Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. P7357-UR

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION ANDDEVELOPMENT

ON A

PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN

,N THE AMOUNT OF US$80.9 MILLION

TO THE

REPUBLICA ORIENTAL DEL URUGUAY

February 4, 2000

Finance Private Sector and Infrastructure Sector UnitArgentina, Chile and Uruguay Country Management Unit LCC7CLatin America and the Caribbean Regional Office

This docurnent has a restricted distribution and may be used by recipients only in the performance of their official duties. Its content may not otherwise be disclosed without World Bank authorization. l

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CURRENCY EQUIVALENTS

Currency Unit = Uruguayan PesoUS$1.00 = Ur$ (11.59)

FISCAL YEARJuly I to June 30

GLOSSARY OF ABBREVIATIONS

BCU = Central Bank of UruguayBHU = Mortgage Bank of Uruguay (Banco Hipotecario del Uruguay)BROU = Banco de la Repfiblica Oriental del UruguayCAS = Country Assistance StrategyCND = National Development Corporation (Corporaci6n Nacional

de Desarrollo)IFE = International Financial Enterprises (off-shore banks)ESW = Economic and Sector WorkGDP = Gross Domestic ProductIDB = Inter-American Development BankMERCOSUR = Common Market of the Southern ConeIMF = International Monetary FundROA = Return on AssetsROE = Return on EquitySAL = Structural Adjustment LoanSECAL = Sector Adjustment LoanSIIF = Superintendency of Financial InstitutionsURs = Wage adjusted pesos

Vice President: Mr. David de FerrantiDirector LCC7C: Ms. Myma AlexanderDirector LCSFP: Mr. Danny LeipzigerTask Manager: Ms. Mariluz Cortes

This operation was prepared by a World Bank team composed of: Messrs/Mmes. Augusto de la Torre, WalterZunic, Juan Ortiz, Mario Guadamillas (LCSPF); Jose Antonio Alepuz (LEGPS); Reynaldo Pastor (LEGLA) andFelipe Morris (consultant). The team was led by Mariluz Cortes, Task Manager, and worked under the generalguidance of Augusto de la Ton.e (Lead Specialist LCSFP).

FOR OFFICIAL USE ONLY

URUGUAYPROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN

TABLE OF CONTENTSPage No.

LOAN AND PROGRAM SUMMARY ......................................................... I

I. THE SETTING .1A. Economic Context .1B. Recent Performance .1

II. URUGUAY'S FINANCIAL SECTOR REFORM PROGRAM. 2A. Characteristics of Uruguay's Financial Sector. 2B. Constraints to the Development of Uruguay's Financial Sector. 6C. The Government's Strategy for Financial Sector Reform ............................. 12

III. BANK ASSISTANCE STRATEGY IN THE FINANCIAL SECTOR 18A. Bank Assistance Strategy in Financial Sector Refor .18B. Experience with Adjustment Lending in Uruguay .19C. Coordination with Multilateral Institutions .19

IV. THE PROPOSED LOAN .20A. Loan Objectives and Description .20B. Policy Actions .20C. Disbursement and Audits .20D. Impact, Benefits and Risks .24

V. RECOMENDATION .25

ANNEX I. Matrix of Policy ActionsANNEX II. Letter of Sector Development PolicyANNEX III Economic IndicatorsANNEX IV. Status of Bank Group OperationsANNEX V. Status of IFC InvestmentsANNEX VI. Uruguay at a Glance

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

URUGUAYPROPOSED FINANCLIL SECTOR ADJUSTMENT LOAN

LOAN AND PROGRAM SUMMARY

Borrower: Repuiblica Oriental del Uruguay.

Amount and Terms:US$80.9 million LIBOR-based US Dollar, single currency loan,with a maturity of 15 years, including five years of grace and levelrepayment of principal. A 75 basis points commitment fee onundisbursed loan balances, beginning 60 days after loan signing,less any waiver, and a 1% capitalized front-end fee.

Description: The operation will support the first phase of the Borrower'sfinancial sector reforn program which includes measures alreadytaken to:

Measures to improve competition in the banking sector.Measures taken include: (i) issuance of an Executive Decreeregulating the right of public agencies to open bank accounts inpublic or private banks in Uruguay; (ii) issuance of BCU's Circularproviding that public banks shall have their financial statementsaudited by external auditors; (iii) hiring of independent consultantsto carry out external audits of BROU's and BHU's 1999 financialstatements; (iv) issuance of BROU's resolution providing that itshall eliminate its deficit of provisions for non-performing loans byJuly 31, 2005; and (v) issuance of BCU's resolution requiringBHU to establish a scheme of reserve requirements.

Measures to restructure public banks. Measures taken include:(i) approval of a new policy of control of BROU's credit risk; (ii)approval of the issuance of a long-term bond by BHU that wouldreduce the flows mismatch between its assets and liabilities by, atleast, 75%; (iii) adoption of a credit policy to improve BHU'scurrency matching between assets and liabilities; (iv) adoption of apolicy to standardize the terms of BHU's loans to facilitate thesubsequent securitization of mortgages; and (v) preparation ofterms of reference for the employment of a consulting firm todesign an institutional restructuring plan for BHU.

Measures to initiate the privatization of Banco de Credito.Measures taken include hiring an investment advisory firm toassess the value of Banco de Credito's loan portfolio, investmentsand fixed assets and design an strategy for the sale of theBorrower's majority stock ownership in this bank.

Measures to strengthen banking regulation, supervision andinspection. Measures taken include: (i) issuance of BCU'scirculars and resolutions requiring public and private banks toadopt a policy of flows matching between assets and liabilities fortransactions with a maturity in excess of three years; to calculatetheir capital adequacy ratio on a consolidated basis; to apply ratingand provisioning norms with respect to loans to state enterprises; tocreate audit committees; and to disclose to BCU the risk modelsused in connection with their lending operations; (ii) approval of aplan for BCU to carry out on-site inspections of public and privatebanks between July 1, 1999 and June 30, 2000; (iii) issuance ofBCU's norms establishing: procedures to be followed by solventprivate banks that decide to cease operating as banking institutionsin Uruguay; to value assets of public and private banks inaccordance with mark to market valuation method; to value assetsof pension funds administrators in accordance with the mark tomarket valuation method; and to hire independent appraisers toestimate the value of collateral provided to guarantee loans inexcess of 3% of the minimum net equity requirement applicable toall banks in Uruguay.

Measures to improve transparency of the financial sector.Measures taken include the issuance of BCU's norms: (i)providing that all banks make available to the public their annualexternal audit; (ii) providing that all banks publish detailedfinancial information with respect to the preceding calendarquarter; (iii) indicating that BCU's Credit Risk Information systemis providing information with respect to, inter alia, each debtorhaving a debt which exceeds 0.3% of the minimum net equityrequirements; and (iv) indicating that BCU's credit riskinformation system shall group relevant credit risk informnation byseparate categories.

Measures to modernize the financial sector legal framework.Measures already taken include: (i) presentation to Congress of a billof law to require all companies to follow international acceptedaccounting standards; (ii) presentation to Congress of a bill of lawto permit the execution of warrants without judicial intervention;and (iii) enactment of Law No. 17.228 which, inter alia, expandsthe type of goods which may be subject to prenda sindesplazamiento. Also, a Technical Unit has been created withinthe BCU which will, inter alia: (i) carry out technical and legalanalyses of financial sector reform proposals; (ii) present policyrecommendations resulting forrm the analyses mentioned; and (iii)build consensus with respect to financial sector reform proposals.

Risks and Benefits: The proposed loan would contribute to ensure banking soundness andincrease competitiveness of Uruguayan banks. Strong and competitivebanks would be in a better position to expand credit to the private sector,particularly to small and medium enterprises. Measures taken to ensure amore level playing field between public and private banks willencourage competition in the banking sector, while measures toimprove transparency of information about the financial situationof the banks will allow the public to make more informeddecisions on where to put their money. On the other hand, moreinformation about creditors would help the development of a moreactive domestic credit market by reducing the non payment risksfaced by lenders. In the long run, the benefits of the loan are interms of setting up the stage for a more open public discussion anddialogue on sensitive financial sector issues in Uruguay,particularly on the need to redefine the role of the public sector inthe financial area, on ways to address the factors affecting thecompetitiveness of Uruguay's banks in the region, and on ways toreduce judicial uncertainty and strengthen the enforcement ofcontracts in the financial sector. The creation of the FinancialPolicy Technical Unit is that it will act as a hub to disseminate theresults of technical and legal studies on financial sector issues, andcentralize efforts to generate consensus around policy reformproposals.

The main risk associated with this operation is the possibility thatthe new administration that will take office in March 1, 2000, willnot go ahead with the second phase of financial sector reforms,including the sale of the intervened banks and the proposal of newfinancial legislation. Factors that mitigate this risk are the effortsalready under way to find a buyer for Banco Caja Obrera, and theneed to maintain the credibility of the regulatory function byrequiring Banco de Credito to comply with capital adequacy normsor close down. Also, there is increasing consensus in Uruguay onthe need to strengthen the legal framework to ensure thecompetitiveness of Uruguay's banks, in view of the increasinglymacroeconomic stability and improving banking sector efficiencyin neighboring countries, and the greater openness in factormarkets brought about by MERCOSUR. The new administrationis aware of the proposed loan and is in agreement with the firstphase of financial sector reforms.

Schedule of Disbursements: One tranche to be disbursed after loan effectiveness.

Closing Date: June 30, 2000

Project ID Number: UY-PE-63390

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENTTO THE EXECUTIVE DIRECTORS ON A

PROPOSED FINANCIAL SECTOR ADJUSTMENT LOANIN THE AMOUNT OF US$80.9 MILLION

TO THEREPUBLICA ORIENTAL DEL URUGUAY

1. The proposed Financial Sector Adjustment Loan to the Repiiblica Oriental delUruguay, would be for US$80.9 million (including capitalized front end fee of 1%), tosupport the first phase of the Borrower's financial sector reform program. The loanwould be payable in 15 years, including 5 years of grace and level repayment ofprincipal, at the standard interest rate for US dollar, LIBOR-based, single currency loans.

I. THE SETTING

A. Economic Context

2. Uruguay is a middle upper-income country, with social indicators among the bestin Latin America. Its economy has performed well in recent years. During the period1990-1998, real GDP grew at 3.8%, compared with population growth of only 0.6%.Inflation is under control, and the external current account deficit remains modest. Thecurrent administration that took office in March 1995, has been able to implement anausterity package of measures to reduce the fiscal deficit, together with a gradual, butsustained, structural reform agenda in the areas of social security, education, publicenterprises, modernization of the state, and continued liberalization of the economyassociated with MERCOSUR.

B. Recent Performance

3. During 1998, Uruguay achieved many of its economic objectives. Inflation wasreduced from 15.2% at the end of 1997, to 8.6% by year-end. Unemployment went downfrom 11.5% in 1997 to 10.0% in 1998, and the fiscal adjustment program was successfulin reducing the consolidated public sector deficit to 0.9% of GDP. Although this goodperformance was met by a favorable external financing situation, the domestic andexternal financing environment tightened substantially after the Russian debt crisis inAugust 1998. The authorities responded to this external shock by strengthening thefinancial sector through implementation, in September 1998, of additional prudentialmeasures, including increased capital adequacy requirements for the banking system, andtighter loan qualification regulations and increased risk weighting applied to consumerlending. Despite unsettled international financial conditions, GDP growth reached 4.5%in the last quarter of 1998, compared to the same quarter in the previous year.International reserves grew by US$250 million during the last quarter of 1998, as

Uruguay took advantage of its indebtedness capacity in the international markets, inanticipation of a tighter situation in early 1999.

4. The economic slow down started in the first quarter of 1999, when GDP growthturned negative (-1.0%), as the external environment became less favorable to Uruguaywith increasing oil prices and lower prices for agricultural commodities. The slow downis continued during 1999, due to loss of competitiveness of Uruguayan products in Brazil,following the January 1999 depreciation of the Brazilian real, the slowdown of economicactivity in Argentina, and higher oil prices. Despite the negative effect of the economicslowdown on public finances, the Government remains committed to its medium termstrategy of cautious fiscal and monetary policies and to continue with structural reforms.To help meet the challenges, the authorities requested, and obtained, a new 12-monthsprecautionary stand-by arrangement with the IMF. In early 1999, the Government alsorequested an acceleration in the implementation of projects in the lending program agreedwith IDB.

II. URUGUAY'S FINANCLIL SECTOR REFORM PROGRAM

A. Characteristics of Uruguay's Financial Sectorl

5. In relative terms, Uruguay has a well developed financial sector. This sectorcontributed to about 9.6% of GDP in 1998, has assets with a total value equivalent toabout 105% of GDP, and the degree of monetization, measured as M3/GDP, was 40.8%at the end of 19982. In all these measures, Uruguay scores higher than most LatinAmerican countries except Chile. However, in absolute terms Uruguay's financial sectoris very small and dominated by public banks, generating value added of the order of onlyUS$2,000 million per year. Most of the financial activity is generated by bankinginstitutions, due to the underdevelopment of Uruguay's capital market, which has amarket capitalization of less than 3% of GDP, compared to an average of almost 10% inemerging markets.

6. Uruguay's banking system is composed of 52 institutions: 24 banks, 10 financialhouses, which operate as banks but do not receive deposits; 7 savings and loanscooperatives (they differ from the banks in the composition of their capital); and 11external financial institutions (EFI) which can only operate with non residents, and havetheir assets and liabilities abroad. In addition, there are a number of non-bankingfinancial agencies, including credit administrators and credit card companies, thatcompete with the banks in some limited areas. Some of the salient characteristics ofUruguay's banking sector are the following:

' The data presented in this section comes from an ongoing Bank study "Uruguay: Financial SectorReview". Draft for discussion January 23, 2000.2 These measures of Uruguay's financial depth include off-shore operations by External FinancialInstitutions, which account for about 10% of deposits and assets in the financial system.

2

7. Large Public Sector Role The two largest banks in Uruguay are public banks:Banco de la Repuiblica Oriental del Uruguay (BROU) and Banco Hipotecario delUruguay (BHU), which are independent state-owned entities. They have their ownstatutes (Cartas Orgdnicas). There are two commercial banks under state administration:Banco de Credito (which recently acquired the good assets and liabilities of Banco Pan deAzucar, another intervened bank) and Banco Caja Obrera. Public banks, exclulidng theintervened banks, account for about 40% of total assets, 35% of the system's deposits;and provide 49% of the loans to the non financial sector (excluding EFIs which do notlend locally). In terms of equity, official figures indicate that public banks account forabout 66.5% of the total capital of the system (80% of banking sector equity). However,this does not take into consideration valuation problems in these banks, which leads tothe conclusion that their capital may be overstated. Public banks employ more than half(5 1%) of all bank employees.

