also have been advances in the design o f an investor protection area under the DMV and the automation o f the Capital Markets Registry. Finally, the DMV has continued with the implementation o f its training plan (e.g., staff participation in international expert seminars inMadrid and Toronto). 0 Implementation of risk-based supervision. TORs have been prepared for the IT risk analysis and the risk-based supervision, and a short-list is expected to be prepared for the award o f the contracts for buildingthe system by the end o f 2008. e Certification and professional upgrade of key players and investor education. TORs have been defined for consultancy services inthe area o f certification and professional upgrade o f key players and a discussion o f these issues has started with the stock exchanges. There are no advances in the area of investor education due to lack o f envisaged human resources. e Strengthening of the securities clearance and settlement systems. The DVMhas designed a new plan for the oversight o f the settlement activity o f the stock exchanges, Bolsa de Valores de Montevideo (BVM, Montevideo Stock Exchange) and Bolsa Electrhnica de Valores del Uruguay (Electronic Stock Exchange, BEVSA). More importantly, the B C U Board has decided to implement a new large value payments system that includes a securities depository for bothpublic andprivate securities. 0 Improvements in corporate governance. Following some o f the recommendations included inthe International Organization o f Securities Commissions (IOSCO) Principles assessment o f 2007, the following new regulations havebeen issued by the BCU: o Regulation for the presentation o f consolidated audited financial statements o f issuers, pension fund administrators (Administradores de Fondos de Inversidn, AFISAS) and trust funds administrators (Fiduciarios Financierus, FF). o Regulation regarding the information to be included in the Annual Financial Statement o f issuers, pension fund administrators (Administradores de Fondos de Inversibn, AFISAS) and trust funds administrators (Fiduciarios Financieros, FF). 115. Advances on Medium-Term Indicators (2009). In terms o f market activity, there has been a significant increase o f 69 percent in primary market activity on the stock exchanges in 2007 compared with 2006. Most o f the rise is due to a substantial increase in public securities (Treasury Bills) issues and certificate o f deposit issues. The rise in private bond issues (obligaciones negociables, ONs) by local infrastructure companies is noteworthy (e.g., 7. Agreed between the Uruguayangovernment and the Inter-AmericanDevelopmentBank. 57 Corporacion Vial del Uruguay, Puerta del Sur S.A.). In 2007, the total amount o f ONs issued was US$136 million, compared to under US$10 million for the whole year o f 2006. However, stock exchange secondary market activity has remained almost unchanged and the equities market remains almost nonexistent. Over-the-counter (OTC) market activity has increasedby 33 percent in 2007 compared to 2006. This i s composed almost entirely o f primary issues o f Treasury bills and B C U securities (Notas BCU) (Table 9). Table 9. Evolution of Capital Market Activity (US$ million, unless otherwise stated) Change US$ million 2006 2007 % STOCK EXCHANGE 7,596 12,066 59% PRIMARY MARKET 6,587 11,115 69% BVM 10 41 300% Private Sector 10 41 300% of which ONs 10 19 88% BEVSA 6,577 11,074 68% Public Sector 75 2,128 2737% Private Sector 6,502 8,946 38% of which ONs 7 117 1571% Total ONs 17 136 698% SECONDARY MARKET (BVM+BEVSA) 1,009 951 -6% Public Sector 943 858 -9% Private Sector 20 53 172% OTC (PRIMARY MARKET) 2,641 3,506 33% Source; BCU, Informes Trimestralesdel Mercadode Valores. 111.2 Bankruptcy law MEF has formulated and is carrying out the action plan for implementing insolvency reform. The Plan includes benchmarks and a chronogram of actions for: (i) Dissemination of relevant information to the sectors mainly involved in the process (corporate, financial, labor, legal, and judicial sectors) and to the community in general; and (ii) Training and educating of stakeholders including lawyers, judges and judicial staff who are to manage insolvency cases and professional insolvency experts who are to act as trustees in reorganization and liquidation procedures. 116. Policy Developments and Status. Parliamentary approval of the bankruptcy law has been drawn out. In June 2008, a parliamentary commission (Comisiones Permanentes de Constitucidn, Cddigos, Legislacidn General y Administracidn de la Camara de Representantes) completed reviewing the draft law and consulting with key stakeholders. On July 1, 2008, the draft law was approved by the House o f Representatives (Ccimara de Diputados). This becomes the prior action for presentation o f the PFUDPL I1 to the Board: the draft Insolvency and Enterprise Reorganization Law (Ley de Concursos y Reorganizacidn Empresarial) has been approved by the House o f Representatives (Ccimara de Diputados). The law (law no. 18.387) was approved by the Senate on October 23, 2008. The Bankruptcy Law was due to be effective as o f April 2009, but an amendment proposing the advancement o f the effectiveness o f the 58 bankruptcy law was included in law No18.411, which was approved on November 14, 2008. This makes the newbankruptcy law effective as o f November 3,2008. 117. Pending approval o f the law, the MEF representatives had already started training and dissemination activities included under the implementation plan. The new legal framework has been discussed and disseminated in key universities (e.g., Universidad Publica, Universidad Cutdlica, Universidad de Montevideo). Training activities on the specific workings o f the law are due to beginshortly now that the final version o fthe law approved byParliament is available. 118. Advances on Medium-Term Indicators (2009). Until implementation o f the new insolvency regime has commenced, there can be no advances with the medium-term indicators, which jointly measure improved outcomes with regard to insolvency cases. On the medium-term indicators for the bankruptcy law, the MEF is planning to carry out a study in cooperation with the Supreme Court (Suprema Corte de Justiciu) to determine the 2004-06 baseline for the indicator on the number o f insolvency cases satisfactorily resolved and the time required for resolution. It will be necessary for the government, with the assistance o f the World Bank sector specialist, to agree on is a definition o f "cases satisfactory resolved". As the new bankruptcy framework is not going to come into effect untilat the earliest 2009, the final performance under this component would not properlyberevieweduntilafter 2009. 111.3InformationTransparencyandDisclosure Trigger: Amendmentsto the CorporateLaw and draft legislationfor the strengtheningof the CPNCA have been presentedto Parliament,including: (i)Requirement for enterprises to consolidate financial statements, and when applicable have them audited; (ii)Requirementthat enterprisesprovideinformationabout ownership and related party transactions; (iii)Establishmentof a system of independent oversight,and (iv) Draft legislationfor the institutionalizationof the CPNCA. 119. Policy Developments and Status. The government has met the objectives o f the trigger, which was written prior to the finalization o f the planned legislative steps to implement the new accounting framework inthis area. The prior action reflects the steps taken by the government to: (i)establish as obligatory the International Financial Reporting Standards (IFRS); (ii)to strengthen the accounting norms commission (Comisibn Permunente de Normus ContubZes Adecuadus, CPNCA); and (iii) to create a new entity (Ente de Emisor Normas Contables), in charge o f accounting standards, which would have the technical and financial capacity, and independence to lead the process in ensuring the latest accounting norms are adopted. The new entity will be responsible for the application o f the International Financial Reporting Standards (IFRS). Under the new law, the role o f the existing accounting norms commission (CPNCA) will be institutionalizedas a formal advisory body for the new entity. 120. The next step will be to improve the audit framework. The authorities have gone beyond expectations in this area and will move forward with the establishment o f a system o f independent oversight for obligatory audits. The new audit law is being prepared and is envisaged as necessary to define which accounting reports are to be reviewed and their scope, as well as the mechanism by which the body would exercise control over auditing professionals. 59 The consultation process is still underway. A key obstacle that remains is reaching agreement to separate audit and consultancy services. The aim is to gain consensus on the audit law among stakeholders, rather than to go ahead with a reform that does not have adequate support. The situation regarding the sub-components of the triggers is as follows: (i) Requirementfor enterprises to consolidatefinancial statements,and whenapplicable have them audited. 121. InJuly 2007, the Executive issued Decree266/07 establishing as obligatory from January 1, 2009, the IFRS adopted by the International Accounting Standards Board as o f the date o f publication o f the decree. The IFRS include: (a) the requirement for enterprises to consolidate financial statements when a group o f enterprises comes together under one company (International Accounting Standard (IAS) 27); and (b) the requirement that enterprises provide information about related party transactions (IAS 24). The new entity that i s to be in charge o f accounting standards will be responsible for the application o f the IFRS. The Corporate Law was inconsistent with the IFRS as consolidated financial statements were deemed complementary rather than required information for financial reporting. The House o f Representatives (Cdmara de Diputados) has approved amendments to the Corporate Law (law 16.060) o f September 4, 1989, to eliminate these inconsistencies with the IFRS (IAS 27). For Banks and insurance companies, the central bank will remain responsible for accounting standards. The IFRS i s already being complied with by banks and insurance companies under the supervision o f the central bank (FSSA, 2006). Once the IFRS standards come into force in January 2009, consolidated accounts will be audited, where applicable, through the requirement that auditors verify that the accounts have been prepared according to the accounting standards ineffect. (ii) Requirement that enterprises provide information about ownership and related party transactions. 122. This i s fulfilled by the adoption o f the IFRS, which requires under I A S 24 that enterprises provide information about ownership and related party transactions. The requirement that information on ownership and related party transactions i s provided by enterprises will be the responsibility o fthe new entity incharge o f the application o f the IFRS. (iii) Establishment of a system of independent accounting oversight. 123. The draft law establishes a new entity in charge o f accounting standards (Ente de Emisor Normas Contables) thereby establishing a system o f independent accounting oversight o f the application o f the IFRS. The law creates a new entity that would be responsible for the emission, interpretation, dissemination and diffusion o f accounting norms. The entity would also be the comptroller o f the application o f accounting norms in the transmission o f financial status information and would provide technical assistance to state agencies with regard to general policies for improvement o f informative transparency. The entity i s to be a decentralized body linked to the executive branch through MEF. Financing would come from budgetary funds and income resulting from service provision. Annually, the entity is to sign an accord with the MEF outlining the commitments o f management, which establishes annual goals for the entity. Financing received from the budget would be conditional on the entity fulfilling these annual commitments. The organizational structure o f the entity would include a technical unit for the interpretation and emission of accounting standards; a dissemination unit; a technical review/control unit, and an administrative unit. 60 (iv) Draft legislation for the institutionalization of the CPNCA. 124. Duringthe preparation of the entity law, steps were taken to strengthen the institutional framework o f the CPNCA. A workshop was organized on July 19, 2007 with all stakeholders (e.g., MEF, centralbank, tax authority, industry and commerce associations, banking association, Tribunal de Cuentas, etc.) to discuss the new composition, resources and functions o f the CPNCA and the advances and next steps of the Implementation Plan (Information Transparency and Disclosure). Following the workshop, the MEF issued a resolution, in September 2007, strengthening the composition o f the CPNCA, by integrating into it delegates from the auditing body o f the central bank (BCU), the DGIand the court of accounts (Tribunal de Cuentas, TCR) as well as representatives from the private universities (Resolucidn del Poder Ejecutivo 580/07). The resolution eliminated the participation of representatives o f the association o f notaries (Asociacion de Escribanos) due to considerations ofrelevance. MEF is already represented inthe CPNCA. The commission then began meeting frequently (every two weeks) to work on the implementation o f an action plan in the area of accounting norms. From November 2007, the reinforced CPNCA worked intensively on the drafting of new accounting standards legislation, including the drafting o f the law to create the new entity responsible for accounting norms, which was submitted to parliament in June and July 2008. Under the law establishing a new entity in charge o f accounting standards, the role o f the existing accounting norms commission CPNCA will be established as a formal advisory body for the new entity. 