Moody s Baa2 / S&P BBB / Fitch BBB- 1 Economy: Agriculture 7%, Industry 27%, Services 66%

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1 Uruguay Summary Moody s Baa2 / S&P BBB / Fitch BBB- 1 Economy: Agriculture 7%, Industry 27%, Services 66% Uruguay is a small open economy with strong institutions and one of the highest GDP-per-capita measures in emerging markets. Prudent government policies and a favorable global macroeconomic backdrop resulted in years of strong growth, but output has moderated during the slowdowns in neighboring Argentina and Brazil. Uruguay s economy is driven by consumption, which accounts for 81% of GDP. Most of the country s exports are agricultural products, exposing Uruguay to global commodity prices. Uruguay is also susceptible to global credit conditions as nonresidents hold a relatively high share of public debt. The country faces several additional challenges, including persistent inflation and fiscal imbalances. However, as an oil importer, the drop in oil prices has benefited its economy. Characterized by strong governance and adherence to the rule of law, Uruguay s progressive policies contribute to its political and social stability. Economic Indicators F 2018F Population (Millions) GDP per Capita (USD) 16,762 16,592 15,382 15,091 16,481 16,917 Nominal GDP (USD Billions) Real GDP (%) Year-End CPI (%) Fiscal Balance (% of GDP) Interest (% of Revenues) FC Debt/Public Debt (%) Government Debt (% of GDP) Government Debt (% of Revenue) Current Account (% of GDP) FDI (% of GDP) External Debt (% of GDP) Foreign Reserves/External Debt (%) Foreign Reserves (Mo. of imports) Foreign Reserves (% of GDP) As of November Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Lazard, Bloomberg, Central Bank of Uruguay, IMF, Ministry of Economy and Finance, National Statistics Institute 449

2 Lazard Emerging Markets Debt Rating History Below is a history of the country s foreign and local currency ratings by the major agencies dating back to We have also included a chart of the country s hard currency external debt spread and the JP Morgan EMBI Global Diversified Index spread for comparison. Rating History Hard Currency Local Currency BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C D BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC Moody s S&P Fitch Moody s S&P Fitch As of December Performance represents past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Fitch, Moody s, Standard and Poor s Bond Spreads 1000 Local Yield Uruguay EMBIGD Uruguay GBI-EM Global Div As of December Performance represents past performance. Past performance is not a reliable indicator of future results. Source: JP Morgan 450

3 Uruguay Strengths Political Stability, Policy Continuity, and Institutional Strength Political stability and continuity of sound economic policies are Uruguay s hallmarks, with centrist economic policies pursued regardless of the political party in power. This pattern was demonstrated most recently by former president José Mujica, who continued the orthodox economic policies of his predecessor, Tabaré Vázquez. Although both presidents are members of the broad Frente Amplio political coalition, Mujica had a more leftist political orientation than the more centrist Vázquez, who left office in March 2008, with a record approval rating of 80%. Vázquez was re-elected in November 2014 to a new five-year term that began in March The Frente Amplio coalition has controlled the Uruguayan presidency since 2005, and Vázquez has continued his political coalition s policies during his second term. Uruguay has a strong institutional framework, ranking highly on a number of indicators including governance, democracy, economic freedom, and transparency. 2 Uruguay also has a relatively low level of poverty and inequality, a high level of education, and a life expectancy that is among the highest in the region. These factors are conducive to the country s favorable investment and business climate. Domestic and foreign capital are treated equally, the tax system is neutral toward foreign investment, and there are no limits on capital repatriation or the transfer of profits. Decoupling from Argentina and Brazil Uruguay is a small and open economy, surrounded by the two larger economies of Argentina and Brazil. Traditionally, strong financial and trade links among the three have left Uruguay vulnerable to downturns of these larger neighbors. Uruguay suffered an economic collapse in 2002 that was caused largely by its overreliance on Argentina. Since then, the Uruguayan authorities have taken steps to protect the country from the misfortunes of its neighbors. In 1995, one-third of Uruguay s exports were shipped to Brazil; this ratio had dropped to 14.8% by The share of exports to Argentina fell from 12.6% to 5.1% over the same period. 3 Similarly, in the financial sector, the proportion of nonresident deposits, which were traditionally dominated by Argentine holders, fell substantially from a peak of 40% in 2001 to about 14% in However, tourism from Argentina and Brazil remains strong: of the 3.0 million visitors annually, Argentines account for 58% and Brazilians another 14%. 5 Well Positioned for an External Shock with Proactive Liability Management Foreign direct investment (FDI), which averaged 4.8% of GDP between 2010 and 2014 before declining in recent years, has been a source of stable and diversified financing for Uruguay s current account deficit. Uruguay recently signed an agreement with Finnish company UPM for construction of a third pulp mill, which should result in greater FDI in the coming years. The country is further protected from external shocks by its stock of nearly US$16 billion of foreign exchange reserves, amounting to approximately 30% of GDP and 14 months of imports of goods and services. 6 Uruguay can also draw upon contingent credit lines, roughly 4.5% of GDP from the World Bank, Inter-American Development Bank, Corporación Andina de Fomento, and the Fondo Latinoamericano de Reservas. The Uruguayan government has actively and prudently managed its debt by reducing its share of foreign currency debt, extending its maturity, and increasing the proportion of fixedrate loans, thus reducing interest rate risks. Uruguay s public debt stock is projected to slowly 451