8. BROU, founded in 1896, is the country's most important commercial bank,accounting for 23.8% of total deposits and 25.3% of total loans in the system. BROUoperates both as a multiple-purpose bank and as a development bank. It underwritesalmost all types of loans, serving as wholesale bank and corporate lender, as well asconsumer banker. It lends to all types of enterprises, but is the most active bank inlending to small and medium enterprises and to the agricultural sector. It is the mainprovider of foreign trade services to the economy, in charge of collecting import taxesand paying export tax rebates. The BHU was created in 1892 and acquired by the state in1912. Until 1990, it acted as the Housing Ministry. BHU is the principal provider ofhousing credits in the country (offering loans for construction, acquisition or refurbishingof houses). It accounts for 11% of total deposits and 17% of total loans (excluding EFIs).Its current portfolio comprises about 90% of the stock of mortgage loans in the country.While in recent years private banks have started to provide housing loans, these areconcentrated on the high end of the market not attended by BHU.

9. Assessing the performance of the public banks is difficult due to lack of detailedinformation. Official data indicate that BROU has a satisfactory financial situation, andthat it has been making profits during the last few years (it distributed US$11.24 millionin dividends to the Government in 1998). Its ROE (return on equity) and ROA (return ofassets) ratios in 1997 are significantly higher than those of the private banks3. However,the quality of its portfolio is below the system's average4, due in part to the high-riskprofile of its portfolio, with one third of loans given to the agricultural sector5. BROUhas initiated an institutional transformation process aimed at improving its effectivenessand productivity (see par. 36).

10 After posting losses in 1997, BHU generated profits of US$37.0 million in 1998.The 1998 financial results of this bank do not reflect the poor quality of its loan portfolio,

3 In 1997, BROU's ROE was 19.3%, while that of the private banks was 7.7%, and its ROA was 3.1%compared to 0.6% for private banks.4 As of June 30, 1998, BROU had a ratio of non-performing to total loans of 4.6%, compared to 1.1% forprivate banks, excluding the two intervened banks, which had a ratio similar to public banks (4.0%).

The agricultural sector includes cattle raising and integrated agricultural industries.

3

which is over one third overdue6. In 1998, BHU had to make extraordinary provisions asa result of a law, approved by Congress in December 1998, mandating BHU to refinanceall those loans that were three months overdue as of October 31, 1998, extending thematurity of the loans without penalties. Unlike BROU, BHU has not initiated aninstitutional transformation process.

11. In Uruguay, the state has followed the policy of taking over the administration offailing banks to avoid losses to depositors and prevent the loss of jobs. In the first half ofthe 1980s, in response to a generalized financial crisis in Uruguay, the Central Bank(BCU) implemented a bank-rescue program to save banks by buying their bad-loans.Most banks were eligible to participate in the program except for four of them, whichwere intervened by the BCU and subsequently managed by the state during many years.At the beginning of the 1990s, two of the four entities merged. One of the remainingintervened banks, Banco Comercial, was privatized in 1990, after the Government tookover a portion of its bad loans. It was acquired by a consortium of international banksand has become profitable. The second intervened bank, Banco Pan de Azucar, wasprivatized in 1994, but had to be intervened again in 1996 due to bad management andalleged fraud by the buyers of the bank. The third intervened bank is Banco Caja Obrera.This bank has been under Govermnent control since 1984, when BCU acquired part of itsbad loan portfolio. In 1990, the Government took control of Banco Caja Obrera throughCorporaci6n Nacional de Desarrollo (CND), a government development agency, as thesole owner. Towards the end of 1998, another private bank, Banco de Credito, which wascontrolled by a foreign group, experienced financial difficulties that led to its interventionby BCU. The government decided to create a more viable Banco de Crddito by having itacquire the good assets and liabilities of Banco Pan de Azuicar. The irrecoverable andnon-performing loan portfolio as well as the assets and liabilities in litigation remained in"Banco Pan de Azucar, S.A.", an entity responsible for their liquidation. The CNDcontributed US$25 million in exchange for 51% of the shares, and the foreign owners ofBanco de Crddito committed themselves to contribute another US$27 million (includinginterest payments) for the remaining 49%. CND's participation was through the issuanceof seven-year, 7.5% fixed rate treasury bonds. The foreign partner's capitalization is ininstallments over the next three years, in accordance with a pre-established agreement.Both banks account for 6.4% of the deposits and 6.5% of the loans of the banking system.

12. Preponderance of Private Foreign Banks. Almost all the private banks inUruguay are subsidiaries or agencies of foreign banks. Only one bank is owned totallyby Uruguayan interests. All EFIs, Finance Houses and the largest credit administratorsare owned by foreign banks. Only cooperatives are mostly locally owned. Thepreponderance of foreign banks has historical reasons. Following the banking crisis inthe early 1980s, almost every private bank was converted into a subsidiary (or branch) ofan important international bank. Measures to strengthen banking regulation andsupervision coincided with the ownership changes, and eventually resulted in arestoration of confidence in the banking system.

6 As of June 30, 1998, BHU had a ratio of non performing to total loans of 9.1%.

4

13. Hifh Degree of Dollarization. The Uruguayan financial sector is highlydollarized . In 1996, 82.4 % of the deposits in the banking system were in US dollars.The percentage of dollar deposits ranged from 70% in public banks, to 89% in privatebanks and to nearly 100% in EFIs. Similarly, the majority of loans to the non financialsector are in dollars. In 1996, 63% of all loans were denominated in dollars, rangingfrom 40% in public banks, to 82% in private banks, and 100% in EFIs. Foreign exchangedeposits are made by both residents and non residents. In 1996, 36% of all deposits weremade by non residents. The percentage of deposits from non residents ranged from 13%in BROU, to 38% in private banks, and to 100% in EFIs. About 14% of all loans to theprivate sector in 1996 were to non residents.

14. The high degree of dollarization of the banking system also has its roots in thefinancial crisis of the last decade. Following a large devaluation at the end-1982, localand international savers have preferred to avoid the exchange risk and invest in dollars,despite the low interest rates paid on dollar deposits, compared to the interest rates paidon local currency deposits. Many banks have traditionally operated as off-shore centers,taking advantage of recurrent bouts of macroeconomic instability among neighboringcountries and Uruguay's strong banking secrecy regulation. Off-shore banking by EFIshas expanded since 1989, when new regulation provided these agents with taxexemptions. However, Uruguay off shore banking business tends to attract relativelysmall savers from neighboring countries8 , and as confidence grows in other financialsystems in the region, the attractiveness of Uruguay as a financial safe heaven maydiminish.

15. Limited Development of the Credit Market and of New Financial Products. TheUruguayan banks main business is in the area of traditional financial intermediation andforeign trade transactions. There is little involvement in cash management, securitiesunderwriting, derivatives, securitization of assets, leasing and the like; or in risk controlinstruments such as futures, options, forwards, and foreign exchange insurance. Thereare no investment banks in Uruguay. Banks invest a significant share of their assets inpublic securities and loans to the financial sector (28% in 1998) in detriment of loans tothe private sector. Lending to the non financial sector (49.6% of assets in 1998) isdirected mostly to the largest local firms and multinationals. Lending to small andmedium enterprises is limited and subject to liquid guarantees. The extreme cautiousnessof Uruguayan private banks is a response to the experience of the financial crisis of theearly 1980s, when banks were forced to restructure their loans through subsequentrefinancing laws; to inadequate legislation concerning the execution of guarantees; and tothe perception of a judicial system biased against creditors. Some sectors, such asagriculture, which was particularly affected by the refinancing laws, now get creditmostly from BROU. Consumer credit, however, has expanded at a fast pace since thebeginning of the 1990s. About 23% of private bank lending and 14% of BROU's lendingis for consumer credit. This expansion has been aided by the creation of a relatively goodinformation system about credit history of borrowers, which is privately managed.

7 These figures are taken from J. Caumont: Modernizaci6n y Desarrollo del Sistema Financiero Uruguayo,Diciembre 1997.8 The average size of deposits of non residents is US$60,000.

5

B. Constraints to the Development of Uruguay's Financial Sector

Limited Competition Between Public and Private Banks.

16. Public banks have traditionally received preferential treatment in a number ofareas, which gives them an advantage vis a vis private banks. The most importantadvantage is the deposit insurance that they receive from the Government, which isexplicitly mentioned in their statutes, and implicitly extended to the intervened banks9 .This allows the public banks to receive deposits at lower cost than the rest of the privatebanking system, and constitutes a contingent public debt liability, in the case of BHU andthe intervened banks. BROU has other privileges such as being exempt from payingVAT on interests collected on consumer loans, which allows BROU to provide consumerloans at lower interest rates than private banks. In addition, BROU has a monopoly onthe central government payroll deposits, on the central government judicial andadministrative deposits made by private entities in guarantee of contracts with the publicsector and, until recently, a monopoly on deposits and salary payments of publicenterprisesl'. These are all sources of low cost deposits for BROU. Furthermore, BROUhas an extra source of income as a result of its role of trade tax collector" In 1998(through November), BROU received for these activities an amount equivalent to its totalprofits during the first eleven months of 1998. In addition to similar privileges, BHUenjoys an extra-judicial regime for the liquidation of debts, and until recently, amonopoly in issuing asset backed securities. This has been eliminated with the recentapproval (September 1999) of the Securitization Law.

17. One important advantage enjoyed by public banks is that they are not subject toBCU's prudential norms with the same rigor as private banks. Public banks and theintervened banks do not fully comply with the provisioning and capital requirementregulations that apply to private banks . In cases in which the BCU has detected equityshortages, these banks have received extended period of time to adjust to the BCU'srequirements. In addition, BHU does not have to create reserves against deposits. Thisunequal treatment creates a bad precedent, as other banks may feel entitled to similarpreferential treatment. The difficulties that BCU has in enforcing prudential norms in thecase of public banks is, to large extent, due to an interpretation with respect to thecapacity of BCU to impose sanctions on the public banks in case of non compliance withits norms and regulations. This ambiguity stems from the fact that the Charters of BROUand the BHU have the same hierarchy under the Constitution, as the Charter of the BCU.

18. Under the proposed loan, the Government of Uruguay is committed to take anumber of measures to, inter alia, improve competition in the banking sector by: (i)

9 This advantage of public banks is reduced by the government's implicit guarantee of deposits in the restof the banking system.10 State funds are subject to 100% reserve requirements, which makes them unattractive and expensive forBROU." It charges a fee of 1% on the country's irnports (except for imports under the temporary admissionregime) and 0.5 per thousand on its exports.12 BCU requires that banks maintain a ratio of capital to risk-based assets of 8.5%. While officially BROUand BHU meet capital requirements, the intervened banks do not.

6

creating a more level playing field between public and private banks; (ii) establishing thebasis for the privatization of a bank under public management; and (iii) establishing theframework for the restructuring of BHU. A new administration that will take over onMarch 1, 2000, is expected to complete the privatization of the two banks under publicmanagement and implement the restructuring of BHU. In the longer run, however,important efficiency gains would be obtained by "corporatizing" the public banks"3 (withstatutes similar to those of public enterprises), and by focussing their activities in areas inwhich they can support the private banks. An important new role for the public bankswould be to focus on mobilizing long term resources as second-tier institutions tofacilitate term lending through private banks. These more far reaching changes wouldrequire changes in the Charters of BROU and BHU, which have to be approved byParliament.

Legal Constraints

19. Uruguay has made significant improvements in modernizing its financial sectorlegal framework. The Financial Intermediation Law, approved in November 1992,expanded the regulatory and supervisory function of the Central Bank through the SIIF.The new Charter of the Central Bank, approved in 1992, helped to eliminate somelimitations that the BCU had in carrying out its supervisory function. Other twoimportant pieces of financial legislation approved in the last few years are the newCapital Markets Law and the Investment Funds Law, both passed in 1996. Nevertheless,the legal framework is still somewhat disperse and incomplete, and has internalinconsistencies that limit the full application of the existing financial regulation to thepublic banks. There are important legal constraints to the execution of guarantees thatrestrict the development of a credit market in Uruguay. New legislation is required toexpedite procedures to execute security interests in pledged assets. Also, a reform of theLeasing Law (of January 1998) is needed to permit non financial entities to lease capitalgoods.

20. Lack ofAdequate Market Exit Mechanisms for Banks. An important limitation ofthe legal framework is the absence of adequate legal mechanisms to allow banks to exitthe market, or acquire and merge with other banks in an orderly fashion. Recently, whena bank decided to leave the market voluntarily after paying all its debts, lack of anadequate exit mechanism created a crisis situation and the forced absorption of theredundant workers by other banks in the market14 . To avoid the repetition of thisexperience, in May 1999, the BCU issued new regulation concerning voluntary cease ofactivities of solvent banks. However, the Government's reaction to banking crisis, up tonow, has been not to allow banks to fail, with the Government taking over ailing banks.Although the intention has been to restructure these banks and sell them to the private

13 A more far reaching reform would be to open their equity to minority private participation. Someadvantages of private participation in these banks would be: (i) increased transparency; (ii) incentives forimproved efficiency by being subject to the scrutiny of private investors; (iii) reduced pressure to use thebanks to fulfill political mandates; and (iv) stimulus to the development of the local capital market.14 Eurobanco, a foreign owned bank experienced difficulties with the financial authorities when it decidedto leave the Uruguayan market voluntarily, after paying all its debts.

7

sector, in practice the Government has been saddled for many years with the managementof the intervened banks. The difficulties to close banks go beyond the lack of a legalmechanism to do so. The militancy of the labor unions to preserve the jobs of itsmembers is a stumbling block to the exit and eventual liquidation of any troubled andeven solvent bank. The adoption of an exit mechanism for troubled banks would allowthe Government to play a more indirect role in banking crisis resolution.

21. Judicial Legislation and Practices A major constraint to the expansion of creditmarkets in Uruguay is the distrust that lenders have with respect to the legal system, as aresult of past forced restructuring of bank debts. There is a need to accelerate thedefinition of property rights over intangible assets (such as a loan) in cases of bankruptcy,and to strengthen the judicial legislation and practices to redress the perception that theyare biased against creditors. Similarly, it is necessary to take measures to redress theperceived bias of the labor justice in favor of workers.