125. With regardto advanceswith the ImplementationPlan(not a formal trigger): Improve and strengthen the institutional framework for the presentation, registry and disclosure of the companies'financial statements. A new legal strategy to define the responsibilities for the consolidated financial statements presentationwas discussed inthe July 2007 workshop and is currently under study. The AIN i s leading the process for the modernization o f the companies' financial statements registry (Registro de Estados Contables, REC). The Auditoria Interna de la Nacidn (AIN) is in discussions with the Direccidn General Impositiva (DGI) and the Banco de Previsidn Social (BPS) to share information and determine the adequate incentives for the companies to file their financial statements with the AIN. An expert accountant and IT specialist have been hired (with the Bank TA Loan resources). It is estimated that the amount of companies filing financial statements will go from the current 2000 to 8000. The A N is working on the processes, organization and resources for the REC management. The biddingprocess for the automation o f the REC i s expected to take place at the end o f 2008. A Decree has been drafted to establish the new REC. Establishment of a sustainable and effective processfor the adoption of the most recent IFRS standards. In terms o f legal and regulatory changes, a decree of July 31, 2007 adopted the most updated version of IFRS for the publication o f financial statements. There will be a transitory period o f 18 months for the application o f the new standards, which are due to become effective on January 1, 2009. As mentioned, a draft law has been prepared for the creation o f a new entity responsible to issue accounting standards. An agreement of cooperation was signed with the international oversight institution (International Accounting Standard Board, IASB) inAugust 2007 and the standards have beenpublishedin Spanish and are available on the web page o fthe AIN. 61 126. Advances on Medium-Term Indicators (2009). There were four indicators originally included for the information transparency component. The first was an improvement in the extent o f disclosure index o f the World Bank's Doing Business database, which measures the transparency o f transactions. It will be difficult to measure progress using this indicator before 2009, as it will be necessary to wait for the Doing Business Survey 2010 (to be prepared in2009) to reflect changes in the law in 2008. In addition, the use o f the Doing Business statistics needs to be reviewed overall given the revised scoring for Uruguay's 2007 position, which resulted in a fall from 64`h place for ease o f doing business inthe original DoingBusiness 2007Report to 89`h inthe revised2007 data the doing business unit has produced. N o detailed explanation has been provided for this substantial revision. The team would therefore like to develop new medium- term indicators to substitute for that givenby the doing business survey. 127. Progress on the remainingthree medium-term indicators will need to bejudged following the passing o f the law creating new entity for accounting standards. These indicators are: (i) the most recent version o f IFRS implemented by all corporate companies; (ii) the availability o f large and medium enterprises financial statements inthe companies' registry on-line; and (iii) the entes autonomos (UTE, OSE, ANCAP and ANTEL) make public timely their audit reports and financial statements with improved quality o f information (including management indicators) following the same standards as private companies. COMPONENTIV. STRENGTHENINGSOCIAL PROTECTION Trigger 1: Plande Equidad Social, the new structuralincometransfer policyhasbeen adopted and is under implementation.This programreplacesthe emergency planPANES. 128. Policy Developments and Status. The trigger has been met. In December 2007, legislation was approved by Parliament on a core component o f Plan de Equidad Social-the reform o f family allowances-which i s to be the main instrument used to make income transfers to poor families (Law no. 18.227). The new family allowances program was introduced on January 1, 2008 and immediately replaced the benefit received under the Citizen's Income program (PANES income transfer component). The first payment under the new system took place inFebruary 2008. 129. In addition to the new family allowances system, the government's social protection structural matrix-Plan de Equidad Social- includes a collection o f structural policies aimed at promoting social justice in health (Integrated Health System, Sistema Nacional Integrado de Salud), employment (Uruguay Trabaja), subsidies for the payment of the UTE and OSE tariffs and equality o f opportunities between men and women. Further policies targeting employment and access to housing are also expected. 130. The extension o f the family allowances program i s expected to increase the coverage as well as to reduce the overlap among Uruguay's income transfer programs. The 2007 Income Transfers Policy Study carried out by the World Bank also emphasized the importance o f strengthening the family allowances program (increasing the amount o f the benefit and extending 62 the coverage) to reduce the overlaps with other programs (especially with respect to PANES) and to help fill coverage gaps. Both the amount o f the benefit and the eligibility criterion to qualify for the family allowances program take into account the size and composition o f the household. The benefits from the new family allowances program are significantly larger, creating incentives for secondary students not to drop out (family allowances are not provided for drop- outs). 131. The amount o f the benefit under the new family allowances program is estimated according to an equivalence scale that combines the number of children in the household and their educational level. The benefit for the children at the secondary level o f education is higher, and larger families will receive a smaller per capita benefit, exploiting the economies o f scale within the household. The coverage expansion is expected to be achieved progressively during 2008 (incorporating 330,000 children and young adults in 2008) and 2009 (covering a further 170,000 in 2009), inparticular for those households that currently qualify but do not participate. Eventuallyit is expected that the law will benefit 500,000 children and young people, of which 125,000 were not incorporated by the previous laws. Although a portion o f that coverage expansion will be self-motivated by the larger benefits o f the program after the reform, some active enrollment strategy may need to be applied, similar to that carried out when launching the PANES program. Trigger 2: Implementation of tax reform legislation (law no. 18.083 of December 27,2006) to reduce exemptions and to adopt the new unified social contribution rate of employers (7.5% of wages). 132. The measure was implementedas part o fthe tax reform package put into effect on July 1, 2007, to eliminate exemptions to selected sectors and industries and to adopt a new unified social contribution rate o f employers (7.5% o f wages) (Articles 87-94 o f the Tax Reform Law). Details ofroll-out o f exemptions to be added from the tax reform legislation. 133. Advances on Medium-Term Indicators (2009). As o f end-2006, 61 percent o f the poorest quintile households were covered by PANES or the non-contributory family allowances program. Following the introduction o f Plan de Equidad Social, any change in coverage will be analyzed to measure movement toward the medium-term goal o f 70 percent coverage for the poorest quintile households. With regard to the coverage o f active workers by the social security system, at this stage it is too early to measure the progress that has been made moving from 65 percent at end-2006 toward the medium-term goal o f at least 70 percent in2009. 63 64 ANNEX 3. TAX REFORM PSIA 134. The Poverty and Social Impact Assessment (PSIA) analyzes the impact o f the tax reform, which came into effect in July 2007, on tax incidence and poverty in Uruguay. The essence o f the reform is the introduction o f a dual personal income tax, which taxes labor income at progressive rates and capital income at lower, proportional rates. A further modification is the reduction in the revenue share o f indirect taxes. The study aims to provide information to inform policy discussion on distributional implications o f tax reform. In addition, it gives impetus for further more sophisticated analysis o f current and proposedtax reforms. 135. Indesigning atax system, atrade-off exists betweenefficiency, equity and administrative simplicity. The paper focuses on one aspect o f this trade-off by evaluating the equity impact o f the tax reform inUruguay. Neither the efficiency o f the post-reform tax system nor the effect on tax administration are examined. Assessing the distributional impact o f a tax reform is important, firstly, as there i s a potential to mitigate the equity-efficiency trade-off in the design o f tax structures, and secondly, as the expenditure side o f the budget can then be employed to diminish any adverse distributional impacts. 136. The aim o f the tax reform in Uruguay is to create a more efficient and equitable tax structure, and to promote productive investment. The reform is designed to be broadly revenue neutral. The report concentrates on the equity dimension o f the reform. In this regard, the pre- reform tax system was somewhat inequitable due to the importance o f consumption taxes and the partial taxation o f income. The pre-reform tax system did not meet the basic criteria for horizontal equity. Direct taxes on individual income were derived almost exclusively from labor income from employees and pensions, while personal income from capital sources, such as financial assets and property, was tax exempt, irrespective o f whether it was generated domestically or abroad. With regard to the impact o f the reform on equity, the study focuses on the impact o f eliminating the personal receipts tax or wage tax (Impuesto a las Retribuciones Personales, IRP) and the implementation o f the dual personal income tax (Impuesto a la Renta de la Personas Fisicas, IRPF), as well as the effects o f reducing the VAT rate and eliminating the social security financing contribution tax (ContribuciBn a1 Financiamiento de la Seguridad Social, COFIS). 137. The analysis employs a static micro-simulation model using household survey data to calculate for each individualhousehold the total amount o f direct and indirect taxes due before and after the tax reform. This makes it possible to assess how each individualhousehold is affected, and thus calculate the poverty and income inequality indicators before and after the reform. These static models, unlike behavioral 'models, do not incorporate changes in individuals' behavior in response to changes in the tax system. However, using a simple micro- simulation approach for the analysis entails certain benefits: it allows comparison with previous studies done on Uruguay and other countries; and it i s a transparent method that generates results, which are easy to communicate to a general audience. 138. The welfare measure used i s individualhousehold income taken from the 2006 Expanded National Household Survey (Encuesta Nacional de Hogares Ampliada, ENHA). Income rather than a consumption measure i s used as at the time when the analysis was done the latest 65 household expenditure survey was over a decade old. Nevertheless, the Household Income and Expenditure Survey is employed in the analysis in order to provide detail on consumption patterns (Encuesta de Gastos e Ingresos de Zos Hogares, EGIH 1994-1995). Figure 7. Mean Tax Rate on Labor Income IRP and IRPF (YO) The average income tax rate falls for the bottom 80 percent of income earners under the post-reform tax structure (in percent) 1 2 3 4 5 6 7 8 9 l o Deciles of labor income 1 0 Pre-reformwage tax(IRP) Dualpersonal income tax(IRPF) Source: Based on the ENHA. 139. To begin, the study examines the impact o f the replacement o f the wage tax (IRP) with the dual personal income tax (IRPF). Results indicate that the replacement o f the IRP with the IRPF results in an improved situation for the bottom 80 percent o f labor income earners, for whom the mean tax rate falls (Figure 7). The mean direct tax rate increases for the top 20 percent o f taxpayers. The mean tax rate here refers to the average IRP and IRPFpayments by decile as a share o f labor income, including any labor income from secondary occupations. Workers in the tenth decile are calculated to pay, on average, 7 percentage points more tax on their labor income, which implies an increase in their tax burden by 150 percent. For the ninthdecile, the increase inthe mean tax rate i s much lower at 0.3 percentage points. 140. For pensioners, the tax burden is increased from the eighth decile onwards due to the introduction o f the IRPF. Pensioners paid little wage tax on pension income prior to the tax reform. The top 20 percent o f pension earners faced a tax rate o f 2 percent prior to the tax reform. Following the reform, for the top 30 percent o f pension earners the difference between the average tax rates before and after the reform is in excess o f 8 percentage points. The bottom 70 percent o fpension earners continue to pay no tax. 141. The analysis next examines the impact o f the reform of indirect taxes on household income. The pre-tax reform situation i s estimated to have beenregressive, in that the percentage decrease inincome due to indirect taxes is higher for the bottom 40 percent compared to the top 60 percent o f income-earninghouseholds. All households benefit from a reduction inthe indirect tax rate due to the tax reform, which falls by on average over 2 percentage points over the different income groupings (Figure 8). In terms o f average indirect tax rates, the post-reform indirect tax structure remains regressive. To restate-as i s regular in this type o f analysis-it is assumed that indirect taxes on goods are shiftedcompletely to consumers. 66 Figure8. MeanIndirectTax Rate(IVA COFIS) onHouseholdsBeforeandAfter the Tax Reform, + by decile (YO) ~~ ~ Indirect tax rates fall by over 2 percentage points on average for under the post-reform tax structure (in percent) 12 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 Deciles ofhouseholdincome 0 Pre-reformindirecttaxrate Post-reformindirect taxrate Source; Basedon the ENHA. Figure9. Tax Burdenas a Shareof Per CapitaPre-TaxIncome: ComparisonBetweenthe Pre- ReformRegimeandthe Post-ReformSituation - The combined impact of the tax change is to reduce the tax burden for the bottom 80 percent and to increasethat of the top 20 percent of income earners (Tax burden as a share of per capita pre-tax income) 4yo 2% -.