4 Lazard Emerging Markets Debt decline in the coming years; about three-fourths of this stock is central government debt with an average maturity of nearly 15 years, and more than half is denominated in local currency. Central bank debt accounts for nearly 20% of the stock of public debt, 85% of which is peso-denominated, and most is short-term debt with maturities of less than one year, issued to sterilize the accumulation of reserves. The debt of public enterprises amounts to less than 20% of all public debt. Despite these strengths, 46% of Uruguay s public debt is held by nonresidents, leaving the country vulnerable to rapid outflows in the event of deterioration in either domestic or global financial conditions. 7 Weaknesses Structural Inflation and Ineffective Monetary Framework Despite the country s sound macroeconomic management, Uruguay has the dubious distinction of consistently having the third-highest inflation rate in Latin America, after the poorly managed economies of Argentina and Venezuela, and this persistent inflation is one of the country s key vulnerabilities. Price pressures have been fueled in recent years by the government s loose fiscal policy and a sharp currency depreciation since mid Inflation in Uruguay is also a structural problem as wages are widely indexed each year to the expected inflation rate. This indexation creates a negative feedback loop via two channels: price shocks are amplified in the economy and not absorbed by any specific population, and many sectors of the economy anticipate rising labor costs and attempt to maintain their profit margin by raising prices as a precautionary measure. Salaries are increasing at a faster rate than productivity, which over the longer term will undermine Uruguay s competitiveness. Since introducing an inflation-targeting regime in 2007, the central bank has missed its target most years, thus eroding the credibility of the monetary authority and compounding the inflation problem, as expectations are not properly anchored. Efforts to reduce inflation have also been complicated by the introduction in mid-2013 of a new monetary policy framework targeting money supply growth rather than traditional inflation-targeting regimes, which are more transparent and thus more successful at influencing inflation expectations. The government has responded to these inflationary pressures with ad-hoc measures such as price agreements, temporary tax cuts, and aggressive exchange-rate intervention to stem the inflationary peso depreciation. However, a shift to a more sustainable low-inflation environment would require fiscal tightening, which is difficult to implement during a period of slow economic growth. Vulnerability to Commodity Price Fluctuations Uruguay is exposed to the volatility of global agricultural prices as well as poor weather and pest problems because agricultural commodities account for two-thirds of exports. 8 Uruguay is also vulnerable to the slowing economic conditions of its principal trading partners, which include China, Brazil, Argentina, and Venezuela. In the past, growth and commodity prices have been highly correlated because declining commodity prices presented a dual shock to Uruguay: the agriculture sector would be adversely affected by falling prices, and trade with Argentina would suffer because Argentina also a commodity exporter would experience a slowdown as well. Uruguay has been working in recent years to diversify its export base in terms of both products and markets. A pulp mill in operation since 2008 has annual exports estimated at US$700 million per year. A second mill that was Uruguay s largest investment project, valued at US$2 billion, began operations in June This facility also exported an estimated US$700 million in 2015, equal to about 1.3% of GDP. 9 Uruguay exported 2.5 million tons of pulp in 2016, making it the third-largest pulp exporter in the 452