22. Difficulty of Getting Financial Legislation Approved The difficulty of gettingfinancial legislation approved is an obstacle to the development of new financialproducts. One mechanism to mobilize resources to expand credit would be throughsecuritization of assets. A draft Securitization Law was recently approved by Parliamentafter more than two years of having been submitted. Many of the legal initiatives in thefinancial sector that are presented to Parliament take a long time to be approved or arenever approved. In part, the delays are due to lack of concerted efforts to build consensusand to adequately respond to questions raised by members of Parliament with respect tothe proposed legislation.

Constraints to Increased Efficiency and Competitiveness of the Banking Sector.

23. The future role of Uruguay as a sub-regional financial center will be affected bythe success of its neighbors in achieving macroeconomic stability, and by the efficiencyand competitiveness of Uruguay's banking sector. Since many of the foreign banksoperating in Uruguay also have subsidiaries and branches in other countries in the region,their decision on where to expand their banking activities will increasingly depend on therates of return obtained in the different locations. Although international comparisons aredifficult, figures on overhead costs and net interest margins in Uruguay and othercountries in the region give a flavor for the competitive difficulties that the Uruguayanfinancial sector may face in the future. Uruguayan banks have overhead costs to totalassets of 6.5%, lower than banks in Argentina, Brazil, Colombia and Peru, but muchhigher than those of Chile and Bolivia, which are in the 3-4% range. Also, at 5.6%, thenet interest margin (the ratio of net interest income to total banking assets) of Uruguayanbanks is higher that those of Chile (3.9%), Argentina (4.2%) and Bolivia (5.2%). Therelatively high overhead costs and net interest margins of Uruguayan banks offerindications that they are not intermediating funds as efficiently as they might. Thisconclusion is supported by a recent study that compares the returns of the Uruguayanbanking system with those of other countries in the region (Bolivia, Chile and Peru), andconcludes that in terms of ROAs and ROEs, the Uruguayan banks, on aggregate, are theleast profitable of the sample, even if only private banks are included in the Uruguayan

8

figures'5 . These results reflect low efficiency levels in which the gross margin, althoughat reasonable levels on the aggregate, barely cover operating costs (cost of personnel andadministration).

24. High labor costs are an important factor in the low rates of return of theUruguayan banks. Salaries of bank employees tend to be more than twice the salarylevels of similar employment categories in other sectors. Social security contributionsare also higher in the banking sector'6 (employer contributions are 261/4th % comparedwith 12.5% in the rest of the economy). As a result, labor cost represent in Uruguay ahigh percentage of total operating costs (80% compared with about 64% in Brazil and50% in Argentina17 ). High labor cost and the difficulty to reduce staff, because of tradeunion strong bargaining power and militancy, have led to a reluctance on the part of thebanks to hire new employees and has displaced other investment expenditurepossibilities, particularly in technology. As a result, employment in the banking sector,as a whole, has decreased from 13,900 people in 1992, to 12,600 in 1998 (most of thisdecrease has occurred in the official banks). A decreasing labor force has resulted inefficiency gains measured as deposits per employee and as loans per employee, whichincreased by nearly 38% and 48% respectively between 1992 and 1996; but theseefficiency gains were more than compensated by cost of labor increases in the sector ofover 111% 8. Future efficiency gains, and the introduction of new banking products andtechnology, may be limited by the serious deficit of skills in the banking sector, resultingfrom low investment in training activities. High operating costs among the banks havestimulated the development of non banking financial intermediaries in Uruguay, such asbanking houses and credit administrators. These intermediaries are able to compete withthe banks with lower costs, because their workers do not belong to the banking tradeunions and do not contribute to the banking pension fund.

25. Segmentation of the Uruguayan financial market is encouraged by substantialasymmetries in the tax treatment of similar financial transactions carried out by differentfinancial entities. One example of this is the different treatment by the BCU and by thetax authorities with respect to the time allowed to write off bad loans from the books.Banks are permitted by both the tax regulators and BCU to write off bad debts in sixmonths. However, the tax regulators do not allow other financial agents, outside BCU'sregulatory authority, to obtain tax credits on their writes off, until after 30 months.During that time, non banking financial intermediaries have to pay IVA over accruedinterests, even if the loans are non performing. Another tax asymmetry is thatcooperatives are exempt of income and equity taxes paid by other financial institutions.

15 From Roberto Zahler, Eficiencia y Competitividad de la Banca Uruguaya, Diciembre 1998.16 Despite high contributions, the Banking Pension Fund is actuarially unsustainable, because of highdefined benefits and falling number of participants. The Banking Pension Fund has been bailed out by theGovernment in the past and is likely to be bailed out again in the future.17 From Caumont 1997. The average, wage cost in Uruguay's banking sector is 37% higher than inArgentina and was 145% higher than in Brazil, before the devaluation of the real.1 From Caumont. 1997.

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Limitations in Banking Regulation and Supervision.

26. The Charter of the BCU establishes that supervision of banks and other financialintermediaries is to be carried out though the Superintendency of FinancialIntermediation Institutions (SIIF). The SIIF, established in 1991, has technicalindependence but is hierarchically under BCU's Board. In recent years, the SIIF hasundertaken a number of technical improvements through a program of technicalassistance financed by the IDB. Banking regulation is in general adequate, althoughnorms need to be strengthened in the areas of risk, solvency, audits, and valuation ofassets and guarantees. For example, Basle norms for capital requirement are not beingapplied for interest and market risks, although they are applied for credit risk. Also, thecapital requirement norms are not applied on a consolidated basis.

27. As indicated above, the major limitation of banking regulation and supervision isin the application of the regulation to public banks. Until recently, the SIIF devoted itsefforts mostly to supervise and inspect the private banks, while giving a less rigoroustreatment to the two public banks BROU and BHU, which represent close to half of thebanking system. The role of the SIIF with respect to the public banks was limited to helpthem to convert their accounting plans to the format of the official statements provided bythe rest of the banks. Since 1997, the SIIF has been carrying out limited inspections ofselected activities of these two banks, such as the valuation of their loan portfolio. In1998, the SIIF undertook an evaluation of BHU's assets and liabilities and detected anumber of weaknesses in the credit area that were reported to BHU's Board. While allprivate banks are periodically qualified by the SIIF using CAMEL methodology, untilrecently the public banks were not subject to qualification. In July 1999, the SIIF carriedout, for the first time, a global inspection of BROU applying the newly adoptedCAMELS methodology'9 . BHU has not yet been qualified using this methodology.

28. The SIIF is hampered in its effort to supervise and inspect the public banks notonly by these banks legal autonomy, but also by the limited number of inspectors that theSIIF has in its staff, as a result of the freeze in public sector hiring limits. Currently, theSIIF has 33 inspectors who in 1997 were fully occupied in inspecting the private banks20.Extending the SUF inspection to BROU and BHU would require at least three or fouradditional inspectors in-situ for each public bank In addition to hiring more inspectors,the SIIF needs to implement a training program to familiarize its inspectors with modempractices for reviewing risks in foreign exchange, money markets and derivative areas.

29. Risks Associated with Mismatch Between Currencies and Terms. As indicatedbefore, Uruguay's financial system is highly dollarized. While most private financialinstitutions keep a reasonable currency match between assets and liabilities, banks thatoperate in local currency face important currency risk. In nornal periods, banks function

19 CAMELS stands for capital, assets, management, earnings, liquidity and sensitivity torisks.20 The SIIF has under its inspection 51 financial entities plus 58 other entities such as credit administrators,exchange houses and others, of which 16 are subject to full inspection.

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with more liabilities than assets in foreign exchange. When the market changes andbanks want to reduce their position in foreign exchange, the absence of a forward marketforces them to do so by canceling credits in local currency. The BHU and other financialinstitutions (pension fund administrators, insurance companies, the public pensionsystem) use as an index the unidades reajustables (URs)21. These institutions are subjectto a double financial indexation: to the dollar and to the UR, which complicates their riskmanagement. The BCU has recently issued regulation requiring the matching of flowsbetween assets and liabilities for those transactions with a maturity in excess of threeyears.

30. The BHU has a specially difficult mismatch problem. BHU's maturity mismatchis evident because the stated average term of its housing loans is 15 years, while theaverage maturity of its liabilities is eight months (with the exception of a long-term loanprovided by.BCU). An even more worrisome problem is BHU's currency mismatch.December 1997 figures show that the bulk of BHU's assets were denominated in URswhile the largest percentage of its liabilities were dollar-denominated. The significantgap between devaluation and inflation in the past decade, with devaluation laggingbehind inflation, has implied that BHU's assets have adjusted at a faster pace than itsliabilities, resulting in accounting gains and increases in its net worth which are notsubstantiated by the real value of its assets This encourages non-payment, since debtorsrealize that due to UR adjustments, the amount due of their loans often exceed the marketvalue of the properties acquired.

Lack of Transparency in the Financial Sector.

31. Lack of transparency of financial information is an important obstacle toimproved standards of efficiency and competitiveness in the banking sector. Financialinformation available to the public about the banks is very limited. Although since 1998,private banks in Uruguay are required to have their accounts audited by external auditors,these audits are not published. While all banks are obliged to publish their income andloss statements, only private banks comply, but in a very aggregated form which does notprovide the basis for depositors to assess the solvency and liquidity of the financialinstitutions, and make choices among banks. Lack of financial information is in part theresult of Uruguay's stringent banking secrecy law. Although this law has beeninstrumental in the development of off-shore banking in Uruguay, its strict interpretationcan restrict the sharing of information between banking supervisors recommended by theBasle Committee in February 1998. This is probably an issue that will be discussed inthe context of financial integration within MERCOSUR.

32. There is also lack of information about debtors to the banking system. Untilrecently, the information on debtors published by BCU's Credit Risk System (Central deRiesgo) was limited to only the largest debtors, and presented at a very aggregated level.In part, this reflects an interpretation of the banking secrecy law as covering both the

21 The URs are units of account that adjust automatically to reflect changes in the index of average salariesof the country.

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information on assets and liabilities22 . Lack of information about debtors difficult theimplementation of credit portfolio risk analysis and limits the availability of credit and

23the use of corporate debt to finance productive activities

C. The Government's Strategy for Financial Sector Reform

33. The Uruguayan authorities recognize that the best protection against externalfinancial shocks is a solid and competitive financial sector. The authorities arecommitted to a phased program of reforms aimed at: (i) strengthening banking regulation,supervision and inspection; (ii) establishing mechanisms for an orderly exit of banks fromthe market; and (iii) stimulating the development of new financial products and thecompetitiveness of Uruguayan banks vis-a-vis those of other countries in the region. Thefinancial sector reform program is expected to be implemented in two phases. The firstphase of the reform involves measures to: (i) improve competition in the banking sectorthrough a more level playing field between public and private banks; (ii) establish thebasis for privatization of a bank under public management; (iii) establish the frameworkfor the restructuring of BHU; (iv) strengthen banking regulation, supervision andinspection; (v) improve transparency of financial information; and (vi) establish the basisfor a systematic approach to modernize the financial sector legal framework. The secondphase of the reform will be a challenge to be faced by the new administration that willtake office on March 1, 2000. It is expected that the new govermment will continue themodernization of the financial sector legal framework and the re-privatization of the twobanks under public management. Another step would be the amendment of the chartersof the public banks to emphasize their role in mobilizing long term resources allowingthem to operate as second tier institutions.

Improvement of Domestic Competition in the Banking Sector.

34. In the first phase of reform, the Uruguayan authorities are taking important stepsto create a more level playing field and stimulate competition between public and privatebanks, including reducing special regulatory treatment of public banks and returning theintervened banks to private administration.

35. Measures to this effect already implemented include the following:

* Since December 1998, public agencies included in the national budget are allowed toopen deposits in public or private banks. This right was regulated by ExecutiveDecree issued on July 1999.

22 Uruguay has the most strict banking secrecy normns in all the region. Banking secrecy can only be liftedby resolution of the criminal justice and by resolution of the civil justice only in cases involving theobligation to provide maintenance.23 Lack of transparency was a factor in the collapse of the market for corporate bonds following theunexpected bankruptcy, in January 1998, of one of the first large bond issuers. Although that firm hadreceived loans from 16 banks, most of the banks were unaware of its true credit history.

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* External audit of public banks. Starting in 1999, public banks are required to haveexternal audits. Public banks need to start as soon as possible with the audit process,to ensure that the accounts of the year ending December 1999 will be adequatelyaudited. The external audit will emphasize, among other things, the review of theloan portfolios of both banks, the level of provisions, and the value of their assets.

* Acceleration of the reduction of BROU's provision's deficit. Since 1993, BROU hasbeen provisioning heavily to reduce its deficit of bad debt provisions, estimated nowat US$250 million, down from an estimated deficit of US$600 in 1992. At that time,BCU and BROU agreed on a schedule to allow BROU to cover the deficit in 17years. BROU is now committed to eliminate its provision shortfall by July 2005,thereby decreasing by five years the adjustment time initially agreed.

* Introduction of a Scheme of Reserves for BHU. The BCU has issued regulationrequiring BHU to establish a scheme of reserve requirements.

Restructuring of Public Banks.

36. Restructuring of BROU In 1995, BROU initiated an institutional transformationprocess aimed at improving its effectiveness and productivity, so that it would be betterprepared to face the forthcoming more competitive environment in the banking business.BROU hired an international consulting firm to assist it in implementing the changeprocess, which included the reengineering of credit processes, finance, planning,marketing, human resources, accounting, administration and audit. The transformationalso involved the acquisition of new hardware system and migrating to a new, state of theart, software system. As part of the program, the consultant assisted BROU in preparingits Strategic Plan for 1998-99. So far, the modernization of processes has resulted in anew organizational structure, a 15% reduction of personnel, a 36% productivityimprovement, and reduced operating costs. Changes accomplished under the programare very substantial, but there is the need to accelerate work on credit processes and themanagement information system.

37. Restructuring of BHU BIHU has not yet initiated an institutional transformationsimilar to the one being implemented by BROU. In addition to institutional weaknessesthat need to be addressed by a comprehensive restructuring program, BHU has significantmaturity and currency mismatches of its assets and liabilities (see par. 30) that requireurgent action. There is also a need to assess the true value of BHU's net worth, which islikely to be overvalued due to: (i) current valuation practices on assets obtained in lieu ofloan payments, which result in values exceeding market prices; and (ii) doubts about theclassification of the credit portfolio and the insufficiency of provisions for bad loans.