-.I..- 0% 8Yo 6% 4% 2% 0% I 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Household incomevingtile - - - - m - VAT taxes beforetax reform -H * IRP Total taxesbeforetax reform U I R P F VAT after tax reform Total taxes after tax reform 142. An analysis o f the total impact o f the reform shows it to be progressive. The grey and black smooth lines in Figure 9 represent total taxes before and after the reform, respectively. Under the pre-reform system, the tax burden as a share o f pre-tax income remains relatively constant (close to 12 percent) throughout the distribution curve. The pre-reform system was 67 neutral from the point o f view o f inequality. This neutrality arose from the combination of regressive consumption taxes and progressive personal income taxes. The reform alters the relative neutrality o f the pre-reform tax system. There is a monotone increase o f the tax burden from the median onwards. As a result, the global tax burden o f the households below the 16th percentile falls, while it becomes markedly higher inthe last three vingtiles (five-percent bands) o f the distribution (Figure 10). Figure 10. Variation of Household Disposable Income Before and After the Tax Reform(in percent) Disposable income increases for the bottom80 percent of households after the reform, but falls for the top 20 percent of households due to 4% the direct tax change __ 2% 0% - -2% Viigtile ofhousehold income -4% Vanation due to change in dlrect taxes .6% 4% Source: Based on the ENHA. 143. If the total impact on households is considered, the reform represents a progressive change. Taking into account changes to VAT, COFIS and the introduction o f the IRPF, along every measure considered the tax reform has a small, but positive impact on equity. The Gini coefficient o f after tax income is estimated to fall due to the reform: The Gini coefficient o f before tax income i s calculated as 0.45 and the Gini coefficient o f after tax income following the reform is calculated as 0.44 (the pre-reform Gini o f after tax income i s 0.45) ( 68 Table 10). 144. The reform also has a small, but beneficial, impact on the poverty headcount. Poverty incidence i s estimated to fall by 0.7 percent due to the change in the tax structure. The slight reduction in poverty i s fundamentally due to the price reduction effects generated by the modifiedconsumption tax regime on the basic food basket and the poverty line. 69 Table 10. Inequality Measures are Estimated to Fall Following the Tax Reform Before tax reform After tax reform After After After After After After Before taxes indirect direct taxes indirect direct variation taxes (1) taxes taxes (2) taxes taxes (2)-( 1) Gini coefficient 0.454 0.453 0.457 0.448 0.442 0.456 0.440 -0.011 Entropy 0 0.351 0.350 0.357 0.341 0.338 0.361 0.334 -0.012 Entrow 1 0.376 0.376 0.382 0.366 0.353 0.380 0.349 -0.023 Source; Based on the EGIHand the ENHA. 70 ANNEX 4. LETTER OFDEVELOPMENT POLICY Montevideo, 15 dedicimbrede2008,- 71 72 73 74 75 2 76 3 77 iii) 4 78 5 79 6 80 7 81 8 82 9 83 84 85 12 86 13 87 14 88 89 90 17 91 92 19 93 94 95 96 3 91 LETTER OFDEVELOPMENT POLICY Unofficial translation Minister o f Economy and Finance Uruguay Montevideo,December 15,2008 Sr. Presidentof the World Bank Mr. RobertE. Zoellick WashingtonDC Dear Mr.Zoellick: This letter o f development policy presents the economic and financial program o f the Government o f the Oriental Republic o f Uruguay, and describes the present status o f reform policies related to the Second Programmatic Reform Implementation Development Policy Loan (PRIDPL 11). The economic and financial management o f our Government in the first three years o f administration has permitted us to take full advantage o f the opportunities offered by the favorable international context to obtain better results than expected in the economic and social areas. This has permitted the economy to be in a solid macroeconomic situation to face the current international financial crisis, although further strategic improvements are continuing to be made to face this crisis. The main points to be highlighted are the generalized growth on at the sector level, extraordinarily levels and diversification o f exports, and a significant recovery o f investment. The increase in investment, fundamental base for achieving sustainable growth, has been bolstered by exceptional levels o f foreign direct investment, which-in relative terms-was higherthan inthe principd economies o fLatinAmerica. Output is expected to grow by approximately 10.6 percent in 2008. While part o f this growth i s accounted for by the launch o f a large pulp mill plant, the potential growth rate o f the Uruguayan economy is estimated to increase inover the next years. This strong productive performance is reflected in labor market outcomes, with unemployment falling to the lowest rate in the last 14 years, dropping below the target o f 10 percent in only three years, rather then the five years originally projected. At the same time, the implementation o f programs o f focused policies, such as National Plan to Attend the Social Emergency (Plan de Atencidn Nacional a la Emergencia Social-PANES), significantly reduced the number o f people inextreme poverty. 98 On the fiscal side, the country has registered a substantial improvementinconsolidated accounts, with a zero deficit at the close o f the last fiscal year. The deficit for 2008 is estimated to close higher than programmed (1.2 percent o f GDP) due to the impact o f a drought at the start o f the year on the operating results of the National Electric Company (UTE). Nonetheless, the average annual deficit for 2005-2009 will equal 0.8 percent o f GDP, the lowest level since the 1970s. Also, the management of Government liabilities has allowed a satisfactory reprofiling of the amortization schedule, a substantial increase inthe percentage o f debt in local currency (indexed units) and the extension o f the average maturity of public debt. This has left the country in a favorable position inthe current scenario o f worsening access to capital markets for all emerging economies, including Uruguay. The country has covered its financing needs until 2010 by successhlly swapping short-term debt for long-term debt. Giventhis framework, the Uruguayan public sector i s not expected to face liquidity difficulties inthe short term. The financial system has significantly improved its solvency, with low delinquencyand adequate liquidity. The delinquency level remained stable at 1.1 percent in June 2008, compared to 1.0 percent inMarch 2008 and 3.2 percent June 2007. The rate o f equity adjustment,measured as the quotient between regulatory equity and the capital requirements based on risk, amounted to 2.34 at the close o f the second quarter o f 2008, compared to 2.20 at the close o f the first quarter o f 2008 and 2.32 inJune 2007. Non-resident deposits in the Uruguayan financial sector decreased considerably, which has reduced the vulnerability o f the banking sector in the face o f a potential worsening o f the international financial situation. By the end of December 2001-prior to the last financial crisis-56.3 percent o f total deposits inthe Uruguayan bankingsystem were from non-residents, while at end-September 2008 they amounted 25.8 percent. The process of de-dollarization o f banking deposits continued. While on December 2001 deposits in foreign currency represented 91 percent o f total deposits, by end-September 2008 this ratio had fallen to 78 percent. The improvement in macroeconomic indicators, together with the re-orientation o f public expenditures towards priority areas defined in the Government plan, was also reflected in progress inthe social sectors. An example of this is the PANES project, runby the Ministryo f Social Development (MIDES), the objective o f which i s to work toward a more fair and equitable society, focusing on poverty and extreme poverty. Since January 1, 2008, the new Plan de Equidad has been under implementation. At the same time, a healthreformplanwas beenput inplace in2007, approvedbythe legislation that createdthe IntegratedNational Health System, which is meant to provide universal coverage to all the people o f the country. This legislation also created the National Health Fund (Fondo Nacional de Salud-FONASA), managedby the Social Protection Agency (Banco de Previsidn Social-BPS), which i s designed to finance health coverage for all Uruguayan workers. This new health care model is accompanied by a series ofprogramson specific health issues. 99 In the area of public security, the Program for Institutional Strengthening has been under implementation since 2006. Additionally, in the area o f education the highly innovative Plan Ceiba1i s under implementation, which will represent a major step toward granting equal access to new technologies for Uruguayan children o f all social classes. In spite of these macroeconomic and social improvements, the Uruguayan economy will face some challenges in the short-term, such as the loss o f bilateral competitiveness with the United States and the relative loss o f competitiveness o f exports with competitors such as Brazil and Argentina due to the substantial appreciation o f the U.S. dollar against the currencies o f these neighboring countries. Another warning sign for the short and medium term is the significant decrease inthe price o f commodities exported by the country. To confront this, the Government has put inplace several productive and financial measures, and also structural reforms intended to further strengthen the efficiency o f the private sector and improve the general conditions o fthe economy. Among the productive measures i s the approval of the New Regime o f Investment Promotion, which supports projects that create high value-added employment, increase exports, incorporate technologies, and care for the environment. The recent increase in the Inter-American Development Bank's Revolving Fund Multisectoral Loan I11will make it possible to expand credit lines to private sector projects in a time o f increasingcredit costs throughout the world. From the financial point o f view, the Corporacibn Andina de Foment0 approved a contingent credit line, which, along with the available credit lines o f the Fondo Latinoamericano de Resewas (FLAR), will mitigate the risk o f the lack o f access to credit inprivate debt markets. At the same time, the Government is continuing to explore the possibility o f expanding other contingent credit lines with multilateral institutions. In addition, structural reforms have been accelerated, including approval of: the Central Bank Charter Law (Ley de Reforma de la Carta Organica del Banco Central del Uruguay), which unifies the supervision o f the Central Bank over the Uruguayan financial system; the Bankruptcy Law (Ley de Concurso Judicial y Reorganizacidn de Empresas), whose main objective i s to provide companies in financial difficulties with an instrument that allows their survival and also to efficiently liquidate non-viable companies; the reform o f the pension and retirement fund for bank personnel (Ley de Reforma de la Caja Bancaria), which brings long-term sustainability to the fund; and the reform o f the pension and retirement fund for the police (Caja Policial) which aligns its performance with the rest o f the social security system. Likewise, laws reforming financial markets have been drafted to grant the Central Bank more regulatory and monitoring power, and to improve the efficiency o f the payments system. In brief, the country has taken several measures to protect itself from the present financial turmoil, and continues moving forward with its strategy to withstand the current international context. It i s still premature to know the consequences o f a worsening o f the current crisis, but 100 the Government understands that a decrease in the economic activity and a fall in international prices o f the goods exported by Uruguay can exert pressure on the fiscal revenues, and maintains its commitment to fiscal discipline. Annex 1 (attached) describes in detail the objectives, implementation strategy and results achieved to date in relation to the economic and social reforms introduced by the Government and supported by the PRIDPL series: tax reform, business climate and capital markets development, and improving the social protection system. Annex 2 presents the cost o f electric power generation during2008. Following this exposition o f the general Government program and its economic, financial and social results, and having explained the present status o f the reforms agreed to be included inthe continuation of the PRIDPL I,we present our request for a Second Programmatic Reform Implementation Development Policy Loan (PRIDPL II), using the deferred draw-down option (DDO), for an amount o fUS$400million. Yours sincerely, 101 Annex 1 PolicyLetter for PRIDPL I1 November,2008 The objective o f the PRIDPL program is to support the implementation o f the Government's priority economic and social reforms. The program aims to provide the Government with a framework for implementing reforms identified as necessary to achieve higher sustainable growth rates, and at the same time fightingpoverty and exclusion and ensuring equitable access to opportunities for all Uruguayans. The first programmatic operation o f the series (PRIDPL I) supported the implementation o f the reform program o f the Government inthree areas: - Tax reform - Business climate and capital market development - Social protection system improvement The Government has achieved important progress in the implementation o f these reforms. The second programmatic operation inthe series (PRIDPL 11)will continue supporting these policies, inadditionto another component supportingthe modernizationofpayment systems. The Government program includes a package o f institutional reforms that have the objective o f contributing to confidence, stability and an agreed framework for undertaking economic activities. (a) Reforms o f the fiscal and budget institutions - Tax reform - Revenue collection agenciesreform - Budgetreforms to stimulate improvedpublic management - Creation o f a debt management office (b) Reforms to improve the business climate for investment - Improved tax system to promote investment - A project to improve policies