5 Uruguay world. 10 Construction will soon commence on a third pulp mill, which will result in foreign investment equal to 7% of GDP, the largest in Uruguay s history. 11 In addition, Uruguay s legislature has approved guidelines for large-scale iron ore mining projects that are expected to boost investment as well as export and fiscal revenues in the medium term. Dollarization of the Banking System Dollar-denominated deposits account for 80% of all bank deposits, and this poses potential risks for Uruguay. 12 Foreign currency-denominated loans to borrowers in the nontradable sector, i.e., borrowers with peso-denominated revenues who might experience difficulty servicing their dollar loans in the event of a sharp currency depreciation, have increased as a share of total credit, exposing the banking sector to potential currency mismatch risks. In addition, a rapid withdrawal of dollar deposits in response to deteriorating domestic or global financial conditions could potentially result in a credit crunch for the Uruguayan banking system. Moreover, the high dollarization rate has reduced bank profitability, owing to low interest rates on dollar assets and high operating costs. Finally, high dollarization can reduce the effectiveness of monetary policy actions; this has clearly been an issue in Uruguay. Despite these risks, dollar deposits continue to exceed dollar loans by a comfortable margin. 13 Monetary and Exchange Rate Policy Inflation/Monetary Policy The Central Bank of Uruguay s (BCU) main objectives focus on obtaining price stability to contribute to economic growth and employment, regulating and supervising the payment and financial systems in order to promote the development of a sound, solvent, and efficient system. The BCU has five directors with terms that coincide with the president of the republic and are appointed by him. The bank follows an inflation-targeting regime, with the target range (currently 3% 7%) set by the Macroeconomic Coordination Committee. The means of payment, defined as the extended aggregate M1, are the variables of reference for policy implementation. The monetary policy seeks to grow this aggregate consistent with the inflation target and with money demand. The monetary policy actions are taken by the Monetary Policy Committee (COPOM) which uses open market operations (i.e., injecting liquidity by lending through repos or absorbing it by borrowing from the market) so that the primary money offer monetary base reaches levels that are consistent with M1 s indicative trajectory defined by the board. The BCU bills are the main tool. Uruguay has a dual monetary system; hence, the BCU also sets reserve requirements for USD liabilities, and regulation for foreign exchange borrowing and lending. The 12-month headline CPI printed at 6% in October. Real wage gains have bottomed out, reaching 2.5% in July, versus 0.5% in Inflation expectations for the next twelve months are at 6.7%, with an increase in the second half of the year. Inflation is expected to stay around 6% through the first quarter of 2018, but steadily accelerate towards the top of the range (i.e., 7%) by the end of Demand pressures are mixed with real wage growth trending up, while the unemployment rate at 7.5% remains in line with the post-global financial crisis average and credit growth has been subdued. The BCU eased monetary conditions throughout. The M1 growth jumped to 14% in from 3% in A focus on subdued credit growth could prompt further easing in 2018, despite higher inflation. 453

6 Lazard Emerging Markets Debt Exchange-Rate Policy Uruguay has adopted a managed float exchange-rate regime since The BCU intervenes discretionarily in order to smooth the volatility in the foreign-exchange market. The US dollar mostly serves as a store of value for Uruguayans, while the peso serves as the main medium of payment and unit of account. Dollarization is pervasive in Uruguay, with US dollar deposits around 74% in October. The country s basic balance surplus increased from 0.5% of GDP in 2016 to 1.5% in. FDI outflows were slightly up at 0.7% of GDP, in comparison to 0.3% in the previous year, while current account surplus widened to 2.1% of GDP, up from 0.9% in Improvements in the service balance surplus are mostly responsible for the change, whereas the trade balance deficit and income account outflows were steady throughout the period. Financial account inflows remained skewed towards portfolio inflows and short-term flows. FDI outflows were 0.7% of GDP, while portfolio inflows and other investments were 0.9%. Errors and omissions also accounted for a large outflow, roughly 3.3% of GDP. International reserves were at US$15.7 billion in. Following the global financial crisis, the US dollar versus the Uruguayan exchange rate reached a high at in March Over a 12-month period through November, USD-UYU has traded in a wide range. The USD-UYU real effective exchange rate (REER) is currently 7% higher than its 10-year historical average. 454