38. The Uruguayan authorities have indicated their intention to accelerate theinstitutional restructuring of BROU, implement measures to strengthen the financialposition of BHU; and initiate BHU's institutional restructuring. Measures taken to thiseffect include the following:

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* Improvement of BROU's credit risk control function. BROU is taking measures toimprove the quality of the new loans and determine more accurately the realcondition of its loan portfolio. To this effect, BROU has approved a new policy ofcredit risk control. Further progress is being made in credit analysis and approvalprocedures, and in strengthening the new Credit Management Division.

* Reduction of BHU currency and term mismatch. BHU has approved the issuance oflong-term bonds that will reduce the flows mismatch between its assets and liabilitiesby, at least, 75%. It has also adopted a credit policy giving priority to improving thecurrency matching between its assets and liabilities.

* Establishment of conditions for the securitization of BHU's mortgage portfolio.Securitization of BHU's portfolio would provide liquidity to the market andcontribute to the development of a secondary securities market. Securitization ofBHU's portfolio is limited by the lack of information on the quality of the portfolioand lack of standards for the origination of loans. To overcome these constraints, theexternal audit of BHU's accounts will emphasize the review of the quality of the loanportfolio. Also, BHU has decided to standardize the terms of its loans to facilitate thefuture securitization of mortgages. This involves establishing specific criteria interms of standardized loan documentation, origination and appraisals.

* Initiation of BHU's restructuring. BHU has prepared preliminary terms of referencefor the hiring of a consulting firm to help it to design an institutional restructuringprogram.

Return of the Banks Under Government Management to Private Ownership.

39. The Uruguayan authorities are committed to return to private management thetwo commercial banks that are currently under government management. Sale of thesebanks has been difficult because of the difference between the book and the real value ofthese banks assets, and the opposition by the banking workers union to any job losses.

40. Banco Caja Obrera. At the end of 1998, Banco Caja Obrera revalued variousassets, which made it possible for its net worth to remain positive. With the purpose ofaccelerating the sale of the bank, the BCU, at shareholder's expense, hired aninternational bank as financial advisor. The process for selling the bank began in 1997,but due to comments by potential bidders on the sale conditions, the sellers agreed tomodify them, including allowing staff reductions, to increase the attractiveness of thebank. Four interested parties acquired the bidding documents and were qualified tosubmit a bid: However, only one joint offer by two banks was submitted. In June 1999,the Government rejected the purchase offer because, according to the technical advisorsof the BCU, their offer did not comply with the conditions of the bid documents. Thebuyers were supposed to buy the bank "as is", but in the final offer, they proposed to takethe US$235 loan portfolio with the condition that after three years they could return up to30% of the bad portfolio to the Government. This condition would have created acontingency liability for the Government of about US$70 million.

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41. Banco de Credito. The government's intention is to restructure and cleanupBanco de Credito before privatizing it. Although the acquisition by Banco de Credito ofBanco Pan de Azucar's good assets has not reduced its net worth deficit, it had theadvantage of isolating the legal problem with the previous owners of Banco Pan deAzucar from the "good bank", facilitating its sale to a third party.

42. The authorities have expressed their intention to accelerate the sale of these twobanks as follows:

* Sale of Banco Caja Obrera. After rejecting the purchase offer, the authorities haveannounced that the bank would be put again for sale early in year 2000.

* Initiate Sale of Banco de Credito. To sell Banco de Credito, it is necessary to assessthe value of the bank through an evaluation of the quality of its portfolio (of about50,000 loans) and estimate the real value of its investments and fixed assets. Afinancial advisor has been selected and hired to assess the value of the new Banco deCredito and to design an strategy for its privatization.

Strengthening of Banking Regulation, Supervision and Inspection

43. The Uruguayan authorities have indicated their intention to continuestrengthening the supervision and inspection of the banking system and the regulationsconcerning audits, risks, and valuation of assets and guarantees. Some of thestrengthening measures include the following:

* Issuing norms to control risks. The BCU has recently issued new norms andregulations to control risk. These include regulation requiring the banks to adopt apolicy of flows matching between assets and liabilities for those transactions with amaturity in excess of three years. With support from an IDB loan, the BCUestablished a US$60 million fund to provide banks with a seguro de calce (Term GapInsurance) for a fee of 1% on utilized funds. The fund has already been fully utilizedand the BCU intends to replenish it. The SIFF also has issued regulations requiringpublic and private banks to calculate their capital adequacy ratio on a consolidatedbasis and for applying rating and provisioning norns with respect to loans to publicenterprises. In addition, the SIIF has started to implement the change from theCAMEL to the CAMELS system and will require banks to inform about the riskmodels utilized with the objective of assessing their adequacy.

* Strengthening inspection of public banks. To ensure adequate inspection of publicbanks, the BCU's has approved an inspection plan to carry out on-site inspectionspresented by the SIIF, with an schedule of inspections of public and private banksbetween July 1999 and June 2001, in accordance with the CAMELS methodology.This plan includes inspection of information systems and off-site analysis.

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* Strengthening of bank's audits. In September 1999, the BCU issued a norm requiringpublic and private banks to have their accounts audited by external auditors. TheSIIF issued norms establishing the minimum content of external audits. Tostrengthen the audit function, the SIIF now requires that all banks create AuditCommittees by the end of 1999.

* Introducing mechanisms to facilitate market exit. The BCU authorities have recently(May 1999) issued a circular establishing procedures to allow an orderly exit from themarket of banks that do not have financial problems. The procedures includerequirements of the exiting banks to inform the BCU at least 90 days prior to thecease of activities, present a liquidation plan detailing the guarantees, resources andtiming expected for the cancellation of liabilities, and mechanisms for the retirementof deposits and the transfer of credit lines to other institutions.

* Making valuation of assets and guarantees more transparent. Valuation ofcompanies assets cannot be made based on market prices because of illiquid marketsand lack of a yield curve. This is an issue across all financial intermediaries. Assetsare frequently valued at purchase price or last sale. In view of the need to standardizevaluation processes across sectors, the BCU has issued norms to value the assets ofprivate and public banks according to the Mark-to Market Valuation Method. TheBCU has also issued norms requiring private and public banks to hire independentappraisers to estimate the value of the goods, rights or any other form of collateralprovided to guarantee loans in excess of 3% of the minimum net equity requirementapplicable to all banks in Uruguay.

Improvement of Transparency in the Financial Sector

44. The Uruguayan authorities are in the process of introducing greater transparencyinto the financial sector. The measures to achieve this include the following:

- Publication of financial information by the banks. The BCU has issued a circularproviding that public and private banks, starting in the year 2001, make availabletheir external audits for the preceding year. Also, a BCU resolution requires banks topublish, starting in year 2000, detailed financial information with respect to thepreceding calendar year.

* Creation of a New Credit Information Bureau (Central de Riesgo). The BCU is inthe process of implementing a new information system to cover all debtors. The mainbenefit of the new information system is that it will allow telephonic informationabout any debtor of obligations assumed as debtor, co-debtor or guarantor, as well asof their payment situation. The system will have electronic connection with all banksand will submit monthly reports. Another important feature is that it will presentcredit information by categories. The new credit information system beingimplemented by the BCU will provide information about all debtors of the financialand non financial public and private sector having a debt which exceeds 0.3% of theminimum net equity requirement applicable to all banks in Uruguay for purposes of

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operating as banking institutions. Starting on October 1, 2000, the system will grouprelevant credit risk information by separate categories. This information will enablebanks to better assess the credit risk of potential borrowers and allow the SIIF to carryout analysis of the system's global portfolio or of the portfolio of a particular entity.

Modernization of the Financial Sector Legal Framework

45. The Government is aware of the need to accelerate legal reform in the financialsector. However, given the resistance to rapid reform in Uruguay, any major legislativeproposal will require a process of dissemination of information on the policy options andconsensus building in support of the reform proposals. To enable this process to takeplace, the Government has created a unit to manage this process. Some of the bills of lawthat have been recently submitted to Parliament include:

* Application of International Accounting Standards. In July 1999, the executive sentto Parliament a draft law requiring the adoption of International AccountingStandards for all commercial entities.

* Facilitating the use of Warrants, Securitization and pledges. The Executive haspresented to Parliament a bill of law which, if enacted, would permit the execution of"warrants" without judicial intervention. Warrants would be treated as negotiableinstruments (titulo valor), to expedite execution procedures. In September 1999, aftertwo years of discussion, Parliament approved the Securitization Law. Congressenacted a law which expands the types of goods which may be subject to be pledgedunder the concept of prenda sin desplazamiento as a type of secured interest onspecific goods).

D Creation of a Financial Technical Unit. The Government has created a FinancialTechnical Unit within the BCU to carry out technical and legal studies in the financialsector with the assistance of technical consultants. This unit will produce reports thatwill lead to a process of consultation on the reform proposals and to the drafting oflaws to be presented to Parliament. The unit will also work with Parliamentarycommissions and interested groups to generate consensus around the legislativeinitiatives in the financial area to accelerate their passage. Important areas to becovered by the technical unit will be the following: (i) reform of the financial sectorlegal framework, including the preparation of new Charters for BROU and BHU, andproposals for a mechanism to allow for an orderly crisis resolution for troubledfinancial institutions; and (ii) study of the factors that limit banking sectorcompetitiveness and options for policy reform. The Technical Unit would alsoanalyze whether the prohibition imposed on the banks in the aftermath of thefinancial crisis of the early 1 980s, of investing in private securities, is still relevant inview today's stronger regulatory framework.

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III. BANK ASSISTANCE STRATEGY IN THE FINANCIAL SECTOR

A. Bank Assistance Strategy in Financial Sector Reform

46. Rationale for Bank Involvement and Strategy. The Bank has long beenconcerned about the lack of depth of the domestic credit and capital markets in Uruguayand of the dominant role of state banks. These points are highlighted in the CASdiscussed by the Board on June 25, 1997. The 1997 CAS envisioned Bank support tofinancial sector reform through a variety of instruments, including advisory services ofbank restructuring and, in the high-case scenario, a capital markets development loan.The proposed loan in support of Uruguay's program of financial sector reforms isconsistent with the CAS objectives of financial and public enterprise reform andcomplements the capital markets reform loan approved by the Bank in January 1998.

47. The Bank's Strategy for Financial Sector Reform in Uruguay. The Bank'sstrategy is to support incremental policy improvements in the financial sector, whilecontinuing the dialogue and technical work needed to ensure consensus on more farreaching financial sector reforms in the future. Consistent with this strategy, theproposed adjustment loan would support a number of important measures to create amore level playing field between public and private banks by reducing the specialtreatment enjoyed by public banks, strengthening the supervisory capabilities of theBCU; and by assisting in evaluating Banco de Credito, one of the two remaining banksunder public management. To accelerate the pace of policy reform in Uruguay, theexecutive authorities need to be able to present the policy options to the variousstakeholders, the public, the trade unions and the Parliament, in a convincing manner. Toaddress this need, the proposed loan also supports the creation of a Technical Unit thatwould conduct legal and technical studies in key areas of concern in the financial sector.These studies would be the basis of policy reform proposals that would be submitted fordiscussion among the different interested parties, including members of Parliament.

48. Jusdfication for Adjustment Lending. Adjustment lending is justified on thebasis of the balance of payments shortfall rationale. Uruguay is a small, fairly open,economy. Its GDP was approximately US$21 billion in 1998, and combined imports andexports of goods represented nearly one-third of GDP. Under such conditions, theeconomy is susceptible to external shocks. Last fall's turbulence in international financialmarkets led to a restriction in Uruguay's access to foreign lending -- despite successfulcompliance with its IMF program and an investment grade rating from the internationalrating agencies. These difficulties led the authorities to withdraw 90% of the previous"precautionary" IMF stand-by arrangement4. Following this shock on the financial side,a real shock has occurred since the Brazilian devaluation leading to double-digit declinesin trade with MERCOSUR partners during the first quarter of the year. The last twodecades of experience with balance of payments disruptions in emerging economies haverevealed the importance of establishing a strong domestic financial system as a means of

24 The old SBA of SDR 125 million expired 3/19/99, new SBA approved 3/29/99 for SDR 70 million

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cushioning the economy from external shocks. With solid domestic banks, the negativeimpact of the shock is more likely to be limited to exposed sectors. In addition, therecovery from a period of negative growth is likely to be more rapid in the presence ofefficient financial intermediation. The final expected result of the financial sector reformprogram is to lower the degree of economic and social costs associated with the recent,and possible future, external shocks.

49. Uruguay's gross financial requirements through the balance of payments areexpected to be on the order of US$1.4 billion this year -- comprised of a current accountdeficit of US$500 million and public and private external debt amortization of US$900million. The government projects a financing plan with an adequate mix of multilateraland private sector sources. From the multilaterals, the financing plan calls for US$395million from the Bank and IDB, as well as an already approved US$95 million (SDR 70million) precautionary stand-by arrangement with the IMF. The government recentlyissued a ten-year global bond for US$250 million. The IMF is projecting a US$200million loss in reserves for 1999, leaving the country with 6.4 months of coverage ofimports of goods and services; however, this figure will depend upon the degree of accessto private international lenders by both the public and private sectors.

B. Experience with Adjustment Lending in Uruguay

50. The Bank's experience with adjustment lending in Uruguay in the late 1980s andearly 1990s was mixed. Although most of the development objectives supported by theoperations were eventually achieved, implementation lagged. Implementation delayswere the result of the disparity between expectations of quick SAL disbursements andUruguay's deliberate pace in concluding sensitive policy reforms. In contrast, the Bank'sexperience with the Contractual Savings Adjustment Loan, approved in February 1998,has been highly satisfactory, as confirmed by an OED review of the Loan's ICR datedDecember 3, 1998. One-important lesson from this experience is that adjustmnentoperations in Uruguay should be designed to support incremental reforms in areas inwhich there is ample consensus. Another lesson is that to ensure Governmentcommitment to timely implementation, adjustment loans should address a small numberof policy areas, and have maximum up-front implementation. Following this approach,the proposed adjustment loan has been designed as a one tranche loan in support of up-front measures.