and legislation on competitiveness - Review o fbankruptcy legislation - Improvedbusiness information transparency - Measures to develop capital markets - Improved procedures for investment promotion - Creation o f a National Research and Innovation Agency 102 - Improved financial regulation through reform o fthe charter o f Central Bank o fUruguay (Banco Central de Uruguay-BCU) - Identification o fmechanisms o fpublic-private associations for infrastructure projects (c) State Democratic Transformation - Creation anddissemination o f mechanisms o f decentralization and citizen participation - Structural transformation o fhuman resources management - Adjustments inthe competencies and structures o f line ministries - Improved legal framework o f state-owned enterprises The reforms on fiscal and budget institutions were successfully launched in 2006, with notable advances in fulfillment o f the planned stages. These include the creation of a new tax system, effective as o f July 1, 2007, together with the implementation o f reforms to revenue collection institutions (Social Security Agency-BPS and Tax Office-DGI), which have resulted in increased efficiency both incollection and inclient attention. Regarding reforms intended to improve the business climate for investment, there has been progress indrafting legislation on the regulation and functioning o f capital markets, the financial system and the processes o f consultation with the main actors. The Executive passed the Ley de Concurso Judicial y Reorganizacidn de Empresas (Bankruptcy Procedures and Corporate Reorganization Law), the main objective o f which is to provide companies in financial difficulties with an instrument that allows the survival o f the economically viable productive units and the efficient and equitable liquidation o f those that are not. At the same time, the National Research and Innovation Agency was created and has been in operation since September 2007, with the objective o f designing, organizing and managing plans, programs and tools for technological and scientific development and the promotion and strengthening o f innovation capacities, fostering articulation and coordination among the various actors involved inthe creation andutilizationofknowledge. Finally, the most recent budget law o f this administration deepens the democratic transformation o f the State, establishing five medium and long-term strategic pillars: a massive incorporation o f information and communications technology into the management and operation o f the State and fostering o f a digital agenda at the national and state level; improvement inthe quality o f public expenditures with incorporation o f information systems, evaluation and planning in the ministries and across the State; new modes o f career and human resource management for the State; getting closer to the citizen by means o f information simplification and the deletion and integration o f procedures; and functional reorganization to the structure and human resources o f the offices and executing units o f the central administration. This last process will be implemented progressively, by using a simplified set o f restructured units in the reporting o f the 2007 budget results. The main objectives, contents and expected effects for each o f the four components included in PRIDPL I1are as follows: 103 1 Tax ReformanditsImplementation - i) Obiectives The principal objectives o f the tax reform are to: (a) Promote greater horizontal and vertical equity in the tax structure, relating the tax burden with the contribution capacity o fdifferent social and economic sectors. (b) Create a more efficient tax structure inabroad sense, considering that this feeds back into tax management equity and capacity. (c) Consistently promote productive investment and employment, in order to prevent the tax system from becoming an obstacle to economic growth. These objectives must be achieved within a framework consistent with the need to finance the State's responsibilities inall areas, particularly the social and productive areas, thereby satisfying a key objective o f all tax schemes, which is that o f self-sufficiency. These reforms are also designed to favor country competitiveness through the implementation o f the best practices in modem international taxation, within a framework o f legal stability as an incentive and guarantee for citizens, investors, and savers. ii) Mainreformsandimpact The mainpillars o f the tax reform are: (a) Simplify the tax structure to overcome the current chaotic system o f taxes, a product o f partial modifications to address particular issues but without an integrated vision o f the system. (b) Rationalize taxation by creating more consistency among different taxes characteristics, starting from a review o f the taxable base and the exonerations that affect taxes, most o f which have weakened the structure o f the tax burden,prioritized partial and sectoral requests, and inmany cases created more inequalities. (c) Gradual introduce the individual income tax (IRPF) as an instrument to bringmore equity to the overall system, as this tax takes into consideration the citizens' contributory capacity and includes inits coverage the application o fpayment on incomes not currently taxed. (d) Focus on fiscal responsibility, which encompasses the need to assure the provision o f public goods by the State and, at the same time, allows the consolidation o f the virtuous cycle o f reducing the tax burden as far as possible. iii) Implementationstrategy The tax reform became effective on July 1, 2007, and the implementation plan was fulfilled as expected. Since its approval, the new tax legislation has been modified regarding pensions and retirement, inresponse to ajudgment o f the Supreme Court. This modification involves revoking the tax on individual income from pensions and retirement social security assistance (Law 18.314 o f 07/4/08). The modification does not affect the priorities o f the reform or the goals o f 104 the PRIDPL program. Likewise, changes were made to the RPF by Law 18.341 o f 08/30/08, which raised the non-taxable minimum amount and doubled the amount o f deductions per children younger than 18. As o f 2009 this tax can be paid as a family unit. A central component o f the tax reform implementation strategy is to strengthen collecting agencies and institutional coordination. Regarding the Tax Office (Direccidn General Impositiva-DGI), a program is under implementation to achieve more efficacy and efficiency through the following reforms: (a) A new management model that implements quality processes. (b) A new human resources management regime, based on a transparent system o f access, promotion and incentives; pay level in accordance with job requirements; a rigorous incompatibilities regime; and broad and permanent staff training plans. (c) A system o f strategic planning implanted through objectives disseminated in multiannual plans,with management control andperformance assessment o fresults. (d) Change in methods and working procedures as result o f procedure reengineering and computerization. (e) Substantial improvement o f computer equipment to address the lack o f working stations and to provide the communications and server support necessary to respond to applications currently inuse and those to be developed. (f) Continuous improvement o f assistance to tax contributors, progressively using new technologies such as internet, rationalizing and modernizing the payment systems. As regards the Social Protection Agency (Banco de Previsibn Social-BPS), strategic directives aim to improve tax andbenefits management and financing by: (a) Studyingand eventually redesigning administrative processes in order to reduce the time and effort for contributors for linkingto the Social Protection Agency. (b) Maximizing the exchange o f information and inter-institutional coordination in the private and public sector, to replace the state's vertical vision regarding revenue collection with a horizontal vision o f intensified cooperation. (c) Adjusting the organizational structure for the new processes and developing andor implementing flexible mechanisms that allow quick updates, inaccordance with management changes. (d) Deepening service decentralization andintegrating decentralized management. (e) Improvingthe planning process, budgetingand oversight. (f) Developingnew, modem staffpolicies. (g) Planning and applying an information system and computerized service strategy, in accordance with strategic objectives. The program has been successfully implemented, achieving its objective o f increasing management efficiency in both institutions. The established goals in PRIDPL Iregarding staff training, computer equipment and consolidation o f tax information, and attention to the taxpayer have been achieved. 105 At the same time, DGIis leading and coordinatingthe collection o f IRPF from several collecting and retention agencies, as set forth inArticle 8 o f the Tax Reform Law (which amends Article 1 o f Chapter Io f Title 7 o f the 1996 code). The following implementation goals o f the Tax Reform Law have been met: i)training was provided to DGI and BPS inspectors; ii)210 DGIposts were created to attend tax queries inthe central office and a call center; iii)the single tax registry is operating, iv) BPS transfers RPF tax files to DGI on a monthly basis; and v) DGIhas consolidated, in a consolidated solely tax file, incomes from several sources for each multi-employed taxpayer. Articles 87 to 94 o f the Tax Reform Law (No18.083), refemng to special social security contributions, eliminate exemptions to certain sectors and unify the rates o f the employer's retirement contribution, fixing in some cases a schedule o f adjustments to the base rate. The above-mentioned articles are being observed as established by law iv) Expected outcomes o fthe reform The proposed new tax scheme-with lower rates in most taxes, a simpler structure, greater sectoral equity and with more oversight facilities-promotes business formalization and discourages tax evasion, which inturnhelps lower the tax burden on contributors. Increased equity by sector and income facilitates system transparency, which-along with the substantial reduction o f loopholes-promotes an explicit shift in concentration o f subsidies to public expenditure and away from the revenue side. The consolidated impact o f the proposed changes on income and consumption confirms that the reforms will most benefit households in the lower income deciles: the eight deciles with lower income will see an increase in available income of between 1 and 3 percent, while the income o f the two highest deciles will bereduced. Investment, production and employment will be stimulated by a series o f changes. The broadening o f the tax base mitigates unfair competition that might exist in different economic sectors, facilitating investment. The sectoral equity o f private employers' contributions to social security allows a decrease o f the tax burden on certain employment-generating sectors, like services and trade. Decreased employer contributions in non-financial state-owned enterprises results inbetter provision o f public services and more national production competitiveness. The differential taxation on interest according to maturity and currency composition promotes long- term saving and contributes to de-dollarizing the economy, which reduce uncertainties and vulnerabilities. The decreased corporate income tax will promote economic activity, especially in sectors that apply technology innovation and create employment. 106 2. BusinessClimateImprovementandCapitalMarket Development 2.1 CapitalMarket PromotionandRegulatoryFramework i)Obiective This component's objective is to establish an institutional, legal, regulatory, and infrastructure framework to promote market development, ensure investor protection, improve supervision and provide a safe and efficient infrastructure. ii)Mainreformsandimpacts The reform objectives will be achieved through simultaneous actions indifferent areas: - Promotional actions bythe Government and regulatory agency. - Legal changes: new regulatory powers, development o f the use o f book-entry securities, corporate governance rules for security issuers, and rules for auxiliaries in the capital and stock markets. - Regulatory strengthening. - Improved supervision focus and methods: change for a supervision focus o f prevention and based on risks. - Improved compensation systems. - Improved corporate governance for market agents. iii)Implementationstrategy (a) Promotion o f instruments andpublic-private projects The Government has already put inplace a set o f measures intended to facilitate the use financial market tools to finance productive projects. Programsto facilitate the use o fjoint funds from IFIs and the Government with private funds in trusts are being drafted. As well, Law 18.127 was regulated in 2007, granting special tax status to structured trust funds according to the IDB Multisectoral I11Global Financing Program. This law, together with other regulatory initiatives, has helped make the private pension fund (administradora defondos de ahorro provisional- MAP)investmentregimemoreflexiblebybroadeningthe scopeoftheirinvestments. (b)Promotional actions bythe regulator Promotional actions will be developed intwo areas: - Professionalization and certification o f agents: utilizing schemes for certifying agents in various positions, designing a certification proposal, discussing the certification proposal with key market agents to reach a consensus, and designing an implementation strategy for the certification o f each kindo f agent. Dialoguewith stock market agents helpedindesigning 107 terms o f reference for consulting services needed for the certification and professionalization o f the relevant actors, and this consultancy i s currently under execution. - Investor education: designing and contracting a survey on investor knowledge, designing and executing an investor educational strategy that could include the use o f the B C Uwebsite, and a mass media and events strategy. N o significant advances occurred in this area due to the lack o f the human resources needed. (c) Changes inthe stock market law A draft bill written by the Securities Market Office (Diviszdn de Mercado de Valores y Control de Administradora de Fondos de Ahorro Previsional-DMV) and discussed