Uruguay: Investment Grade Next

BY FRANCO A. UCCELLI

Growth continues to outperform expectations. Infrastructure projects are set to take center stage Fiscal consolidation is firmly underway. The public debt burden is poised to decline. No international bond issuance is planned for 2010. Fundamental support for the currency remains intact. A return to IG has become a key priority for the government.

GDP GROWTH

Growth continues to outperform expectations. Real GDP continues to post solid numbers, with first quarter 2010 growth reaching 8.9 percent oya supported by all economic sectors, but specially by public utilities (electricity & water), which are recovering strongly from the adverse effects of a very severe drought. With recent numbers showing both private and public consumption growing below GDP, concerns about the possible overheating of the economy have significantly diminished. Indeed, increased gross capital formation, which surged almost 25 percent in real terms in 1Q10, has not only become a key driver of economic growth, but should also have a positive impact on future growth prospects. While officially the government expects real GDP to expand 5.1 percent in 2010 (a May upward revision from an earlier 4.0 percent estimate) after growing 2.9 percent last year, unofficial government estimates put growth at around 7 percent, higher than both the market consensus 6.0 percent forecast (as per the central bank’s latest survey) and our own 6.5 percent projection. The government’s revised forecast sees GDP expanding 4.2 percent in 2011, lower than our more bullish 5.0 percent; potential growth in Uruguay is estimated at 3.5-4.0 percent.  

INFRASTRUCTURE

Infrastructure projects are set to take center stage. Two important pieces of legislation designed to ensure increased investment in infrastructure have been recently drafted by the government, which from the beginning of its term on March 1 has highlighted infrastructure development as one of its principal objectives. The first, which raises from 25 percent to 50 percent the percentage of pension fund assets under management that can be invested in infrastructure projects, was sanctioned by congress earlier this month. The second, which seeks to establish a new legal framework for the association of private and public sectors in infrastructure development projects, is currently under congressional consideration and its final approval is expected shortly. The Uruguayan government believes that these two laws will significantly bolster investment in infrastructure (particularly in railroads, ports, roads, and renewable sources of energy, such as wind) and boost economic dynamism while providing the investment community with an attractive investment alternative.  

FISCAL CONSOLIDATION

Fiscal consolidation is firmly under way. Robust GDP growth, escalating revenues, and spending restraints have enabled Uruguay to post better-than-expected fiscal results, with the 12-month deficit coming in at only 0.9 percent of GDP in May, half the 1.8 percent of GDP level it printed a year earlier. As both the economy and fiscal revenues continue to grow and the government returns to a neutral fiscal stance after having had to absorb extraordinary one-off expenses last year (related to the severe drought), the Mujica administration expects the fiscal shortfall to close 2010 at around 1 percent of GDP, slightly higher than our own 0.8 percent estimate and the latest market consensus 0.9 percent forecast. By end-August, the government is required by law to submit to congress a multi-year budget covering the next five years. Preliminary indications are that said budget will include fiscal deficit targets of less than 1 percent of GDP for 2011-2013 and 0.5 percent of GDP for 2014; our current forecasts do not go beyond 2011, when we expect the fiscal deficit to moderate to 0.5 percent of GDP (the goal for 2014). 

PUBLIC DEBT

The public debt burden is poised to decline. The gross public debt to GDP ratio rose from 53.0 percent of GDP in 2008 to 69.4 percent in 2010 boosted by a sizeable $5.2 billion nominal rise in the stock of debt. The breakdown of the numbers shows that of the total increase, $1.7 billion responded to the accumulation of reserves, $600 million to fiscal deficit financing, and a remarkable $2.2 billion to the 20 percent appreciation of the currency during the course of 2009. A considerable expansion in nominal GDP, a depreciation of the peso, and modest growth in total indebtedness levels should enable the gross public debt to GDP ratio to decline to around 61% by the end of this year (it stood at 64 percent of estimated GDP in March) before continuing to gradually trend down to around 40 percent of GDP by 2014. 

NO BONDS

No international bond issuance is planned for 2010. The government’s current financing plan for 2010, which seeks to fill $1.8 billion in needs, calls for $700 million worth of market issuance. Of the total, approximately $150 million have already been issued locally so far this year, with the government planning to issue the remaining $550 million also locally during the second half. The additional $1.1 billion in financing will come from a $500 million primary surplus, $320 million from multilateral disbursements, $124 million from fiscal savings, and $149 million from other unidentified sources. The government’s financing needs are projected to rise to almost $2.1 billion in 2011, more than half of which would be covered through market issuance. While the stated preference is to continue to use only locally issued, inflation-linked paper to fill the government’s financing needs, domestic demand for such paper, liability management transactions (if any), and overall market conditions will ultimately determine if the government issues abroad next year or not.

CURRENCY SUPPORT

Despite recent weakness, fundamental support for the currency remains intact. In early June, the government announced that it would increase its intervention in the foreign exchange market and stated that, in its view, the peso should ideally trade between 21 and 22 per U.S. dollar. The decision was promptly viewed as evidence that the government had become increasingly uncomfortable with the negative effect that the steady appreciation of the peso has had on the competitiveness of the country’s vital export sector. While the impact of the government’s announcement was quickly felt, with the exchange rate rising from 19 to 21 pesos per U.S. dollar in a matter of days and staying at around that level since mid-June, very few people believe that the peso’s weaker level has any significant staying power, pointing to the myriad of factors that underpinned its appreciation during the preceding 12 months--including strong export demand, steady FDI inflows, and stable political and business climates--and that are still present today. Against this backdrop, many local observers believe that while the government’s intervention in the foreign exchange market may result in some peso weakness in the near term, eventually market forces will prevail and cause the currency to strengthen to around 19.5-20.0 per U.S. dollar; no consensus on a timeframe for this to occur has emerged, however. We believe that the recent “forced” depreciation of the peso has generated better entry points for investors interested in either the Uruguayan currency or in inflation-indexed (UI) bonds (or both). 

INVESTMENT GRADE

A return to Investment Grade (IG) has become a key priority for the government. After Moody’s on July 15 placed Uruguay’s Ba3 rating on review for possible upgrade and Fitch on July 27 upgraded the country’s rating from BB- to BB with a positive outlook, both the government and market participants alike now believe that Uruguay is resolutely on its way to reclaim the IG status it lost in 2002 amid its worst economic and financial crisis in recent history, in our view. The Mujica administration has made no secret of the fact that one of its main goals is to leave office in 2014 with Uruguay having attained a coveted IG rating, and is expecting that robust growth supported by increased investment and external demand and fiscal discipline will help the country improve its fiscal and external solvency and liquidity ratios enough to earn it an IG rating.

Franco Uccelli is an analyst with JP Morgan Chase. This column is based on a recent trip report. Republished with permission.