C. Coordination with Multilateral Institutions

51. During preparation of this loan, the Bank has been in close contact with the IMFand the IDB. The precautionary Stand-by with Uruguay, approved by the Fund Board inMarch, 1999, also supports the Government's program of financial sector reforms. TheFund gives particular importance to the privatization of the intervened banks and thecarrying out of the external audits of the public banks The IDB and the Bank havecollaborated in the past in support of financial sector reforms in Uruguay.

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IV. THE PROPOSED LOAN

A. Loan Objectives and Description

52. This proposed adjustment loan would support the first stage of the Government'sfinancial sector reform program aiming at: (i) improving competition in the bankingsector establishing a more level playing field between public and private banks; (ii)strengthening banking regulation, supervision, and inspection; (iii) restructuring of publicbanks; (iv) assisting in the privatization of a bank under public management; (v)introducing more transparency in the financial sector; and (vi) assisting in themodernization of the financial sector legal framework. The ultimate objective of theGovernment's reform program is to create an environment conducive to a betterfunctioning financial sector, able to withstand external shocks and with greaterparticipation in the domestic credit market.

53. The proposed loan to the Repuiblica Oriental del Uruguay would be disbursed inone tranche, upon loan effectiveness. It would support the first phase of Government'sfinancial sector reform program, which has been implemented. The Borrower would bethe Repuiblica Oriental del Uruguay and implementation of the first phase of the reformprogram has been carried out by the Ministry of Economy and Finance, the BCU, BROUand BHU.

B. Policy Actions

54. The Government and the Bank have agreed on the objectives of a program offinancial sector reforms that are expected to be implemented in two phases. The mainobjectives of this program are described in a Letter of Sector Policy (attached). Thisproposed loan would support the first phase of the Government's financial sector reformprogram in areas concerning the public banks, the intervened bank, banking regulation,supervision and inspection, transparency of financial information, and financial sectorlegal issues. Some of the policy reforms have been implemented in the context of loanpreparation, following recommendations proposed by Bank missions. All of the agreedpolicy actions under the first phase of the financial sector reform program have beenimplemented. The Bank expects to continue the dialogue on the follow up phase of thefinancial sector reform program with the new authorities that will take office in March 1,2000.

55. Loan proceeds would be disbursed upon effectiveness. The following measureshave been taken prior to Board presentation, in a manner satisfactory to the Bank:

I. Measures to Improve Competition in the Banking Sector

* Issuance of the Borrower's Executive Decree No. 188/99 of July 1, 1999 regulatingthe right of public agencies included in its national budget to open bank accounts inpublic or private banks in Uruguay;

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* Issuance of BCU's Circular No 1664 of September 9, 1999, providing that publicbanks in Uruguay shall, starting in the year 1999, have their financial statements(balance sheets, statements of incomes and expenses and related statements) auditedby external auditors;

* Issuance of BROU's Resolution of December 9, 1999, selecting an internationalauditing firm, satisfactory to the Bank, to carry out an external audit of BROU's 1999financial statements (balance sheet, statements of income and expenses and relatedstatements);

* Issuance of BHU's Resolution of December 1, 1999, selecting an internationalauditing firm, satisfactory to the Bank, to carry out an external audit of BHU's 1999financial statements (balance sheet, statements of incomes and expenses and relatedstatements);

* Issuance of BROU's Resolution of September 10, 1999, providing that BROU shalleliminate its deficit of provisions for non-performing loans by July 31, 2005;

* Issuance of BCU's Resolution of January 18, 2000, requiring BHU to establish ascheme of reserve requirements.

'I. Measures to Restructure Public Banks.

- Issuance of BROU's Resolution of January 18, 2000, approving a new policy ofcontrol of its credit risk;

D Issuance of BHU's Resolution of November 3, 1999, approving the issuance of long-term bonds that will reduce the flows mismatch between its assets and liabilities by atleast 75%;

* Issuance of BHU's Certificate No. 13628 of September 22, 1999, approving a creditpolicy to improve the currency matching between its assets and liabilities;

* Issuance of BHU Resolution No. 13626 of September 8, 1999, adopting a policy tostandardize the terms of its loans to facilitate the subsequent securitization ofmortgages; and

* Preparation of BHU of terms of reference for the employment of a consulting firm todesign an institutional restructuring plan for BHU.

III. Measures to Initiate the Privatization of Banco de Credito

* Agreement dated February 3, 2000 entered into between the BCU and an investmentadvisory firm, satisfactory to the Bank, to assess the value of Banco de Credito's loan

21

portfolio, investments and fixed assets and design an strategy for the sale of theBorrower's majority stock ownership in Banco de Credito;

IV. Measures to Strengthen Banking Regulation, Supervision and Inspection

* Issuance of BCU's Circular No. 1.639 of March 4, 1999, providing that public andprivate banks in Uruguay shall, starting on April 1, 1999, adopt a policy of flowsmatching between its assets and liabilities for those transactions with a maturity inexcess of three years;

* Issuance of BCU's Circular No. 1.662 of September 9, 1999, requiring public andprivate banks in Uruguay to calculate their capital adequacy ratio on a consolidatedbasis;

* Issuance of BCU's Resolution of September 7, 1999, providing that public andprivate banks in Uruguay shall, starting on January 1, 2000, apply rating andprovisioning norms with respect to loans to state enterprises;

* Issuance of BCU's Circular No. 1.664 of September 9,1999, requiring public andprivate banks in Uruguay to create and audit committee by not later than March 31,2000;

* Issuance of BCU's Notice No. 99/108 of September 9, 1999, requiring public andprivate banks to disclose to BCU the risk models used by such banks in connectionwith their lending operations for the purpose of the assessment of the adequacy ofsuch models by BCU;

* Issuance of BCU's Resolution of July 16, 1999, approving a plan to carry out on-siteinspections of public and private banks in Uruguay between July 1, 1999 and June 30,2001 in accordance with the capital, assets, management, earnings, liquidity andsensitivity to interest risks (CAMELS) methodology;

* Issuance of BCU's Circular No 1.645 of May 5, 1999, establishing procedures to befollowed by solvent private banks in cases in which such banks have decided to ceaseoperating as banking institutions in Uruguay;

* Issuance of BCU's Notice of September 2, 1999, establishing norms to value theassets of public and private banks in Uruguay in accordance with the Mark to MarketValuation Method;

* Issuance of BCU's Circular No. 1.626 of December 22, 1998, establishing norms tovalue assets of pension funds administrators in Uruguay in accordance with the Markto Market Valuation Method; and

* Issuance of BCU's Notice No. 99/109 of September 9, 1999, requiring private andpublic banks in Uruguay to hire independent appraisers to estimate the value of the

22

goods, rights or any other form or collateral provided by borrowers to guarantee loansin excess of 3% of the minimum net equity requirement applicable to all banks inUruguay for purposes of operating as banking institutions.

V. Measures to Improve Transparency of the Financial Sector

* Issuance of BCU's Circular No. 1.663 of September 9, 1999, providing that publicand private banks in Uruguay, shall, starting in the year 2001, make available to thepublic their annual external audit reports for the immediate preceding fiscal year;

* Issuance of BCU's Resolution of September 8, 1999, providing that public andprivate banks in Uruguay shall, starting in the year 2000, publish detailed financialinformation with respect to the preceding calendar quarter;

* Issuance of BCU's Notice No 99/49 of May 11, 1999, indicating that its Credit RiskInformation system (Central deInformacion de Riesgo) is providing information withrespect to, inter alia, each debtor having a debt which exceeds 0.3% of the minimumnet equity requirements applicable to all banks in Uruguay for purposes of operatingas banking institutions; and

* Issuance of BCU's Notice No. 99/49 of May 11, 1999, indicating that BCU's creditrisk information system shall, starting on October 1, 2000, group relevant credit riskinformation by separate categories.

VI. Measures to Modernize the Financial Sector Legal Framework

* Presentation to the Borrower's Congress of the bill of law dated July 15, 1999, which,if enacted, would require all companies in Uruguay follow international acceptedaccounting standards;

* Presentation to the Borrower's Congress on December 10, 1998, of a bill of lawwhich, if enacted, would, inter alia, permit the execution of "warrants" withoutjudicial intervention;

* Enactment of the Borrower's Law No. 17.228 of December 21, 1999 which, interalia, expands the type of goods which may be subject to prenda sin desplazamiento(as a type of secured interest on specific goods); and

* Creation of a Technical Unit within the BCU which will, inter alia: (i) carry outtechnical and legal analyses of financial sector reform proposals; (ii) prepare andpresent to the Borrower's executive branch the recommendations resulting form theanalyses mentioned in (i) herein; and (iii) build consensus amongst the Borrower'sexecutive and legislative branches of government and stakeholders with respect tofinancial sector reform proposals.

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C. Disbursement and Audit

56. Loan disbursements would be made under simplified SAL/SECAL procedures.The Borrower would be required to open and maintain a Deposit Account in its CentralBank. When the loan becomes effective, the Borrower would submit a simplifiedwithdrawal application against which the Bank would disburse the loan proceeds into theDeposit Account for the borrower's use.

57. Upon the Bank's request, the Borrower will have the Deposit Account audited byan independent auditor acceptable to the Bank. Copies of the Deposit Account auditswould be submitted to the Bank no later than four months after the date of the Bank'srequest for such audits. The loan Closing Date would be June 30, 2000.

D. Impact, Benefits and Risks

58. Social Impact. The proposed loan would have very little social impact in theshort run. In the longer run, however, the reform measures supported by the proposedloan would have important social implications in terms of increased economic activity,with the associated generation of job opportunities. The ultimate objective of the reformmeasures supported by this loan is a better functioning financial sector, able to withstandexternal shocks and with greater participation in the domestic credit market. Greateraccess to credit by local businesses, particularly small and medium enterprises, wouldcreate more job opportunities, an important social objective in a country of relatively highunemployment levels (currently, unemployment is about 11%).

59. Fiscal Impact. Some of the reform measures would initially generate extraGovernment expenditures, although in the long run they should reduce budgetary outlays.For example, the decision to apply 100% of BROU's profits to the reduction of thisbank's provisions deficit, will represent a loss of revenue for the Government. Similarly,the introduction of a scheme of paid reserves for BHU will generate costs. However, inthe longer run, the measures supported by this loan will reduce the burden of the financialsystem on the budget. The restructuring of the public banks and the strengthening ofBCU's supervision of these banks will reduce the risk of another Government bailout ofBHU in the future.

60. Environmental Impact. The financial sector reformn program is not expected tohave any environmental impact and would be ranked C for environmental purposes.

61. Benefits. The proposed loan would contribute to ensure banking soundness andincrease the competitiveness of Uruguayan banks. In the short run, the main benefit ofthe reform measures supported by this loan would be in terms increased competition inthe banking sector, brought about by a more level playing field between public andprivate banks. The special treatment enjoyed by public banks in Uruguay (including thebanks under public management), have allowed them to lend at lower rates and be morelenient in collecting loans than private banks. This has contributed to marketsegmentation, with private banks focusing mostly on lending to the largest firms or

24

operating in off shore markets. In particular, the external audit of the public banks andthe independent assessment of the value of Banco de Credito, will reveal the true level ofthe contingent liabilities faced by the Government with respect to publicly managedbanks. The measures to improve transparency of information about the financialsituation of the banks will allow the public to make more informed decisions on where toput their money. On the other hand, more information about creditors would help thedevelopment of a more active domestic credit market by reducing the non payment risksfaced by lenders. In the long run, the benefits of the proposed loan are in terms of settingup the stage for a more open public discussion and dialogue on sensitive financial sectorissues in Uruguay, particularly on the need to reduce the role of the public sector in thefinancial area, on ways to address the factors affecting the competitiveness of Uruguay'sbanks in the region, and on ways to reduce judicial uncertainty and strengthen theenforcement of contracts in the financial sector. As indicated above, some reforminitiatives in the financial sector take long to be approved, or do not come to fruition, dueto lack of concerted efforts to build consensus and to timely respond to the questionsraised by Parliamentarians to the bills submitted to Parliament. A major benefit of thecreation of the proposed Financial Policy Technical Unit is that it will act as a hub todisseminate the results of technical and legal studies on financial sector issues, andcentralize efforts to generate consensus around policy reform proposals.

62. Risks. The main risk associated with this operation is the possibility that the newadministration that will take office on March 1, 2000, may not go ahead with the secondphase of financial sector reforms, including the sale of the intervened banks and theproposal of new financial legislation. Factors that mitigate this risk are the effortsalready under way to find a buyer for Banco Caja Obrera, and the need to maintain thecredibility of the regulatory function by requiring Banco de Credito to comply withcapital adequacy norms or close down. Also, there is increasing consensus in Uruguayon the need to strengthen the legal framework to ensure the competitiveness of Uruguay'sbanks, in view of the increasingly macroeconomic stability and improving banking sectorefficiency in neighboring countries, and the greater openness in factor markets broughtabout by MERCOSUR. The new administration is aware of the proposed loan and is inagreement with the first phase of financial sector reforms.

V. RECOMMENDATION

63. I am satisfied that the proposed loan complies with the Articles of Agreement ofthe Bank, and I recommend that the Executive Directors approve it.