with macroeconomic advisors from the Economics and Finance Ministry (Ministerio de Economia y Finanzas-MEF) was approved by B C Uboard and submitted to MEF's consideration. On April 2008 the B C U and the MEF held the seminar on the stock market with participation of the main market actors in order to discuss key reform issues: self-regulation framework, demutualization o f stock markets and the organization of stock market intermediaries, and the development o f promotional actions, among other issues. Following this, the MEF camed out a consultation process on the project with the main interested parties and drafted a law that was submitted to the Executive on November 19,2008, which inturn will send it to the Parliament for consideration. (d) Resource strengtheningandregulator organization The actions contemplated inthis component include: - Gradually increasingthe number o f DMV staff, with employee profiles and training adequate to needs. - Installing information systems prepared to respondproperly to different DMV tasks. - Hiringconsultants who are expert inthe implementation o fsystem improvements. - OverhaulingDMV's organizational structure. - Redesigningprocedures and writing a procedure manual. - Drawing up a regulatory code o f conduct. The main advances inthis area are: - Hiringof an information specialist for DMV. - Capital Market Registry systematization. - Design o f an investor protection area within DMV. - Continuation o f the training plan, with participation o f DMV staff in several seminars given by international experts. (e) Change o f supervision focus: supervisionbased inrisks 108 - Contract advisory services to define the risk matrixes to be applied to stock market intermediaries, investment fund administrators and financial trust funds. - Applymatrixes as apilot to some entities to assess and adjust them as needed. - Define supervision criteria for eachkindo f entity based on the level o f risk. - Define supervision plans based on the risks o fmajor entities. - Define supervision criteria and plans for smaller institutions. Progress has beenmade inpreparingthe terms o f reference for systematized risk analysis and for risk-based supervision. The assignment o f contracts for the construction o f the system i s expected to be done by the beginning o f 2009. (0Improvedpayment and settlement systems The improvement o f the corporate governance o f market agents critically depends on the new powers o f the regulator and the obligations for specific agents established by the proposed Stock Market Law. This law will allow DMV to supervise stock market activity, reducing self- regulation. Additionally, the law will strengthen corporate governance o f issuing companies, since it includes regulation on the composition o f the board o f directors, the inclusion o f independent directors, and the protection o f minority stakeholders, among other aspects. When the law is passed and regulated, several actions are expected to be taken regarding the current powers o f the regulator. In particular, the BCU, following the guidelines o f the International Organization o f Securities Commissions (IOSCO), has issued new regulations related to the presentation o f consolidated and audited financial statement, as well as on the information that these statements must include, with the intention o f improving the corporate governance o f the issuers, investment funds administrators and financial trust funds. iii)Expectedoutcomesofthereform These actions, including the approval and regulation o fthe proposed Stock Market Law, will: Promote financial instrumentsthat facilitate the financing o f huge productive projects. Create a regulatory system that guarantees the transparent, competitive and efficient functioning o f the stock market. Develop a regulator with enough resources and expertise to efficiently supervise the market and its agents, and to fulfill its role o f protecting the investor through informational and educational actions. Develop market agents with appropriate levels o f professionalism and good corporate governance to foster innovation and promote market growth. Establish a market infrastructure that brings security to transactions. 109 2.2 Bankruptcy and Corporate ReorganizationLaw i)Obiective This component's objective i s to provide companies in financial difficulties with an instrument to allow the survival o f economically viable productive units, as well as the efficient and equitable liquidation o f non-viable ones, thereby protecting investment, employment and healthy commercial relationships. The approval o f a new bankruptcy law was defined as a main element o f the reform program, and was submitted to Parliament. The law was approved and signed into law on October 23, 2008 as Law No18.387, named "Ley de Concurso y Reorganizacion Empresarial". Although originally planned to be enforced by April 2009, it came into full effect inNovember 2008 (Law No. 18.411.) ii)Mainreformsandimpacts The central element o f the reform is the creation o f new bankruptcy procedures L a oracion anterior no esta en el original. The previous regime established an inefficient and perverse system based on out-dated concepts and unable achieve the objectives mentioned above. Bankruptcy execution procedures (bankruptcy, judiciary liquidation) have been predatory to the patrimony o f debtors. Many times a productive and viable corporate unit disappears. It also has led to the presence o f slowly decaying debtor entities that compete unfairly with the rest o f the market. This panorama translates into credit retraction, increased cost o f credit and excessive collateral repossession, which produces transaction costs and immobilizes productive assets. The reforms are supported bynine fundamentalpillars: (a) Simplify procedures: the current multiplicity o f procedures must be simplified and replaced by a uniform procedure for all companies, detailed and predictable (but accommodating the particularities o f small enterprises). (b) Establish a single procedure: financing and economic difficulties can only be addressed under a single procedure that assesses the company's viability, taking into consideration all its possible options through three stages: bankruptcy, sale inblock, and liquidation inparts. (c) Facilitate access to procedures for debtors, creditors, workers and other relevant actors. (d) Provide a flexible framework to help actors reach an agreement, increasing their available options, considering that only they can find the best path to solve their difficulties. (e) Improve the collective decisionprocedures for creditors. ( f ) Reduce procedure costs by shortening time periods as well as reducing the costs of trusteeship, publications, and other procedural aspects. (8) Enhance specialized courts. (h) Promote the conservation o f viable enterprises, allowing solutions that facilitate the continuity o f those economically viable productive units. (i)Makemoreapplicablepenalsanctionsmoreapplicableincaseoffraudulentdebtorbehavior, creating a pre-established framework o f incentives and punishments for the debtors according to their behavior before and duringbankruptcy proceedings. 110 Below i s the implementation plan for the Bankruptcy Procedures and Corporate Reorganization Law. Three areas will be focused on to bringabout the expected impacts o f the law: (a) Regulation o f the new law The contents o f the regulation specified in the law are: definition o f fees applicable to trustees, intervention experts, investigators and other auxiliaries, and the establishment o f a bidding process for the auction o f operating companies (Art. 172). Other aspects to facilitate the proper enforcement o f the law will have to be added as well. (b) Strengthening bankruptcycourts The Law establishes several elements to strengthen the judiciary branch. Moreover, judiciary officials must be trained and court equipment reinforced. The main planned actions are: creation o f a Trustee Assessment Unit, drawing up a list o f trustees and intermediaries based on a public call for applications, creation o f a secretary-accountant post as an auxiliary to each o f the two bankruptcy judges, and physical infrastructure strengthening o f the two bankruptcy courts inthe capital and 10 civil courts intheinterior o f the country. (c) Training and dissemination The changes envisioned in the new Bankruptcy Law will require training and dissemination in order to be fully incorporated into the daily operations o f economic agents and judiciary officials. Activities are planned inthis regard related to judicial training at the university level as well as among economic agents. iii)Expectedoutcomesofthereform - Increased use o f bankruptcy procedures for enterprises in difficulties and o f sufficient dimension and complexity to require this sort o f specialized procedures. - Increased resource recovery by creditors. - Increased proportion o f economically viable enterprises inoperation. - Shortened periods to complete bankruptcy procedures. - Elimination o f distortions causedby unfair competition by enterprises inbankruptcy. 2.3 Transparencyand Disseminationof Information i) Obiective The Government's objective i s to improve the transparency o f information in the markets by improving the quality and dissemination o f information to the corporate and financial sectors, public as well as private. Improved information quality will result from adopting International Financial Reporting Standards (IFRS) and International Standards on Auditing (ISA). 111 Many countries are implementingnorms and principles to improve the performance and stability o f the financial sector. A key aspect o f this challenge is to improve transparency and develop mechanisms for disseminating accounting and financial information. This i s particularly important inLatinAmerica, considering the financial inestability the region has experienced. 111 Mainreforms and impacts Three aspects are particularly important to improve the regulatory and institutional context for accounting and auditing practices inUruguay. (a) Improve and strengthen the institutional framework for the presentation, registry and dissemination o f companies' financial information. This requires the technological reformulation o f the registry o f accounting statements, as well as adjustments inrules to ensure the compulsory registration o f high-quality accounting statements and their timely dissemination. All public offices as well as the main market agents must have easy and prompt access to this new registry. The following advances havebeen achieved inthis area: - Hiring a certified public accountant consultant to analyze the present situation o f REC registry, to identifyinefficiencies and suggest improvements. - Consultations with DGI and BPS to determine which companies should be obliged to register. - Hiring an information technology consultant for the REC, responsible for analyzing the current registry andidentifyingpossible alternative management technology. - Drafting a decree on the new Statement o fAccounts Registry. (b) Adopting a sustained and effective process to implement IFRS. This implies drawing up and approving a legal framework to adopt the current IFRS and strengthening the institutional framework through the creation o f a new institution to replace the Commission on Accounting Standards (Comisidn Permanente de Normas Contables Adecuadas-CPNCA). - Members o f the present CPNCA, incooperation with MEF, drafted a bill for the creation o f a new entity to issue accounting standards to eventually substitute CPNCA. After consideration by MEFauthorities, this was submitted to Congress on July 21,2008. - In the interim, CPNCA's composition was modified by Resolution 580/07 to include representatives o f monitoring institutions such as BCU, DGI and Public Accounts Tribunal (Tribunalde Cuentas-TCR), one representative from private universities and one from the Uruguayan Association o fPrivate Banks. - On July 2007 the Executive approved Decree 266/07, which makes the use o f IFRS, issued by the International Accounting Standards Board (IASB), mandatory as o f January 1, 2009 for the preparation and presentation o f statement o f accounts. This decree establishes the application o f the IFRS, fulfilling: 112 o Requirements for companies to consolidate financial account statements, in application o f IFRS standard 27: "consolidated and separated statement o f accounts". o Requirements for companies to provide information on transactions with related parties, in application o f IFRS standard 24: "information to be revealed by interested parties." Legal amendments to the Corporations Law were approved in the Accountability Law (No. 18/362), in articles 499 and 503. These amendments eliminate inconsistencies between Uruguayan law and the accounting rules to be applied as o f January 2009. The current Corporations Law includes in Article 89 "the obligation by monitoring corporations to present consolidated statements o f accounts as complementary information." This article was in conflict with IFRS standard 27's call for "consolidated and separated statements o f accounts", since it requires the presentation of consolidated statements o f accounts as the main information. Since Decree No. 266/07 makes IFRS mandatory as o f January 2009, it was decided that the law would be adapted to conform to these changes. (c) The design and implementation o f an independent system to oversee the actions o f auditors and auditing firms, as well as a strong regulatory framework accepted by all parties that conforms with International Auditing and Assurance Standards and the ethics code o f the International Federation o f Accountants. This new legal and institutional framework will, once consolidated, free up resources and jurisdictions from other public entities such as BCU, DGI, Internal Audit Agency (Auditoria Interna de la Nacibn-AIN), etc. nl) Implementationstrategy The implementation strategy integrates legal changes, creation o f new institutions and regulatory organizations, a strong dissemination campaign, international cooperation, and consultancies and training for users, issuers, public institutions and professionals. A cooperative approach will be followed that will involve the relevant market, public sector and academic actors inthis area. Inbrief, theimplementation strategy will include the following activities: (a) Improving and strengtheningthe institutional framework for the presentation, registry and dissemination o f company financial information by reviewingand modifying the legal and regulatory framework o f the Corporations Law (No. 16.060); strengthening REC processes, systems and resources; and providing training and information to users, issuers, professionals and public institutions. (b) Establishing a sustainable and effective process to adopt IFRS by creating an adequate institutional framework (including both a temporary, short-term framework for their immediate adoption, as well as another for the medium term) and the preparation and execution o f a planto adopt IFRS. 113 (c) Designing and implementing an independent oversight system for professionals and auditing firms (for all types o f financial reporting) via an adequate institutional framework, a plan for professional certification, and on-going training. Expectedoutcomes o f the reforms The main expected impacts o fthese reforms are increased access to better quality information for users o f the system. This includes particularly the financial system, capital markets, regulatory organizations, and research institutions. Access to more and better information will decrease information asymmetries betweenmarket agents, resulting inbetter decisions and better financial risk management. The expected improvements in corporate information transparency will create a better investment climate, better conditions to attract direct foreign investment, more developed capital markets, and improved corporate governance and autonomous public entities. 