James D. WolfensohnPresident

By Sven SandstromWashington, D.C.February 4, 2000Attachments

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URUGUAY ANNEX I

FINANCIAL SECTOR REFORM PROGRAM

1. MACROECONOMIC POLICzY FRAMEWORKMaintenance of supportive * In 03/1999, the FMI approved a precautionary Stand-bymacroeconomic program until 3/2000

* Maintenance of sound macroeconomic frameworkconsistent with the policy objectives and programdescribed in the Letter of Sector Policy

2. MEASURES TO IMPROVE COMPETITION IN THE BANKING SECTORTo create a more level playing * Issuance of Executive Decree No. 188/99 of July 1, 1999, * Equal tax treatment of financial institutionsfield for public and private banks regulating the right of public agencies included in the and transactions to reduce spread distortions

national budget to open bank accounts in public or privatebanks in Uruguay

* Issuance of BCU's Circular No. 1.664 of September 9,1999 providing that public banks shall, starting in year1999, have their financial statements audited by externalauditors

BANCO REPUBLICA ORIENTAL DEL URUGUAY(BROU)

* Issuance of BROU's Resolution of December 9, 1999, * Modification of BROU's Charter to: (i)selecting an international auditing firm, satisfactory to the permit the sale of part of its equity to theBank, to audit BROU's 1999 financial statements private sector; and (ii) increase its role as

second tier bank

26

. ~ ~ ~ ~ ~ ~ UIN 1'KR DtO1 1/AR fl:'TAI~ KJ9 JtvECEf OI*- WE F:

* Issuance of BROU's Resolution of September 10, 1999,providing that BROU shall eliminate its deficit ofprovisions for non-performing loans by July 31, 2005

BANCO HIPOTECARIO DEL URUGUAY (BHU)

* Issuance of BHU's Resolution of December 1, 1999, * Modification of BHU's Charter to: (i) permitselecting an intemational auditing firm, satisfactory to the the sale of part of its equity to the privateBank, to audit BHU's 1999 financial statements sector; (ii) increase its role as second tier

bank; and (iii) permit greater flexibility in* Issuance of BCU's Resolution of January 18, 2000 granting mortgage loans in US dollars.

requiring BHU to establish a scheme of reserverequirements

3. MEASRUES TO RESTRUCTURE PUBLIC BANKSTo strengthen the productivity BANCO REPUBLICA ORIENTAL DEL URUGUAYand financial position of public (BROU)banks

* Issuance of BROU's Resolution of January 18, 2000approving a new policy of control of its credit risk

BANCO HIPOTECARIO DE URUGUAY (BHU)

* Issuance of BHU's Resolution of November 3, 1999approving the issuance of long-term bonds that willreduce the flows mismatch between its assets andliabilities by at least 75%

* Issance of BHU's Resolution 13.628 of September 22,.______1 1999, approving a credit policy to improve the currency

2 7

6 < 0 0~~~~~~~~~~~~~~~~UGA~ SEON ' AEO

matching between its assets and liabilities

* Issuance of BHU's Resolution 13.626 of September 8,1999, adopting a policy to standardize the terms of itsloans to facilitate the subsequent securitization ofmortgages

* Preparation by BHIU of terms of reference for the hiringof a consulting firm to design an institutional restructuring * Formulation and implementation of anplan for BHU institutional restructuring plan for BHU

4. MEASURES TO PRIVATIZE BANKS UNDER GOVERNMENT MANAGEMENTTo transfer management of BANCO DE CREDITO * Full privatization of Banco Caja Obreraintervened banks to the privatesector * Agreement dated February 3, 2000 between the BCU and * Full privatization of Banco de Credito

an investment advisory firm, satisfactory to the Bank, toassess the value of Banco de Credito and design anstrategy for its privatization

5. MEASURES TO STRENGTHEN BANKING REGULATION SUPERVISION AND INSPECTIONTo strengthen banking regulation NORMS AND REGULATIONSto:* improve the bank's internal * Issuance of BCU's Circular No. 1.639 of March 4, 1999, * Strengthened BCU's functions to regulate

and external controls and requiring public and private banks to adopt a policy of and supervise public bankstheir evaluation flows matching between assets and liabilities for

* allow for orderly exit of transactions with maturities in excess of 3 years * Prudential regulation for derivatives

banking institutions from the transactions in placemarket * Issuance of BCU's Circular No. 1.662 of September 9,

* strengthen BCU's inspection 1999, requiring public and private banks to calculate theircapacity, ensuring adequate capital adequacy on a consolidated basis

28

* i Q fBJT1EwTS . :: TIONS TAXK BI¢FO 0WPRESENTATION K; i EXPECED OBllECTVS O1

coverage of all the bankingsystem * Issuance of BCU' Resolution of September 7, 1999,

providing that public and private banks shall, starting onJanuary 1, 2000, apply rating and provisioning norms withrespect to state enterprises

* Issuance of BCU's Circular No. 1.664 of September 7,1999 requiring public and private banks to create AuditCommittees no later than March 31, 2000

* Issuance of BCU's Notice 99/108 of September 9, 1999requiring public and private banks to disclose to BCU therisk model utilized with the objective of assessing theiradequacy

BANKING EXIT MECHANISMS

* Issuance of BCU's Circular No. 1.645 of May 5, 1999 * Mechanisms to allow for an orderly marketestablishing procedures to be followed by solvent banks to exit of insolvent banks in placecease operating as banking institutions

INSPECTION AND SUPERVISION

* Issuance of BCU's Resolution of July 16, 1999, approvinga plan to carry out on-site inspections of public andprivate banks between 07/99 and 06/2001 in accordancewith CAMELS methodology

VALUATION ASSETS AND GUARANTEES

* Issuance of BCU's Notice of September 2, 1999,

29

establishing norrns to value assets of public and privatebanks in accordance with the Mark-to Market ValuationMethod

* Issuance of BCU's Circular No. 1.626 of December 22,1998, establishing norms to value assets of pension fundadministrators in accordance with the Mark to MarketValuation Method

^ Issuance of BCU's Notice 99/109 of September 9, 1999requiring private and public banks to hire independentappraisers to estimate the value of collateral provided toguarantee loans in excess of 3% of the minimum netequity requirement applicable to all banks

6. MEASURES TO IMPROVE TRANSPARENCY OF FINANCLIL SECTORTo improve depositors' choices INFORMATION ABOUT BANKSthrough more and moreaccessible information about * Issuance of BCU's Circular No. 1.663 of September 9,banks 1999, providing that public and private banks shall,

starting in the year 2001, make available to the publictheir annual external audit reports of the preceding year

* Issuance of BCU's Resolution of September 10, 1999,providing that public and private banks shall, starting inthe year 2000, publish detailed financial information withrespect to the preceding calendar quarter

INFORMATION ABOUT DEBTORSTo diminish financial risks, and

30

Q1JfVS ACTION(S TAE S.BEFRE DO4ARJ) PRSENAON KY _XECE _~ETSO

increase lending, through more * Issuance of BCU's Notice 99/49 of May 11, 1999,information about debtors indicating that its Credit Risk System (Central de Riesgo)

is providing information concerning each debtor having adebt which exceeds 0.3% of the minimum net equityrequirement of the banks

* Issuance of BCU's Notice 99/49 of May 11, 1999indicating the BCU's credit risk information shall, startingon October 1, 2000, group relevant credit risk infornationby separate categories

7. MEASURES TO MODERNIZE THE FINANCIAL SECTOR LEGAL FRAMEWORKTo create a legal framework * Presentation to Congress of a bill of law dated July 15, * Full implementation of Internationalconducive to the development of 1999, which, if enacted, would require all companies in Accounting Standardsan efficient and solvent financial Uruguay (including public and private banks), to followsector, capable of expanding internationally accepted accounting standards * Legislation approved to expedite proceduresaccess to credit to execute security interests in pledged assets

* Presentation to Congress of a bill of law on December 10,1998, which, if enacted, would, inter alia, permit the * Modification of the Leasing Law (approved inexecution of Warrants without judicial intervention 01/98) to allow non financial entities to lease

capital goods* Enactment of the Borrower's Law No. 17.228 of

December 21, 1999, which, inter alia, expands the type ofgoods which may be subject to prenda sin desplazamiento(as a type of secured interest on specific goods)

POLICY ANALYSIS AND FORMULATION* Reports to be issued by the Financial

policy analysis, formtion,and * Creation of a Financial Technical Unit within the BCU Technical Unit proposing policy reforms inapprolicyalysis, formulation, which will inter alia: (i) carry out technical and legal the following areas:approval analyses of financial sector reform proposals; (ii) prepare

31

and present the recommendations resulting from the *Financial sector legal frameworkanalyses; and (iii) build consensus among government *Banking sector competitivenessbranches and stakeholders with respect to financial sector *Mechanisms to allow for an orderly market exitreform proposals of financial institutions

*Estimation of contingent liabilities for theGovernment from the public and intervenedbanks.

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ANNEX II

Montevideo, January 31, 2000

Mr. James D. WolfensohnPresidentThe World BankWashington D. C.

Dear Mr. Wolfensohn:

1. This Letter of Development Policy describes the objectives of the Government ofUruguay financial sector reform program, including the objectives, policies and actions of thefirst phase of such reform designed to: improve competition in the banking sector, restructureof public banks, assist in the privatization of a bank under public management (Banco deCredito), strengthen banking regulation and supervision, improve the transparency of financialinformation, and modernize the financial sector legal framework. In order to implement thefirst phase of the reform, we are requesting financial assistance from the International Bank forReconstruction and Development (the Bank). Bank assistance is particularly needed at thisjuncture, when successive financial crisis have impacted negatively the public finances of thecountries in South America. We would like to take this opportunity to also describe themacroeconomic framework which serves as the basis of the reform program, and theGovernment of Uruguay's major achievements under the social security and capital marketreforms.

I. Main Objectives of Economic Policy

2. The main objectives of economic policy of the Uruguayan Government are, to improvethe standard of living of the population, in particular that of the poorest segment, and providestability in the conditions under which the economy operates, with the aim of achievingsustainable economic growth. To achieve these objectives, the current Government, whichstarted its administration in March 1995, has adopted a program of medium-term stabilizationbased on the strengthening of public sector finances, limiting public expenditure and utilizingin a responsible manner the offer of funds. Other instruments utilized to achieve the sameobjectives are the reduction of the external vulnerability, controlling the disequilibrium of thecurrent account of the balance of payments, and extending the maturity of the public debt. Thegradual reduction of the inflation rate to close to international levels, is the most visiblemanifestation of the achievement of the Government's targets. The stabilization program iscomplemented by a set of structural reforms and the commitment to take into consideration themost sensitive social areas.

33

3. Among the most important structural measures that have been adopted since 1995, arethe reform of the social security system; reform of the tax system; the reform of the state; andthe reform of the education sector. There have been also important advances in thederegulation of the economy and the privatization or concession of services (roads, ports,utilities) that were previously in government hands.

4. The Uruguayan banking sector has a strong reputation as a regional financial center.The Government has taken measures to preserve and improve this reputation, strengtheningbanking supervision and modernizing the legal framework, in order to promote the sector'sdevelopment, while maintaining its solvency. Also, measures have been taken to improve thelegal framework for the development of the capital markets. The introduction of institutionalinvestors has become one of the engines for the development of the capital market, which incomparative terms, is very small and underdeveloped in Uruguay. At the same time, there hasbeen progress in the legal framework to expand the supply of securities in the capital markets.

5. The social policy of the government is geared towards assisting the most vulnerablegroups of the population such as the unemployed, children, young mothers, and the lowincome elderly. The strategy is to provide them with greater and better social services, and, insome cases, with monetary support. One of the characteristics of Uruguay in the last fifteenyears, has been the improvement in income distribution and in the main social indicators onpoverty, health, and basic education. The challenge faced by the Government has been toconsolidate and improve the advances achieved since 1985.

6. In the section below, we describe the main aspects of the macroeconomic program, thestructural reforms, including the major achievements under the social security and capitalmarkets reforms, and the measures taken to modernize the financial sector.

II. The Macroeconomic Program

7. The level of economic activity during the years of implementation of thisAdministration's program of fiscal control and macroeconomic stabilization has experiencedsome fluctuations. There was a brief mild recession at the beginning of our mandate, due tothe impact of the Mexican crisis at the end of 1994. In 1995, GDP fell by 1.8%. In thefollowing three years, however, growth was particularly vigorous, with rates of 5.3% in 1996,5.1% in 1997 and 4.5% in 1998. The year ended at September of 1999, GDP contracted by2.5%, with respect to the previous year. The fall of income was even greater due to theunfavorable evolution of the terms of trade.

2

34

8. The recovery of economic activity in the period between 1995 and 1997, wasaccompanied by a strong dynamism in exports and in private sector investment. Exports grewby 10% in 1995 and 14% in the two following years. The increase in the investment rate wasalso high in these three years: 13% in 1995, 31% in 1996 and 14% in 1997. The expansion ofboth imports and exports reflected the process of openness and integration that has taken placein a continuous way in the last two decades.

9. In 1998, growth rates remained at the previous levels until August; but once Russiadeclared a debt moratorium, the pressures on the region increased, and there was an abruptslowdown in trade. The year ended with exports growing at 2% and imports at 2.5 %. Thetrade account in the year ending in September 1999, showed a deficit of US$1,002 million,equivalent to 5.0% of GDP. This deterioration was mainly the result of a reduction in exportprices and the increase in oil prices. Although the trade account had a deficit of US$1,039million in 1998, the strong positive result of the service component (tourism and other servicesand transference) resulted in a current account deficit of only US$400 million, equivalent to1.9% of GDP, which has been more than compensated by capital inflows both in the privateand public sectors.

10. With respect to the public debt policy, the Government has taken advantage of thefavorable opportunity to substitute short term debt for new debt with longer maturities, as partof a strategy to reduce the external vulnerability of the economy. The total gross debt of thepublic sector, including the state enterprises, has increased slightly in the last years to reachUS$6,191 million at the end of 1998. International reserves in the hands of the monetaryauthority were increased to US$2,589 million at the end of 1998, in order to reduce thevulnerability of the economy. The moderate growth of the external debt, together with theaccumulation of international reserves, has resulted in a relatively stable net external debt ofaround US$2,500 million in 1998, equivalent to about 12% of GDP. This level of debt,strengthens the inter-temporal solvency of the public finances, which is necessary to maintainmacroeconomic stability. This performance has led the main international risk rating agenciesto rate Uruguay's public debt as investment grade free of speculative risk.

11. The confidence and credibility of the model of gradual stabilization, the stablemacroeconomic environment, and a favorable investment climate are based on a responsiblefiscal policy. The public sector deficit was about 1.6% of GDP in 1996, including the quasi-fiscal operations of the Central Bank, the cost of the social security reform and the reduction ofthe number of public employees. Under the same conditions in 1997, the deficit reached 1.4%of GDP, and in 1998, it was again lower at 0.9% of GDP. When all the resources necessaryto implement the reforms are considered, it is clear that the fiscal evolution has been veryfavorable, reaching in 1998 a surplus of 0.3% of GDP.

3

35

12. Although we expected a contraction of economic activity in 1999, we were then andstill are, committed with the process of lowering inflation and with the consolidation ofstructural reforms. In spite of having a larger than expected decline in our national income, andthen in total public sector revenues, we have been keeping public fmances and inflation onsound footings. Under these basis, it has been possible to reduce inflation from 44.1 % in 1994,to 4.2% in 1999.

III. Structural Reforms

13. To support macroeconomic stability and growth, we maintain a general commitmnent toreducing the role of the public sector to only those areas where government intervention isjustified; improving the regulatory environment for private sector development -- including labormarket reform and improved financial sector supervision; liberalization of external trade withinthe context of Mercosur and beyond; and continuing with prudent fiscal policies to maintain thecountry's favorable creditworthiness rating. A numiber of imnportant structural reforms wereinitiated in Uruguay between 1995 and 1996, and consolidated in the subsequent three years:the reform of the social security system, the education reform, reform of the state, and of thenon-financial state enterprises. The social security and capital markets reforms are discussedin the next section. Our program of financial sector reform is discussed in Section V.

IV. Social Security and Capital Markets Reforms

14. The Government initiated a major social security reform in the second quarter of 1996.The main objectives were to reduce a rising trend in expenditures, allow For a reduction of the

tax burden on labor, and improve the administration of the pension regime. To this effect, thereform established, alongside the public pension system, a complementary system of individualcapitalization accounts, administered by private pension fund administrators (AFAPs). Over90 percent of employees eligible to participate have chosen to put their contributions in thecapitalization regime, far exceeding our initial expectations.

15. We are convinced that the success of Uruguay's social security reform will depend onthe level of pension benefits that the capitalization regime can provide to its affiliates. We alsobelieve that good fmancial performance by the capitalization regime would only be achieved ifthe AFAPs are able to invest in sound but high return marketable securities and to reduce theiroperating costs. To ensure the good financial performance of the AFAPs, the Government,with support from the Bank, has taken measures to: (i) liberalize the investment regimegoverning the AFAPs to allow greater investment in private securities; (ii) increase theavailability of private securities to match the growth of pension funds; and (iii) createincentives to increase cost consciousness and transparency in disclosure among the AFAPs.

36

16. Initially, most of the funds in the AFAPs were invested in government securities. Toallow for greater flexibility in investment decisions by the AFAPs, and to promote thedevelopment of a private securities market in Uruguay, the Government issued an ExecutiveDecree in March 4, 1998, providing for scheduled reductions in the minimum required AFAPinvestment in government instruments, established in the 1995 Social Security Law. Thisminimum was reduced, in stages, from 75 percent in April 1997 to 55 percent in April 1,1999. In addition, to eliminate a possible bias against investment in private securities, inDecember 1997, we submitted to Parliament a bill of law to modify the calculation of thepension funds' special reserve, established in the Social Security Law, to include Governmentsecurities.

17. We also took measures to increase the supply of investment instruments available to theAFAPs, In May 1997, an Executive Decree was issued to regulate the rating of privatesecurities, a requirement to make them eligible for investment by the AFAPs. A SecuritizationLaw was approved by Parliament in September 1999, to stimulate the securitization ofmortgage loans and other assets, also potential investment instruments for the AFAPs. Also,Parliament approved legislation to allow enterprises to issue debt instruments and place mutualfunds operations under a specific legal regime that provides greater security to investors. Theregulatory framework for the securities market has also been approved and the insurance andmortgage markets liberalized.

18. Finally, to create incentives for efficiency and transparency in AFAP activities, sinceMarch 1998, AFAPs have been required to report to their affiliates net returns on the fundsadministered. This allows enrollees to make a better informed choice of AFAP. The formulato calculate net returns uses information on commissions and returns based on a time horizonof 35 years, the minimum time required to acquire pension rights. We also improved thetransparency of AFAP's trading in securities of related entities by requiring that thesetransactions be made through established markets.

19. As a result of the efforts made in recent years to develop the capital markets and thereform of the state, there is a need to advance further in some reforms to strengthen thefinancial sector in general and the banking sector in particular. At the same time, the strategyto reduce the general vulnerability of the public sector imposes greater demands on thesupervision of the financial institutions. We have adopted some measures to this effect, and weintend to adopt additional measures in the near future, as detailed in section V.

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V. Financial Sector Reform Program

20. We recognize that the best protection against external financial shocks is a solid andcompetitive financial sector. We, therefore, envisage a phased program of reforms aimed at:(i) strengthening banking regulation, supervision and inspection, including improving thetransparency of financial sector information; (ii) establishing mechanisms for an orderly enterand exit of banks from the market; and (iii) stimulating the development of new financialproducts and the competitiveness of Uruguayan banks vis-A-vis those of other countries in theregion.

21. The financial sector reform program is expected to be implemented in two phases. The firstphase of the reform, for which the Government of Uruguay has requested financial supportfrom the Bank, involves the following areas: (i) to improve competition in the banking sector;(ii) to establish the basis for privatization of a bank under public management (Banco deCredito); (iii) to establish the framework for the restructuring of BHU; (iv) to strengthenbanking regulation, supervision and inspection; (v) to improve transparency of financialinformation; and (vi) to establish the basis for a systematic approach to modernize the financialsector legal framework.

22. The challenge of the second phase of the reform will be faced by a new administration thatwill take office in early 2000. We expect that the second phase of the reform program wouldcontinue the modernization of the financial sector legal framework and the reprivatization ofthe two banks under public management. Another step would be the amendment in the charterof the public banks to emphasize their role in mobilizing long term resources allowing them tooperate as second tier institutions, as well as commercial banks.

23. The measures under the first phase of the financial sector reform program that have beenimplemented prior to the presentation of the Financial Sector Structural Adjustment Loan to theBank's Board for its consideration and approval, are the following:

Improvement of domestic competition in the Banking Sector

24. In Uruguay, public banks (Banco de la Republica Oriental del Uruguay--BROU andBanco Hipotecario del Uruguay--BHU) have traditionally enjoyed a different treatment withrespect to other banks in terms of compliance with prudential normns and regulations, taxtreatment, and preferential access to deposits from public enterprises. This situation is the resultof public banks having had different functions than those of commercial bar.ks.

638

i.T e2co dw teo'm y. csyr

-2.L6etay

25. Measures to create a more level playing field in the banking sector that have beenrecently implemented include the following:

* Since December 1998, public agencies included in the national budget are allowed to opendeposits in public and private banks;

* External audit of public banks. Starting in 1999, public banks are required to have externalaudits. To insure that the accounts of thte year ending December 1999 of the public bankswill be audited, we have awarded contracts to recognized auditing firms for the audits ofBROU and BHU. The external audits will emphasize, among other things, the review ofthe loan portfolios of both banks, the level of provisions, and the value of their assets.

- Reduction of BROU's provisions deficit. Since 1993, BROU has been provisioning heavilyto reduce its deficit of bad debts provisions, estimated now at about US$250 million.BROU signed at that time an agreement with the Central Bank, to reduce its bad debtprovisions in seventeen years. The bank has now committed to adequately provision allbad debts within the next six years thereby decreasing by five years its original obligation.

• Introduction of a scheme of reserves for BHU. We have also decided to introduce a schemeof paid reserves for BHU, our largest mortgage bank.

Restructuring of Public Banks.

26. Public banks have played and are likely to continue playing an important role inUruguay's financial sector. Our immediate goal is to improve the efficiency andeffectiveness of these banks, so that they will be better prepared to face the forthcoming,more competitive environment, in the local banking business. To this effect, in 1995,BROU initiated an institutional transformation process with assistance from aninternational consulting firm that involved the reengineering of credit processes, finance,planning, marketing, human resources, accounting, administration and audit. So far, themodernization of processes has resulted in a new organizational structure, a 15%reduction of personnel, a 36% productivity improvement, and reduced operating costs.BHU has not yet initiated an institutional transformation similar to the one beingimplemented by BROU. BHU is taking measures to improve its financial managementand will soon initiate an institutional restructuring program.

27. We have accelerated the restructuring of BROU and established the basis for therestructuring of BHU, through the following measures:

39 7

* Improvement of BROU's credit risk control function. BROU has taken measures toimprove the quality of the new loans and determine more accurately the real condition of itsloan portfolio. To this effect, BROU has designed and implemented a new policy of creditrisk control. Further progress is being made in credit analysis and approval procedures,and in strengthening the new Credit Risk Management Division.

* Reduction of BHU's currency and term mismatch. BHU has approved and will soonimplement a plan to issue short and long term securities to reduce the mismatch betweencurrencies and flows of its assets and liabilities. It has also adopted a credit policy givingpriority to improving the matching of currencies and of assets and liabilities.

* Establishment of conditions for the securitization of BHU's mortgage portfolio.Securitization of BHU's portfolio would provide liquidity to the market and contribute tothe development of a secondary securities market. To facilitate securitization, BHU'sexternal audit will emphasize the review of the quality of the loan portfolio. Also, BHUhas decided to standardize the terms of its mortgage loans to facilitate the faturesecuritization of mortgages.

* Initiation of BHU's restructuring. BHU has prepared preliminary terms of reference forthe hiring of a consulting firm to help it to design an institutional restiucturing program.

Return of the Banks Under Government Management to Private Ownership

28. The Uruguayan Government is committed to return to private management the twocommercial banks: Banco de Credito and Banco Caja Obrera, that are currently under publicmanagement. Banco Caja Obrera has been brought to the point of sale, but Banco de Creditoneeds to go through a similar process. The Central Bank (BCU) has awarded a contract to aninvestment bank to assess the value of Banco de Credito and design an strategy for itsprivatization.

Strengthening of Banking Regulation, Supervision and Inspection

29. In the last few years, the BCU, through the Superintendency of Financial Intermediaries(SIIF) has implemented a number of measures to strengthen banking regulation, supervisionand inspection. The BCU has issued new norms and regulations concerning audits, risks, andvaluation of assets and guarantees.

* New Norms and Regulations: In March 1999, the BCU issued a norm requiring the publicand private banks to match the flows (maturities) between assets and liabilities. Mostrecently, the BCU has issued new regulation on: the calculation of capital adequacy ratios

4

40

on a consolidated basis; the application of rating and provisioning norms for loans to publicsector enterprises; and the change from the CAMEL to the CAMELS system. The BCUhas required banks to inform about the risk models utilized with the objective of assessingtheir adequacy.

* Introducing mechanisms to facilitate market exit. In May 1999, the Central Bank issued acircular establishing procedures to order the exit from the market of solvent banks. Theprocedures include requirements of the exiting banks to inform the BCU at least 90 daysprior to the cease of activities, present a liquidation plan detailing the guarantees, resourcesand timing expected for the cancellation of liabilities, and mechanisms for the retirement ofdeposits and the transfer of credit lines to other institutions.

* Strengthening of bank's audits. As mentioned above, in February 1999, the BCU issued anorn requiring public banks to have their accounts audited by external auditors. The BCUissued norms establishing the minimum content of external audits. To strengthen the auditfunction, the BCU has issued a regulation requiring all banks to create Audit Committees byMarch of 2000.

* Strengthening of banking inspection and supervision. Also, to ensure adequate inspection ofpublic banks, the SUF has formulated an inspection plan, approved by BCU with a scheduleof inspections of public and private banks covering a significant period. This plan includesinspection of information systems and off-site analysis. The BCU will ensure that supervisionof banking institutions is conducted on a consolidated basis.

* Improving valuation of assets and guarantees. In view of the need to standardize valuationprocesses across sectors, the BCU issued, in January 1999, asset valuation norms introducingmark-to market valuation methods for the AFAP, complementing the previously issuedregulation for banks. Also, to improve the transparency of valuations of real estate properties,the BCU has issued the necessary regulations requiring the use of independent appraisers toestimate the value of the goods, rights, or any other form of collateral provided by borrowersfor mortgage loans and other loans exceeding a pre set amount.

Improvement of Transparency in the Financial Sector

30. We are aware of the need to introduce greater transparency of information in thefinancial sector, to allow depositors to choose among banks and to allow banks to better assessthe credit risk of potential borrowers. To this end, the BCU implemented the followingmeasures:

419

* Information about banks. Until recently, information about the baniks was very limited,which reduced the ability of depositors to choose among banks. The BCU now requirespubic and private banks to make available, starting in the year 200L, their external auditreports of the statements of the previous year; and periodically publish detailed financialinformation.

* Information about debtors. The BCU has recently created a New Credit Risk System(Central de Riesgo) to provide information about 100% of debtors of the financial and nonfinancial public and private sector, with debts in excess of 0.3% of the minimum net equityof public and private banks. The information includes obligations assumed as debtors, co-debtors or guarantors, and their payment situation. As of September 1999, the system willhave electrcnic connection with all banks . It is anticipated that as of January 2000, thecredit risk information system will group relevant credit risks by separate categories.

Modernization of the Financial Sector Legal Framework

31. In recent years, Uruguay has made important advances in modernizing its financialsector legal framework. The Financial Intermediation Law and the Charter of the CentralBank, both approved at the end of 1994, expanded the banking regulatory and supervisoryfunction of the BCU. Two other important pieces of financial legislation approved in the lastfew years are the Capital Markets Law and the Investment Funds Law, both passed in 1996.In January 1998, a Leasing Law was approved by Parliament. However, it has to be modifiedto allow for non financial entities to lease capital goods.

32. We have recently submitted three important bills of law to Parliament:

* Application of International Accounting Standards. In July 1998, we sent to Parliament a billof law requiring the adoption of International Accounting Standards for all commercialentities, including private banks.

* Use of Guarantees. We have also submitted a bill of law, that will expand the type ofgoods which may be subject to "prendas sin desplazamiento". This law was passed on atthe end of 1999, and will complement and facilitate the implementation of the SecuritizationLaw.

* To facilitate execution of warrants, we have submitted a bill of law permitting theexecution of warrants without judicial intervention.

42 10

33. We are aware of the need to further strengthen the legal framework in areas such as: (i)the modernization of the Charters of the public banks, to make them more in tune with thecurrent financial trend in Uruguay and internationally; and (ii) the establishment of adequatemarket exit mechanisms for troubled banks. However, any major legislative change willrequire a process of diagnosis of the current situation, elaboration of policy options, anddissemination of information on the policy options and consensus building in support of thereform proposals. To enable this process to take place, we have' established a FinancialTechnical Unit. This unit will carry out technical and legal studies in the financial sector withthe assistance of technical consultants, and lead a process of consultation that would culminatein the drafting of further financial sector reform proposals to be submitted to Parliament. Thisunit would also work with Parliamentary commissions and interested groups to clarify issuesand generate consensus around the legislative initiatives in the financial area to accelerate theirpassage.

34. The work agenda for this unit will include, among others, the following studies: (i)review of the financial sector legal framework, including the proposals to reform the Chartersof BROU and BHU, to adapt them to current financial environment; (ii) analysis of bankingsector competitiveness; and (iii) design of mechanisms for an orderly market exit of insolventfinancial institutions. We are committed to providing this unit with the institutional structureand resources needed for it to accomplish the agreed objectives.