2.4 Paymentandsecuritiessettlementsystem reform i)Objective The main objective o f this reform is to have a safe and efficient payment and securities settlement system, which would contribute to the stability of the financial system and to the development o f the country's financial and capital markets. ii) Implementationstrategy The B C U has adopted a strategic approach for the reform o f the payment system. This approach has been described and agreed upon with interested parties in the document "Uruguayan Payment System: Medium and Long Term Vision" (El Sistema de Pagos de Uruguay: Visibn de Mediano y Largo Plazo), which was submittedto discussion in the Payment System Discussion Seminar (Taller de Sensibilizacibn sobre Sistemas de Pagos) in May 2006. The document presents the main elements that will characterize future arrangements for the payment and securities settlement system inUruguay. The systemwill be based on the following pillars: Pillar I:The Uruguayan payments system will have a legal framework to guarantee efficient and secure operation. Pillar 11: The payment systems for transactions o f systemic importance shall comply with the basic principles o f the Committee on Payment and Settlement Systems (CPSS) and will function securely and efficiently. Pillar 111: The inter-bank money market will be fully integrated into the gross real time settlement system and into the securities registry system. Pillar N: The inter-bank exchange market will be fully integrated into the gross real time settlement system and will operate on a payment-against-payment basis. 114 Pillar V: Retail payment systems will be secure, efficient and inter-operative, and will provide a wide variety o fpayment processes and tools. Pillar VI: The charges and payments o f the Government will be processed electronically, within more efficient and secure framework. Pillar VII: The deposit, compensation and settlement systems for securities will operate efficiently and securely, according to international standards, contributing to the development o f the capital market. Pillar VIII: Surveillance and supervision o f the payment and securities settlement systems will be exercised by the BCU, pursuant to the powers legally invested init. Pillar E:The payments system o f Uruguay will be developed within a formal framework o f cooperation between authorities and participants. This vision has been agreed among all the interested parties, and the B C U has prepared a detailed implementation plan for each o f the pillars. The implementation plan, approved by the B C U in April 2008, was broadly discussed with all interested parties in a seminar held in M a y 2008. Important advances have already been made: - A draft bill o f the Payment Law was approved by the BCU and is now under MEF consideration before beingsubmitted to the Presidency. - A draft bidding document for an integral system, including not only the gross real time settlement system but also a central securities deposit and the necessary links with the related systems. - The B C U is considering internal organizational arrangements to facilitate adequate surveillance over the payment and securities settlement systems. iii)Expectedoutcomesofthereform Following the approval o f the new legal framework, the operation o f the new integrated system (planned for 2010)' surveillanceby the B C U and other authorities, and the implementation o fthe rest o fthe pillars, expected results include: - More legal security inthe transactions o f hnds and securities transfer. - More legal and operational security in high-value transactions, with a clear decrease in the risks associated with the settlement o f operations with funds or securities. - Availability and greater use o f electronic payment bythe population. - Modernization o f the Government's payments. 115 3. Social Protection iJ Obiectives The Government has defined social polices as an essential component o f economic and socially sustainable development. The following section outlines the main social protection activities developed duringthe current administration and strategies for the future. IIJ Mainreforms since 2004 and their impact During the first years of administration, the Government targeted its social policy efforts on assisting the population excluded from social protection. The country's social security system i s mainly contributive, and the changes in the labor market in the last decades resulted in an important portion o f the population having no access to social security. Two main instruments were used to increase coverage: expansion o f non-contributory family allowances, and implementation o f the National Plan to Attend to the Social Emergency (Plan de AtenciBn Nacional a la Emergencia Social-PANES). Family beneficiaries increased considerably in the non-contributive program: 149,200 in 2004, 197,900 in 2005, 209,700 in 2006 and 211,400 in 2007. Since contributive benefits have also increased thanks to the growth o f formal employment, the total number o f beneficiaries rose from less to 400,000 in 2003 to 560,000 by the end o f 2007, and i s expected to reach over 600,000 in2008. PANEShadthe following objectives: - Guarantee coverage o fbasic needs o f the most vulnerable social sectors and alleviate the risk o f extreme poverty. - Generate conditions and opportunities needed for the full exercise o f social rights. - Construct, ina collective and participative manner, paths out o f extreme poverty and poverty, within a framework o feffective social integration. Over 80,000 homes benefited from PANES during program execution. In December 2007, 68,500 homes received the Citizen Income-the cash transfer component o f PANES-and 64,000 homes participated inthe National Nutritional Plan (Plan Alimentario Nacional). ln) Strategiestowards thefuture Pursuant to the legislation, PANES terminated in December 2007. The program ended with its objectives fulfilled: it attend to the most vulnerable population in the context o f the social emergency. Nevertheless, this does not imply that the State disregards the social and economic needs o f the population. InJanuary 2008, the Social Equity Plan (Plan de Eguidad Social) began implementationto continue assisting the most vulnerable. 116 The general objective o f Plan de Equidad is to ensure the full exercise o f citizens' right o f all Uruguayan inhabitants, particularly the most vulnerable, by equalizing their opportunities to access universal social services, income through a dignifiedjob, and basic social benefits. The plan's strategic objectives are to: - Improve inter-generation and gender equity, which implies consolidating and deepening solidarity among age groups, as well as addressing persistent inequalities associated with gender di'scrimination. - Develop and expand a social assistance network that addresses new and multiple social risks and vulnerability situations, acting as a safety net to prevent situations o f poverty and extreme poverty from developing or beingperpetuated. - Integrate this safety net with the changes already announced in sectoral social policies, as well as with the country's traditional social benefits, in order to design an integrated social protection system. Among the main programs and actions identified as part o f the Plan de Equidad Social are: a) Tax reform b) Healthpolicy c) Employment policies d) Housingpolicy e) Educationpolicy f) Social security g) Planfor equityo fopportunities and rights Regarding the social assistance components o f the social protection matrix, the following elements are beingdefined: (a) Income transfers - Reformulatethe family allowance benefits system - Reformulatethe pension system for the elderly (b) Education - Increase coverage and quality o fpre-schooling - Improve performance o f and assistance to primary schooling - Reduce drop outs and improving linkages in secondary school (c) Employment - Income work program. Social benefits inexchange for work. - Incentive program to contract the unemployedpoor and provide labor market orientation. (d) Nutrition 117 - Provide nutrition assistance to households in extreme poverty with children under 18 years old and pregnant women. - Improve food security o f the population by optimizing the nutrition programs for the most vulnerable sectors o fthe population. (e) Housing and Environment - Respond to emergency situations with temporary solutions, with a view to integrating individuals into appropriate permanent programs. (f) Disabilities - Revise the methodology used by BPS ("Baremos") to determine the degree o f disability o f the people involved, increase research, training, and specialized services; strengthenrelevant organizations; and promote greater awareness through dissemination o f information and rights. (g) Social Inclusion - Implementationo f social integration policies. One of the main components o f the Plan de Equidad began in 2008: a reform o f the family benefits regime (AFAM). The new AFAM system i s meant to the cover minors under 18 years o f age from more vulnerable homes, substantially increasing the amount o f the benefit and introducing equivalency scales and monthly payments. Other plan components have also been launched, including Asistencia a la Vejez (old age assistance), Uruguay Trabaja and Objetivo Empleo (work programs), Apoyo Alimentario (food support) and disability programs. In 2009, the new AFAM benefits will be extended to cover a total of 500,000 children and adolescents in situation o f socio-economic vulnerability, which will involve broadening the new system to about 170,000 minors. 118 Annex 2 Policy Letter for the Second PRIDPL November 2008 Contingency in the cost of electric energy generation Uruguay hasjust experienced one o f the driest periods since record-keeping began on the matter. Added to this is the extremely high international price o f oil, which impacts the cost o f generating thermal energy, and the complex regional energy situation, which makes it difficult to import electricity from neighboring countries. As a result, electricity rates were raised in February 2008 by on average 7.95 percent, and by another 8 percent in June. The increase reflects the adjustment o f the structural cost o f meeting electricity demand, resulting exclusively from the higher price o f oil derivates (which rose from U S 3 4 0 million estimated inJanuary to US$434 million inJune). It was considered necessary to reflect, albeit partially, the permanent component o f this increase in the prices transmitted to consumers. Hydropower-the least expensive source o f energy-generation available-will tend to gradually decrease in the overall electricity generation structure. Any increase in demand will have to be met by local generation from non-hydraulic sources or imports. The thermal generation component will increase, since there will be a tendency to use thermal plants more hours per year. Although the National Electric Company (UTE) i s developing projects to include new sources o f energy which will allow lower variable costs (liquefied natural gas, coal, renewable energies), these new projects are relatively long-term endeavors. The price policy is intendedto gradually adapt prices to the cost structure over the medium term, giving stable signals and without transferring to the consumer occasional variations' due to temporary water deficits or surpluses. This would result in volatility in the price o f electric energy and would hinder the decision-making process by economic agents. As a result, in2008 deviations could be generated in UTE'S financial results connected to the drought. Unlike the situation in 2006, this deviation cannot be compensated by fiscal margins from other public organizations. Therefore, to measure compliance with the public sector's consolidated results goal, only the structural cost o f electric energy generation will be take into account. This situation could create liquidity problems for UTE, and it was deemed appropriate in the Statement o f Accounts for 2007 to request authorization for the Executive to enter into loan agreements with UTE, in order to cover temporary financial needs derived from the higher cost-connected with climate-of supplyingelectricity. It should be stressed that the forecasts for next year predict better hydrological conditions for Uruguay and the region, and this fact, along with declining o f international crude oil prices, 119 should lead to a substantial improvement in UTE'S2009 financial results, meaning the overall public sector result is expected to be within the original official projections. At the same time, in order to avoid the restrictions o f energy supply faced in the past due to droughts, the Government intends to diversify its energy matrix inthe medium term. In this regard, the construction of a large interconnection between San Carlos (Uruguay) and Candiota (Brazil) will allow the country to receive electricity beginning 2010, thus increasing the security o f electricity supplies during drought conditions. This will also diversify the origin o f imported energy, since at present there is only interconnection with Argentina. As well, within the framework o f the Wind Energy Program, the Ministry o f Industry and Energy will open a bid for the installation o f wind farms in the first six months o f 2009. The program has a short term goals o f incorporating 50 MW per year. In October 2008 the first private wind energy farm in Uruguay was opened in the Rocha department, with 16 windmills using Dutch technology. The project, called Nuevo Manantial SA, has 12 40-meter generators and four 70-meter generators. The farm will provide energy to the cities o f Rocha and Castillos. At present Nuevo Manantial operates at 60 percent o f capacity and generates 6 MW, (enough to meet the energy demands o f these two cities). At full capacity the farm will generate 10MW. The Government i s also bidding out 11 territorial sea areas for oilhatural gas exploration and exploitation through the ANCAP company. From December 1 to 3, 2008 ANCAP began the process o f pre-qualification o f interested firms. Even ifpetroleum is found, according to primary estimates the country will not be ina position to extract and commercialize it before 2015. 