VI. World Bank Support

35. The above description demonstrates the depth of the Government's overall reformprogram. The Government believes that financial assistance from the Bank is important tostrengthen the first phase of financial sector reform in order to create an environmentconducive to a better functioning financial sector, able to withstand external shocks, and withgreater participation in the domestic credit market.

Sincerely yours,

| Ec. Suis oscaMini Economy and Finance

43

ANNE III

1--2

Uruguay - Key Economic Indicators

Actual Estimate ProjectedIndicator 1994 1995 1996 1997 1998 1999 2000 2001 2002

National accounts (as % of GDP)

Gross domestic producta 100 100 100 100 100 100 100 100 100Agriculture 9 9 9 8 8 9 9 9 9Industry 27 27 27 27 27 29 29 29 29

Services 65 63 64 64 64 62 62 62 62

Total Consumption 87 87 88 88 85 87 87 87 87Gross domestic fixed investment 13 12 12 12 13 12 13 13 13

Government investment 5 3 3 3 4 3 3 3 0Private investrnent 8 8 8 9 9 10 10 11 15(includes increase in stocks)

Exports (GNFS)b 21 20 21 23 22 19 20 20 21Imports (GNFS) 22 20 21 23 22 21 22 23 23

Gross domestic savings 13 13 12 12 15 13 13 13 13

Gross national savingsc 12 12 12 12 15 12 13 14 14

Memorandum itemsGross domestic product 16250 18045 19124 19967 20831 19716 20653 22059 23561(US$ million at current prices)GNPpercapita(US$,Atlasmethod) 4630 5120 5780 6130 6180 6177 6179 6182 6186

Real annual growth rates (%, calculated from 1983 prices)Gross domestic product at market prices 6% -2% 5% 5% 4% -2% 2% 4% 4%Gross Domestic Income 7% -1% 6% 6% 7% -8% 1% 4% 3%

Real annual per capita growth rates (%, calculated from 1983 prices)Gross domestic product at market prices 6% -2% 5% 4% 4% -3% 1% 3% 3%Total consumption 7% -3% 7% 5% 3% -5% 0% 4% 2%Private consumption 7% -4% 7% 5% 3% -6% 0% 4% 2%

Balance of Payments (US$ millions)Exports (GNFS)b 3248 3507 3847 4217 4225 3796 4101 4503 4878

Merchandise FOB 1913 2148 2449 2793 2832 2539 2768 3074 3348Imports (GNFS)b 3485 3568 3974 4386 4507 4077 4481 4976 5354

Merchandise FOB 2730 2711 3135 3498 3594 3195 3532 3922 4225Resource balance -237 -62 -127 -169 -282 -281 -380 -473 -476Net current transfers 41 76 83 74 67 -733 -573 -445 -343Current account balance -439 -213 -233 -287 -400 -600 -455 -424 -328

Net private foreign direct investment 154 157 137 113 164 256 261 266 272Long-term loans (net) 280 187 373 723 679 673 283 321 200Official 116 4 49 252 193 74 121 28 -67Private 164 183 324 471 486 599 162 293 267

Other capital (net, incl. errors & ommissions) 242 78 -133 -218 -81 -505 129 109 76Change in reservesd -238 -209 -144 -330 -362 176 -218 -272 -221

Memorandum itemsResource balance (% of GDP) -1.5 -0.3 -0.7 -0.8 -1.4 -1.4 -1.8 -2.1 -2.0Real annual growth rates ( YR83 prices)Merchandise exports (FOB) 18.4 17.1 8.2 5.2 -3.1 -3.5 5.9 6.4 6.5

Primary 24.0 25.1 12.0 4.6 -3.2 -5.0 3.0 4.2 4.2Manufactures 13.3 9.1 3.7 5.8 -3.1 -1.6 9.3 8.9 9.0

Merchandise imports (CIF) 22.0 9.5 10.1 3.4 -2.3 -13.6 5.3 5.8 2.6

44

ANNE III

Uruguay - Key Economic Indicators 2-2

(Continued)

Actual Estimate ProjectedIndicator 1994 1995 1996 1997 1998 1999 2000 2001 2002

Public finance (as % of GDP at market prices)eCurrent revenues 18.7 18.7 19.1 20.3 20.7 20.7 20.5 20.5 20.5Current expenditures 18.2 18.4 18.9 20.1 19.8 18.6 18.6 18.6 18.6Current account surplus (+) or deficit (-) 0.5 0.3 0.3 0.2 0.9 2.1 1.9 1.9 1.9Capital expenditure 2.7 2.3 2.2 2.0 2.4 2.3 2.1 1.9 1.8Foreign financing 0.8 0.3 0.0 0.3 0.6 0.0 0.0 0.0 0.0

Monetary indicatorsM2/GDP 40.5 40.4 41.4 43.0 44.3 44.2 51.3 57.0 63.3Growth ofM2(%) 42.1 39.0 36.6 28.4 19.3 4.9 24.6 20.8 20.2Private sector credit growth/ 70.5 82.1 87.2 92.8 120.6 82.6 83.4 83.4 83.4total credit growth (%)

Price indices( YR83 =100)Merchandiseexport price index 90.6 85.1 89.6 96.9 101.6 94.3 97.3 101.6 103.9Merchandise importprice index 90.6 85.1 89.6 96.9 101.6 104.6 109.9 115.4 121.1Merchandise terms of trade index 100.0 100.0 100.0 100.0 100.0 90.2 88.5 88.0 85.8

Real exchange rate (US$/LCU)f 153.0 157.2 160.4 168.8 172.1 183.0 183.0 183.0 183.0

Real interest ratesConsumer price index (% change) 44.7 35.4 24.3 15.2 8.6 4.2 5.8 4.7 4.5GDP deflator (% change) 41.6 42.0 26.4 17.7 10.7 7.2 5.4 4.5 4.0

a. GDP at market pricesb. "GNFS" denotes "goods and nonfactor services."c. Includes net unrequited transfers excluding official capital grants.d. Includes use of IMF resources.e. Consolidated central government.f. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation.

45

CAS Annex B8 - Uruguay

Status of Bank Group Operations (Operations Portfolio)

ClosedProjects 29

Difference BetweenLast PSR Expected and Actual

BoardDate Supervision Rating b/ Original Amount in US$ Millions Disbursements a/

Fiscal DvlpetIpeettoYear Active Projects Devel Pe o IBRD IDA Cancel. Undisb. Orig. Frm Rev'd

Obiectives Progress

1994 P008171 BASIC ED QUAL IMPRV HS HS 31.5 0 0 5.99 3.19 01994 P008173 IRRG NAT RES MGMT S S 41 0 0 11.33 11.33 01995 P008161 HLTH SCTR DEVT S S 15.6 0 5 2.52 7.52 1.77

4- 1996 P008177 POWER TRNMSN & DISTR S S 125 0 0 101.56 64.26 0(ON 1997 P039203 FOREST PROD.TSP S S 76 0 0 60.48 30.48 0

1999 P041994 EDUCATIONII S S 28 0 0 21.1 4.8 01999 P049267 TRANSPORT II S S 64.5 0 0 39.45 0.35 0

a. Intended disbursements to date minus actual disbursements to date as projected at appraisal.

ANNEX V

CAS Annex B8 (IFC) for Uruguay

UruguayStatement of IFC's

Held and Disbursed PortfolioAs of 8/31/99

(In US Dollars Millions)

Held Disbursed

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic

1985/92 Azucitrus 0 0 0 0 0 0 0 01995 Consorcio Aerop. 3.2 0 4 7.27 3.2 0 4 7.271991 GranjaMoro 1.78 0.75 0 0 1.78 0.75 0 01989 Migranja 3.3 2 0 0 3.3 2 0 0

1980/88/96 Surinvest 0 0 4.9 0 0 0 4.9 0

Total Portfolio: 8.28 2.75 8.9 7.27 8.28 2.75 8.9 7.27

Approvals Pending CommitmentLoan Equity Quasi Partic

47

ANEX VI-1-2Uruguay at a glance - 9/21/99

Latin Upper-POVERTY and SOCIAL America middle-

Uruguay & Carib. income Developmentdiamorld1998Population, mid-year (millions) 3.3 502 588 Life expectancyGNP per capita (Atlas method, USS) 6,180 3,940 4,860GNP (Atlas method, US$ billions) 20.3 1,978 2,862 T

Average annual growth, 1992-98

Population (Y.) 0.7 1.6 1A4Labor force (') 1.1 2.3 2.0 GNP I Gross

per! primaryMost recent estimate (latest year available, 1992-98) capita enrollment

Poverty (% of population below national poverty line) -Urban population (5A of total population) 91 75 77Life expectancy at birth (years) 74 70 70Infant mortality (per 1,000 live births) 16 32 27Child malnutrition (% of children under 5) 4 8 ,. Access to safe waterAccess to safe water (%6 of population) 89 75 79Illiteracy (% of population age 15+) 3 13 11Gross primary enrollment (% of school-age populalion) 109 113 108 ] Uruguay

Male 109 .. -. -- Upper-middle-income groupFemale 108 .. _

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1977 1987 1997 1993 Economic ratios*

GDP (US$ billions) 4.1 7.3 20.0 20.8Gross domestic investmentUGDP 21,5 14.3 12.8 15.8 TradeExports of goods and services/GDP 19.9 21.6 22.6 21.9Grossdomesticsavings/GDP 18.7 16.7 12.5 15.3Gross national savings/GDP 17.2 12.7 11.9 14.6 T

Current account balancelGDP -4.1 -7.0 -1.4 -1.9 .onsiInterest payments/GDP 1.5 3.7 1.7 1.6 omescInvestmentTotal debt/GDP 27,0 58.6 33.3 32.8 Savings nvTotal debt service/exports 36.1 36.5 15.6 -Present value of debtVGDP .. .. 32.1

Present value of debtVexports .. .. 133.3 -

Indebtedness197747 1998-98 1997 1998 1999-03

(average annual growth)GDP -0.3 3.7 5.1 4,5 4.0 UruguayGNP per capita -1,5 3.2 4.2 3.2 3.3 Upper-middle-income groupExports of goods and services 3.3 8.2 13.1 1.6 8.0

STRUCTURE of the ECONOMY

1977 1987 1997 1998 Growth rates of outpiut and investment 1%)(%6 of GDP) 40

Agriculture 16.1 13.7 8.5 8.5 301Industry 31.9 35.8 27.1 27.5 2.

Manufacturing 25.1 28.9 18.3 17.8 o0Services 52.0 50.5 64.4 64.0 10

Private consumption 68.5 70.0 73.8 71.0 s0 ii 94 95 9 97 98

General govemment consumption 12.7 13.2 13.7 13.7 GDI e GDPImports of goods and services 22.7 19.2 22.8 22.5

1977-87 1988-98 1997 1998 Growth rates of exports and imports (%)(average annual growth)Agriculture 0.8 4.1 -1.2 5.6 30

Industry -14 0.9 5.5 5.3 20

Manufacturing -1.3 -0.1 5.8 2.3Services 0.3 5.0 6.1 3.9 10

Private consumption -0.4 5.2 6.0 3.8 oGeneral government consumption 2.6 2.2 2.8 3.3 9 03 94 95 96 17 9aGross domestic investment -8.3 9.2 7.1 31.3 -10Imports of goods and services -1.5 12.6 13.2 9.0 Exports - ImportsGross national product -0.9 4.0 5.0 3.9

Note: 1998 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

48

ANN VI

2-2Uruguay

PRICES and GOVERNMENT FINANCE1977 1987 1997 1998 Inflation (%)

Domesfic prices 8

(% change)Consumer prices .. 96.7 19.9 10.83 r0lmplicitGDPdeflator 55.6 72.8 17.7 10.7 40-

Government finance 20

(% of GDP, includes current grants)Current revenue .. 16.3 20.3 20.7 93 94 95 96 97 98

Current budget balance .. 0.5 0.2 0.9 GDP deflator 0F1Overall surplus/deficit .. -1.3 -1.8 -1.5 1

TRADE

(US$ millions) 1977 1987 1997 1998 Export and import levels (USS millions)

Total exports (fob) .. 1,182 2,726 2,769 4,000

Wool .. 257 729 823Meat .. 99 478 440 3,000

Manufactures .. 623 1,224 1,244Total imports (cif) .. 1,142 3,716 3,808 200 i i i i I

Food .. 93¶00Fuel and energy 176 492 512Capital goods ., 341 1,314 1,406

Export price index (1995=100) .. 76 95 94 92 93 94 9S 9S 97 98

Import price index (1995=100) .. 109 100 94 eExports uImportsTerms of trade (1995=100) ,, 70 95 100

BALANCE of PAYMENTS

(US$ millions) 1977 1987 1997 1998 Current account balance to GDP ratio (%)

Exportsofgoodsandservices 808 1,589 4,217 4,225 0

Imports of goods and services 914 1,804 4,386 4,507Resource balance -106 -214 -169 -282

Net income -68 -307 -193 -185 'E l'Net current transfers 7 8 74 67 -2

Current account balance -167 -513 -287 -400

Financing items (net) 334 597 618 762Changes in net reserves -167 -84 -330 -362 -4

Memo:Reserves including gold (USS millions) .. .. 2,149 2,511Conversion rate (DEC, locaWIlS$) 4.68E-3 0,2 9.4 10.5

EXTERNAL DEBT and RESOURCE FLOWS1977 1987 1997 1998

(USS millions) Composition of total debt, 1997 (US$ millions)Total debt outstanding and disbursed 1,105 4,299 6,652 6,831

IBRD 76 301 393 488 393

IDA 0 0 0 0

Total debt service 296 618 742 1901lBRD 14 45 96 0 3

IDA 0 0 0 0 315

Composition of net resource flowsOfficial grants 0 3 7Official creditors -19 72 189Private creditors 85 164 471Foreign direct investment 66 45 113 164Portfolio equity 21 13 174 419 3191

World Bank programCommitments 0 105 201 193 A-IBRD E-BilateralDisbursements 4 63 50 144 B-IDA D- Other multilateral F - PrvatePrincipal repayments 8 25 68 64 C - IMF G -Short-termNetflows -4 38 -18 80 I_1Interest payments 6 20 28 28Net transfers -10 18 -45 52

Development Economics 9/21/99

49