120 ANNEX 5. FUNDRELATIONS NOTE EXTERNAL RELATIQNS DEPAMMEN1 InternationalMonetary Fund Public tiifomation Notice (PIN)No.08/141 TOO .19* Street, NW FUR IMFUIEDIATERELEASE Washington, D. C. 20431 USA November 11, 2008 lNlFExecutive Board Concfudes2008 Article IV Consultationwith Uruguay On October, 24, 2008, the Executive Boardof the InternationalMonetary Fund (IMF) concluded the Artrcle IV consultationwnth Unrguay.' Background Uruguay hasfurther consolidatedeconomic gains, supported by strong macroeconomicpolicies and a broadlyfavorable externalenvironment. Growth has exceededexpectations, unemploymenthas reachedrecordlows and poverty has continued to fall, while economic vulnerabilitieshave been significantlyreduced. Nevertheless,persistent inflationarypressures, together wrth a deterroratingglobal economy pose key challenges.Moreover,despite significant advances. the government's reformagenda is still ongoing. Sincethe intensificationof the global financialturbulence, Uruguay has experienceda peso-depreciation,higher inkrest rates, and an increasein countfy nsk. Rea! GDP grew by 7 5 percent in 2007, continuingthe strong performancefoBlomng the crisis in 2002. Growthmomentum has been exceptionallystrongthis year, with real GDP growth reaching 13 percent during the first semester, led by domestic demand Together with food and 'UnderAttide 1Vof the IMPSArticles of Agreement, the IMFholdsbilateraldiscussionswith members, usually everyyear. A staff team visitsthe country, collects economic andfinancial information, and discusseswith officialsthe country's economic developments and policies.On returnto headquarters,the staff preparesa report, which forms the basis for discussion bythe Executive Board. At the condusionof the discussion,the Managing Director,as Chairman of the Board, summarizes the views of Executive Directors, andthis summary is transmittedto the country's authorities. WahingtW. D.C. 20431 Telephone 202-623-7100 * Fax 202-623-6772 * \t/WW.LBnf.Org 121 2 oil commodity prices increases,this has fueled persistent snfkationary pressures. Twelve-month inflation through September 2008 was 7.5 percent, above the upper I m t of the central bank's target range (7 percent). Core inflatLon has risen steadily, and remains in the 9-10 percent range. The authorattes took measures to contasn price increases: but pressures remain. The policy rate was raised by 275 basis pointsto 7% percent in 2807 and, naore recently by 50 basis points In October; in May, reserve requirements were increased. Moreover, the exchange-rate channel has been allowed to operate more freeky?with, until this September, the peso appreciating against the U.S. dollar. In addition, in 21007,tax measures were ~mp~ementedto prevent headlltne anflatton from reaching double-digits,which would have triggered more frequent pensronand wage adjustments. Nonetheless,while headline inflation has come down by 1% percentage points since its peak in 2007, both core and headline inflation remain above the central bank's target range While the overall deficit has been below target, fiscal policy has been somewhat expansionary. The headline primary balance declined from 3% percent of GDP an 20136 to an estimated 2 7 percent of GDP in 2008. Adjusting for the economrc cycle and excluding drought-related costs, both the primary and overall balances may iniply a positive impuise in 200849. Stir], with lower interest payments, the overall deficit is expected to remain between 0-0.3 percent of GDP Moreover, the gross debt-to-GDP ratio has continued to fall, to about 65 percent of GDP and 55 percent of GDP (net of Net InternationalReserves - NIR) Nonetheless, looking ahead, more ambrtious fiscal targets would help ease domestic demand pressures and reduce the burden on monetary policy in its fight against inflation, as well as help in achieving faster debt reduction. Uruguay's external sector remains strong, with buoyant exports, and import growth driven by large foreign direct investment projects.The central bank has accumulated USSG biilion in reserves to date. Shota-term debt has been sihapky reduced through debt ~ i a n a g e m e ~ ~ operations, including by de-do11arisingthrough swaps with supportfrom the World Bank. The debt structure has improved, and financing needs are covered through end2009 Financial indicators have improved considerably. Despite strong credit growth, financial system soundness indicators have improved, showing a well-caprtaiised banking system. low nom performing-loan ratios and high liquidity levek. However, bank profita ty has declined of late reflecting in part declining yretdsand the strong peso appreciation until August. Still, Uruguay remains one of the most dollarired economies in the world Despite significantadvances, variclusstructuralreforms are still pending.Progresshas been made in uctclrrngthe housingbank BHU, but the processremains to be, completed. 122 3 Executive Board Assessment The Executive Directorsnoted that prudent macroeconomic policies and deep-rooted structural reforms over the pastfew years, aided by favorable external conditions until mid-2008, have enabled Uruguayto maintain vigorous export and economic growth, lower unemployment and poverty rates, and significantly reduce vulnerability to shocks. High levels of internatronaf reserves and commercialbank lrqurdityare providing important buffers against deteriorating external conditions. Moreover,debt managementoperations have reduced short-term governmentfinancing needs, lowered the debt-to-GDP ratio, and substant~~l~yimproved the debt profiie. As a result, the effects of the recent turmoilin global financial markets have been relatively contained. ~ o ~ i t h s t a n these~achievements, Directors noted that the Uruguayaneconomy remains d ~ n vulnerable. In particular,deteriorating global financial and economic conditions pose downside risksto Uruguay's srnai!, open, and dollarizedeconomy. A main macroeconomic challenge will be to contain inflation in the face of food and firel price increasesand domestic demand and wage pressures.Directorsalso noted the recent sharp increase in Uruguay'scountry risk premium. They accordingly underlinedthe importance of continuedvigilance by policymakers, and of steadfastpursuitof the government's reform agenda to help maintain macroeconomic stability and sustain robust economic growth. Directorswelcomed the measures the authorities have taken to reduce inflationary pressures, including increasesin the policy rate and banksareserve requirements and tax administrative measures. With core and headline inflation stili above the central banks target range and bank credit growing rapidly, Directors saw merit In some additional monetaiy tightening. A few Directorscautioned, however, that relianceon the interest rate channel could intensify capital inflows. Directorsgenerally noted that administrative measuresshould be relied on to control prices only in exceptionalcircumstances Directorsalso emphastzed the importance of Making price stability the core objective of monetary policy in order to strengthen the credibility of the monetary policy framework, and of securing central bank independenceirrespective of the electoral cycle. Directors noted that capital flows have complicated monetary management. Until August 2008, strong inflowsand sterilized rnterventwnto contain the appreciation of the currency led to a sharp rise in reservesand central bank debt. More recently, the deterioratingglobal financial conditions have created new chaflenges, as inflows have abated and the exchange rate has depreciated. Most Directorsconsideredthat fiscal policy has been expansionary, particularly in non-drought years. They noted that the primary balance has deteriorated since 2006, and the structural primary and overall balances may imply a positive irnpuise in 2008-09. Directors stressed that, 123 4 with the gross public debt ratiostili relativelyhigh, it will be essential to maintain high prtniary surplusesto further reducethe debt burden. Most Directors encoura~edthe authoritiesto maintain an ambitiousfiscal stance to help avoid increasingthe burden on monetarypolicy, while supportingwell-targetedmeasures to alleviatethe impact of the food and fuel price shockson vulnerable groups At the same time, some Directorscautionedthat in the current changing economic envtronment~the case for a tighter fiscal stance is debatable. Most Directors also sabv merrt ~nmovingto c~~l~cal~y-ad~ustedfiscal targets-and a few suggested the adoption of a fiscal rule-which they felt would enhance the effectivenessof fiscal policy and reduce medrum-termvulnerabilities.Directorswelcomed the operations carriedout recently to improvethe debt profile and to reducedebt dollarization. Directorsnotedthat the bankingsystem ISwelt-capitalized and liquid, with low n o n - p e ~ o r ~ i n ~ loans. They welcomed the system's increased resilrenceto shocks, and called for further strengthening of the financial sector, pafiicularly in the context of declining bank profitabilrty, global financial volatility, and doliariration of the economy The recent rapid growth of bank credit and an increasein non-residentdeposiZs point to the need for continued proactive bank supervision. Directorsstressed the importanceof deepeningfinancial sector reforms and completing the implementationof the 2006 FinancialSector Assessment Program (FSAP) recommendations.These rnctude further strengthening state banks and banktngsupervision, and completingthe restructuringof the housingbank. Directorsweicarned the important progressmadeso far in this regard They regarded swift approvat of the financial sector law to be key to enhancing central bank independenceand strengtheningthe supeivisoryand resolutionframeworks. Directorsnoted that Uruguay's favorable businessclimate has ied to strong foreign direct investment inflows and a diversificationof expotas and export markets. They welcomedthe efforts berng madeto further improvethe business climate, includingthe reform of competition and bankruptcy legtslation Public Infomatian Notices fPtlus) form part of the IMF's effortsto proniotetransparency of the bfF's wews and analysisof economicdevelopmentsand policies.With the consentof the country forcountries)concerned, PINSare issued after ExecutiveBoarddtscussronsof Al-trcke iQconsultatrons , of itssurveillance of developmentsat the regionallevel,of post-program monrtonng, and of ex post assessmentsof member countries with longer-temr programengagements. PlNsare also issuedafter ExecutiveBoarddwusslons of general polrcy matters, unlessothewsse dectdedby the fxecutlve Board in a particularcase. 124 5 Uruguay. BasicData Ref Preel 2003 MOJ 2005 2W6 307 200.8 2009 (Annualpercenragechanges, unlessotherwise indicated1 RealGDP 2.2 11.8 66 7 0 7.4 9.5 5.5 Realconsurnptm I 1 9 5 28 8 6 9.7 9 8 7 8 Realmvestment 18.0 22.0 12.7 24.7 2.6 16.5 8.0 Prices Conswtlfw pnce index (pen& average) 184 9.2 4 7 6 4 8.1 7.6 7.4 Consumerpnceindex(eoel 102 7.6 4 9 6.4 8.5 8.5 7.5 Terms of trade 2 2 -2.4 -6.3 -1.6 0.6 4.3 0 2 [In pwcen! of GOB) Publicsector finances Total revenues 320 30 9 31.8 3t 8 33.8 32.4 33 8 Expendib.fejincl. dwepancy) 353 33.2 325 325 33.8 327 339 Primarybalance 1 7 3.8 3.9 3.8 3.6 2.7 3.1 Overall balance -32 -2.2 -07 -0.6 00 -0 3 -0 t Puhlicsectordebt 71 110 97 75 66 62 58 53 O ~ sexternaldebt ~ t ~ ~ 9B.2 87.4 68.3 547 52.3 41.3 36.2 Ofvdwch Pubhcexternal&bt 85 3 769 BO 8 48 2 47.3 363.3 31.3 (Annualpercentagechange) Moneyand credit Basemoney (-1 249 111 391 130 16.4 289 _ _ MI 346 234 294 218 29.4 227 . M3 217 -2.0 0.4 12.3 3.8 2.6 _._ Creditto the pmratesector (constantexchange rate) -23.9 -11.2 2 7 9.1 22.1 28.6 _ _ _ Grossoffiaa! resews (US$million)21 2,087 2,522 3,438 3,091 4,096 6,371 6,826 inpercentof short-termdelg 1313 1224 153.8 492 I 495.3 648 3 597 7 Inpercent af short-termckbt and FXdeposrts 20.0 27.7 32.9 328 40.2 62 7 63 1 (Inpercentof GDP, un6essotkwwiseindiMed) Elatanceof payments Current account -05 0.3 0.0 -24 -08 -1.7 -24 Merchandiseexgotis,f 2) b. 203 237 225 227 21.8 224 206 Wchandise imports,f.o b 18.7 226 22.3 252 23.9 24 3 232 Services. m m ,andtransfers(net) -2.1 -0 a -0.2 0.1 1.3 0.3 o 2 Gapbl andDnancmiaccount 9 3 0 5 6.1 2.0 6.1 8 7 4.0 Foretgndirect Investment 3 6 24 4 3 7 1 3.8 3 3 2.8 Overallbalanceof payments(US$ milrons) 4,380 454 95'1 -337 1,005 2,275 555 DebtSeMce ratb(inDementof emorls of (Foods & sewices) 52.3 44.8 53 1 92.5 25.0 16.5 159 Sources. Dataprovidedbythe Uruguayanauthomes; and IMFstaff esbmates. I!Publicsectordebt,netoffreereNeSoftheCentralBankofUruguay. 21 IndudesresenreWildup through rttseeverequirementsof residentfinancial institutrons 125 ANNEX 6. URUGUAY-KEY ECONOMIC INDICATORS Actual Estimate Indicator 2004 2005 2006 2007 2008 National accounts (as YOof GDP) Gross domestic producta 100 100 100 100 100 Agriculture 12 9 9 10 11 Industry 29 31 32 32 30 Services 60 60 59 58 59 Total Consumption 84 85 86 86 84 Gross domestic fixed investment 11 13 15 14 16 Government investment 2 2 3 2 2 Private investment 9 10 12 11 14 ~xp01-t~(GNFS)~ 32 31 30 29 30 Imports (GNFS) 29 28 31 30 31 Gross domestic savings 16 15 14 14 16 Gross national savingsc 13 13 12 13 14 Memorandum items Gross domestic product 13994 16615 19308 23087 30449 (US$ million at current prices) GNI per capita (US$, Atlas method) 4640 4930 5410 6380 11000 Real annual growth rates (YO,calculated from 83 prices) Gross domestic product at market prices 11.8 6.6 7.0 7.4 10.6 Gross Domestic Income 13.5 3.9 5.7 7.8 16.5 Real annual per capita growth rates (YO,calculated from 83 prices) Gross domestic product at market prices 11.9 6.5 6.7 7.3 10.3 Total consumption 9.6 3.8 9.6 I 7.1 7.6 Private consumption 10.7 4.4 10.5 7.6 9.5 Balance of Payments (US$ millions) ~xp01-t~(GNFS)~ 4257 5085 5785 6796 9273 Merchandise FOB 3145 3774 4400 5025 7274 Imports (GNFS)~ 3778 4693 5882 6840 9427 Merchandise FOB 2992 3753 4895 5591 7893 Resource balance 478 393 -98 -45 -154 Net current transfers 113 144 126 134 140 Current account balance 3 42 -400 -235 822 Net private foreign direct investment 315 811 1495 1000 1070 Long-term loans (net) -394 -403 -443 -524 0 Official -8 48 -584 -3 1 384 Private -387 -451 141 -493 -384 Other capital (net, incI. errors & omissions) 531 170 -667 764 383 Change in reservesd(f increase) 454 620 -15 1005 2275 Memorandum items Resource balance (YOo f GDP) 3.4 2.4 -0.5 -0.2 -0.5 Real annual growth rates ( YR83 prices) Merchandise exports (FOB) 45.0 23.2 18.4 19.4 19.1 Merchandise imports (CIF) 49.8 27.7 25.8 22.0 22.4 127 Uruguay Key EconomicIndicators - (Continued) Actual Estimate Indicator 2004 2005 2006 2007 2008 Public finance (as % of GDP at market prices)' Revenues 29.0 29.2 28.8 29.0 27.1 Current expenditures 22.3 22.9 22.6 22.7 22.3 Current account surplus (+) or deficit (-) 6.7 6.3 6.2 6.3 4.8 Capital expenditure 2.6 2.4 2.6 3.0 3.2 Foreign financing 2.8 0.8 -0.9 5.2 2.0 Monetary indicators M2/GDP 55.3 44.9 44.3 39.9 38.4 Growth o f M2 (%) -1.7 -13.1 12.9 5.0 12.1 Private sector credit growth / 101.9 29.2 -106.2 -97.5 71.2 total credit growth (%) Price indices( YR83 =loo) Merchandise export price index 183.2 178.4 175.8 168.2 207.4 Merchandise import price index 183.2 178.4 175.8 168.2 200.5 Merchandise terms o f trade index 100.0 100.0 100.0 100.0 103.4 Real exchange rate (US$/LCU)f 63.3 75.6 79.4 86.1 78.1 Real interest rates Consumer price index (% change) 9.2 4.7 6.4 8.1 7.8 GDP deflator (% change) 7.5 0.6 6.8 8.5 6.5 a. GDP at market prices b. "GNFS" denotes "goods andnonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use o fIMFresources. e. Non-financial public sector. f. "LCU" denotes "local currencyunits." Anincrease inUS$/LCU denotes appreciation. 128 ANNEX 7. URUGUAY-KEY EXPOSUREINDICATORS Actual Estimated Indicator 2004 2005 2006 2007 2008 Total debt outstanding and 15,160 15,900 11,724 13,615 14,797 disbursed (TDO) (US$m)" Net disbursements(US$m)" 48 1,583 -2,718 789 1,809 Total debt service (TDS) 1,544 2,199 5,833 1,482 1,122 (US$m)" Debt and debt service indicators (%) TDO/XGS~ 356.1 312.7 202.7 200.4 159.6 TDO/GDP 108.3 95.7 60.7 59.0 48.6 TDS/XGS 36.3 43.2 100.8 21.8 12.1 Concessional/TDO 0.9 0.8 1.o 0.8 0.6 IBRDexposureindicators (%) IBRDDS/public DS 7.4 6.8 4.3 8.0 13.5 Preferred creditor DS/public 60.0 52.0 64.2 28.6 40.4 DS (Yo)' IBRDDS/XGS 2.4 2.7 4.3 1.5 1.4 IBRD TDO (US$mld 785 816 653 666 822 Ofwhich present value of guarantees(US$m) Share of IBRDportfolio (YO) 0.6 0.7 0.6 0.6 0.8 IDA TDO (US$m)d IFC (US$m) Loans 0 0 0 102 1 Equity and quasi-equity IC 0 2 0 -2 0 MIGA MIGA guarantees(US$m) Note: Debtnumberswere providedby DEC (Development Economics), World Bank a. Includes public and publicly guaranteed debt, privatenonguaranteed, use of IMF credits and net short- term capital. b. "XGS" denotesexports ofgoods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types ofboth loan and equity instruments. 129 130 ANNEX 8. URUGUAY AT A GLANCE Uruguay at a glance 12/30/08 Latin Upper Key Development Indicators America middle Uruguay &Carib. income Age distrlbutlon,2007 (2007) Female Population, mid-year (millions) 3.3 563 823 Surface area (thousandsq. km) 176 20,421 41,497 Populationgrowth( O h ) 0.1 1.2 0.6 Urbanpopulation(% of total population) 92 78 75 GNI (Atlas method, US5 billions) 21.2 3.118 5.750 GNI per capita (Atlas method, US$) 6.380 5,540 6,987 GNI per capita (PPP, international$) 11,040 9,320 11.868 GDP growth( O h ) 7.4 5.7 5.8 5 0 5 10 GDP per capitagrowth ( O h ) 7.3 4.5 5.1 Dercent (mostrecent estimate, 200Cr2007) Poverty headcount ratioat 51.25 a day (PPP. O h ) 8 Poverty headcount ratioat 52.00 a day (PPP. Under-5mortalily rate (per 1.000) O h ) 18 Lifeexpectancy at birth (years) 76 73 70 Infant mortality(per 1,000 live births) 11 22 22 1 6 0 , Child malnutrition(% of childrenunder5) 6 5 Adult literacy,male (YOof ages 15and older) 91 94 Adult literacy, female (% of ages 15and older) 89 92 Gross primaryenrollment, male (% of age group) 117 120 112 Gross primary enrollment, female (% of age group) 113 116 109 Access to an improvedwater source (% of population) 100 91 95 Access to improvedsanitationfacilities 1980 1995 2ow 2 m ( O hof population) 100 78 83 0Uruguay Latin Amenca 8 the Caribbean Net Aid Flows 1980 1990 2000 2007 l15T (US$millions) Net ODA and officialaid 10 52 17 21 Growth of GDP and GDP per capita (%) Top 3 donors (In2006): EuropeanCommission 0 1 2 7 France 1 7 2 6 I O Spain 7 3 4 5 Aid (%of GNI) 0 1 0.6 0.1 0.1 0 Aid per capita (US$) 3 17 5 6 5 -10 Long-Term EconomicTrends 95 05 Consumer prices(annual% change) 63 5 112.5 4.8 8.1 GDP implicitdeflator(annual% change) 548 106.8 4.0 8.5 *GDP -GDPper capita Exchangerate (annualaverage, local per US$) 0 0 1.2 12.1 23.4 Terms of trade index (2000 = 100) 126 100 79 1980-90 1990-2000 2000-07 (average annual growth %) Population, mid-year(millions) 2 9 3.1 3.3 3.3 0.6 0.6 0.1 GDP (US$ millions) 10,132 9,287 20.671 23.087 0.5 3.4 3.3 (% of GDP) Agriculture 13 5 9.2 6.2 10.1 0.1 2.8 6.1 Industry 33 7 34.6 27.2 32.0 -0.2 1.1 3.7 Manufacturing 25 9 28.0 16.9 22.8 0.4 4.1 5.3 Services 52 8 56.1 66.6 57.9 1.8 3.7 2.4 Householdfinal consumptionexpenditure 75 8 70.3 74.5 74.5 0.7 5.0 2.4 Generalgov't final consumDtionexDenditure 12 5 12.1 13.2 11.1 1.8 2.3 -1.3 Gross capital formation 17 3 12.2 14.0 15.1 -6.6 6.3 4.9 Exports of goods and services 150 23.5 19.3 29.2 3.9 6.0 8.4 Importsof goods and services 20 6 18.1 21.o 29.9 0.0 9.9 5.3 Gross savings 8 1 14.1 11.1 13.2 Note:Figuresin italicsare for years other thanthose specified 2007 data are preliminary. . indicates data are not available. a. Aid data are for 2006. Development Economics,Development Data Group (DECDG). 131 Uruguay Balance of Paymentsand Trade 2000 2007 Governance indicators, 2000 and 2007 (US$ millions) Total merchandiseexports(fob) 2,384 5,025 Total merchandise imports(cif) 3,466 5,612 Voice and accountability Nettrade in goods and services -533 -45 Politicalstability Current account balance -566 -235 as a % of GDP -2.7 -1.0 Regulatoryquality Workers' remittances and Ruleof law compensation of employees (receipts) 36 97 Controlof corruption Reserves, includinggold 2,774 4,121 0 25 50 75 1w 2007 Central Government Finance Country's percentilerank (0-100) 02000 higher valuesrmply biter ralrngs (%of GDP) Current revenue (includinggrants) 29.4 29.2 Source Kaufmanc-Kraay-Mastwzz WoM Bank Tax revenue 16.6 18.7 Current expenditure 27.2 22.7 Technologyand Infrastructure 2000 2007 Overallsurplus/deficit 3.4 -0.3 Pavedroads (X of total) 90.0 10.0 Highest marginaltax rate (Yo) Fixedline and mobilephone Individual 0 25 subscribers (per 100 people) 41 120 Corporate 30 25 Hightechnology exports (% of manufacturedexports) 2.1 3.0 External Debt and Resource Flows Environment (US$ millions) Total debt outstanding and disbursed 8,113 13,615 Agriculturalland(YOof landarea) 85 85 Total debt service 1.257 1,482 Forestarea (X of landarea) 8.1 8.6 Debt relief (HIPC. MDRI) - - Nationallyprotectedareas(% of land area) .. 0.4 Total debt (% of GDP) 39.3 59.0 Freshwaterresources per capita (cu. meters) .. 17,848 Total debt service(% of exports) 26.1 19.0 Freshwaterwithdrawal (% of internalresources) 5.3 Foreigndirect investment(net inflows) 274 1,000 C02 emissionsper capita (mt) 1.5 1.7 Portfolioequity (net inflows) 191 1,097 GDP per unit of energy use (2005 PPP $ per kg of oil equivalent) 9.5 10.6 lCornpositionof total external debt, 2006 Energy use per capita (kg of oil equivalent) 932 875 shoo tem 2 208 Other multi- iaierai 1877 Bilateral 101 (US$ mil/ions) IBRD Total debt outstandingand disbursed 552 666 Disbursements 134 74 Principalrepayments 58 61 Interest payments 42 38 IDA Total debt outstanding and disbursed - Disbursements - Private Sector Development 2000 2008 Total debt service - Time requiredto start a business (days) - 44 IFC (fiscal year) Cost to start a business(YOof GNI per capita) 43.5 Total disbursedand outstandingportfolio 24 161 Time requiredto registerproperty (days) -- 66 of which IFCown account 18 80 Disbursementsfor IFCown account 0 57 Rankedas a majorconstraintto business 2000 2007 Portfoliosales, prepaymentsand ( O hof managersSurveyedwho agreed) repaymentsfor IFC own account 5 5 Anticompetitive or informalpractices .. 32.6 Tax rates .. 20.8 MlGA Gross exposure 28 301 Stock market capitalization(%of GDP) 0.8 0.7 New guarantees 0 300 Bank capital to asset ratio (YO) 7.2 10.2 Note:Figures in italicsare for years otherthanthose specified. 2007 data are preliminary 12/30/08 indicates data are not available. - indicatesObservation is not applicable. DevelopmentEconomics,DevelopmentData Group (DECDG). 132 Millennium Development Goals Uruguay Withselected targets to achieve between 1990and 2015 (estimateclosest to date shown, +/- 2 years) Goal 1:halve the rates for extreme poverty and malnutrition 1990 1995 2000 2007 Poverty headcount ratio at $1.25 a day (PPP, % of population) Poverty headcountratio at nationalpovertyline (% of population) 26.0 Share of income or consumptionto the poorest qunitile (%) 5.4 4.8 4.8 4.5 Prevalenceof malnutrition(% of children under 5) 5.4 6.0 Goal 2: ensure that children are able to complete primary schooling Primaryschoolenrollment (net. %) 99 100 Primarycompletion rate (% of relevantage group) 93 94 97 99 Secondary schoolenrollment (gross, O h ) 84 98 101 Youth literacyrate (% of peopleages 1524) 83 90 Goal 3: eliminate gender disparity ineducation and empower women Ratioof girlsto boys in primaryand secondaly education(%) 105 106 Women employed inthe nonagriculturalsector (% of nonagriculturalemployment) 43 45 46 48 Proportionof seats held by women in nationalparliament (%) 6 7 12 11 Goal 4: reduce under-5 mortality by two-thirds Under-5mortalityrate (per 1,000) 23 22 16 12 Infant mortalityrate (per 1,000live births) 20 . 19 14 11 Measles immunization(proportionof one-year olds immunized,%) 97 90 89 94 Goal 5: reduce maternalmortality by three-fourths Maternal mortality ratio (modeledestimate, per 100,000live births) 20 Birthsattendedby skilled healthstaff (% of total) 100 100 99 Contraceptiveprevalence( O hof women ages 15-49) 84 Goal 6: halt and begin to reverse the spread of HlVlAlDSand other major diseases Prevalence of HIV (%of populationages 15-49) 0.4 0.6 Incidenceof tuberculosis (per 100,000 people) 34 32 30 27 Tuberculosiscases detectedunder DOTS (%) 77 80 77 Goal 7: halve the proportion of peoplewithout sustainable access to basic needs Access to an improvedwater source (% of population) 100 100 100 100 Access to improved sanitationfacilities (% of population) 100 100 100 100 Forest area (% of total land area) 5.2 8.1 8.6 Nationallyprotectedareas (% of total land area) 0.4 C02 emissions(metrictons per capita) 1.3 1.4 1.5 1.7 GDP per unit of energyuse (constant2005 PPP $ per kg of oil equivalent) 9.7 10.2 9.5 10.6 Goal 8: develop a global partnershipfor development TeieDhone mainlines(Der 100 people) 13.4 19.3 28.1 29.1 Mo& phone subscribers(per.100 people) 0.0 1.2 12.4 90.5 Internet users (per 100 people) 0.0 0.3 10.6 29.2 Personalcomputers (per 100 people) 2.2 10.6 13.6 i r iducationindicators (%) leasles immunization ("hof I-year olds) 140 - 120 - 1w - 80. 60. 25 2ow 2002 2004 2w6 40. 20. O C 1990 1995 20W 2006 --O-Prtmary net enrollment ratio +Ratio of girls to boys in primary & oUruguay LatinAmerica & the Caribbean Secondaryeducation Note: Figuresin italics are for years otherthan those specified. .. indicatesdata are not available. 12/30/08 DevelopmentEconomics, DevelopmentData Group (DECDG) 133 IBRD 33507 URUGUAY SELECTED CITIES AND TOWNS MAIN ROADS DEPARTMENT CAPITALS RAILROADS NATIONAL CAPITAL DEPARTMENT BOUNDARIES RIVERS INTERNATIONAL BOUNDARIES This map was produced by 58°W 57°W 56°W 55°W 54°W 53°W the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, 30°S or any endorsement or To a c c e p t a n c e o f s u c h Uruguaiana boundaries. Bella Unión B R A Z I L URUGUAY To Curuzú Javier To Cuatiá de Viana Artigas Alegrete Baltasar A R T I G A S Cuareim Brum To Rosário Belén Belén Rivera do Sul 31°S Constitución Constitución 31°S Masoller Biassini To Federal Salto S A L T O H a e d o Tranqueras d e R I V E R A ARGENTINA Minas de To UruguayChapicuy h u c h i l l a Tacuarembó acuarembó Corrales Bagé Vichadero Quebracho C Tambores Ansina El Eucalipto Aceguá Aceguá Piedra 32°S PAY S A N D U Sola TA C U A R E M B O Yáguarón 32°S To Paysandú Paysandú Guichon Villaguay Kilómetro Kilómetro Negro Melo To Tres 329 Pelotas Arbeles C E R R O L A R G O Lago Artificial e Rio Branco Lagoa San Javier de Rincón del Bonete n d Young Paso de r a Mirim los Toros R I O N E G R O Santa Clara G de Olimar Tupambae To Blanquillo Gualeguaychú T R E I N TA Vergara 33°S Negro D U R A Z N O Laguna il la Y T R E S 33°S Merin Fray Bentos Pueblo del c h Carmen C h u Treinta y Trrèss è Mercedes Cebollatí Cebollatí F L O R E S Durazno Sarandí Sarandí To del Yí Yí José Pedro José Rio Grande Varela Lagoa Mangueira S O R I A N O Trinidad Dolores F L O R I D A José E. Rodo José Lazcano Chuy Cerro Pirarajá Pirarajá Colorado R O C H A Cardona Laguna L AVA L L E J A La Coronilla Velazquez Negra 34°S Carmelo C O L O N I A S A N Florida Mariscala 34°S J O S E Castillos Fray Marcos Aiguá Aiguá Minas Cerro Catedral Laguna Rosario San José José (514 m) de Castillos C A N E - Colonia del Juan I. de Mayo Rocha Sacramento Lacaze Rio Canelones L O N E S M A L D O - ATLANTIC de N A D O La Paloma la Atlantida San Carlos OCEAN Maldonado 0 25 50 75 100 Kilometers Plata MONTEVIDEO Punta del Este MONTEVIDEO 35°S 0 25 50 75 Miles 59°W 58°W 57°W 56°W 55°W 54°W 53°W OCTOBER 2004