7 Uruguay Inflation 30 USD/UYU Inflation Policy Rate As of December Source: Bloomberg REER REER Median since Dec 1999 Median last 10 yrs Median last 5 yrs As of December Source: Lazard, JP Morgan 455

8 Lazard Emerging Markets Debt Country Background Size 176,215KM 2 (92nd) Capital Montevideo Population 3.4 Million Religion Catholic 47.1%, Protestant 11.1%, Nondenominational 23.2%, Agnostic 17.2%, Other 1.4% Median Age 35.0 Years Literacy Rate 98.5% Independence 25 August 1825 Political System Presidential Republic Government Leadership President Tabaré Vázquez Next Election 2019 Legislative Branch Bicameral General Assembly Economy Agriculture 6.8%, Industry 27.4%, Services 65.9% Labor Force Agriculture 13.0%, Industry 14.0%, Services 73.0% Merchandise Exports Beef, Soybeans, Cellulose, Rice, Wheat, Wood, Dairy Products, Wool Export Partners Brazil 16.4%, China 12.2%, United States 6.2%, Argentina 5.0% Currency Uruguayan Peso (UYU) As of November Source: CIA 456

9 Uruguay Country Timeline 1828 Brazil and Argentina renounce claims to territories which become the Eastern Republic of Uruguay Civil war between Blancos, or Whites - the future conservative party - and Colorados, or Reds the future liberals Campaign by Tupamaros guerrillas begins and lasts until Armed forces seize power and promise to encourage foreign investment, but usher in a period of extreme repression during which Uruguay becomes known as the torture chamber of Latin America and accumulates the largest number of political prisoners per capita in the world Army and political leaders agree on return to constitutional government and the release of political prisoners; law grants amnesty to members of the armed forces accused of human rights violations during years of dictatorship; Julio Maria Sanguinetti becomes president Emergency measures, including tax increases, are announced by President Batlle in an effort to prevent Argentina's financial crisis from spilling over the border. Government orders banks to close for almost a week to stop mass withdrawal of savings. General strike held in protest at economic crisis World Bank approves loans worth more than $250M. Voters in referendum reject plans to open up state oil monopoly to foreign investment Left-winger Tabaré Vázquez wins presidential elections, marking a dramatic political shift President Vázquez restores ties with Cuba, signs an energy deal with Venezuela, and announces a welfare package to tackle poverty Uruguay pays off its billion-dollar debt to the International Monetary Fund A new parliament of South America s leading trading block Mercosur is inaugurated in the capital Montevideo President Vázquez announces discovery of what could be large natural gas field off Uruguay s Atlantic coast The Supreme Court rules that a law shielding officials of the last military government from prosecution for human rights abuses is unconstitutional. Former military ruler Gregorio Alvarez is sentenced to 25 years in prison for murder and human rights violations. Ruling Broad Front coalition wins parliamentary election. Former leftist rebel-turned-moderate José Mujica of the governing Broad Front wins presidential election Tabaré Vázquez wins the presidency in the second round of voting. Source: BBC 457

10 Lazard Emerging Markets Debt Notes 1 As of November. 2 World Economic Outlook Database, International Monetary Fund, October 2016, external/pubs/ft/weo/2016/02/weodata/index.aspx. 3 As of Source: Economic Indicators, Debt Management Unit, Ministry of Economy and Finance, Uruguay Ministry of Finance, June 2016, 4 Tabaré Vázquez Cierra su mandato con record histórico de apoyo popular: 80%, 22 December 2009, La Red 21, accessed on 4 December 2015, 5 Uruguay is ranked 21st of 167 countries: Corruption Perceptions Index 2015, Transparency International, 52 nd of 188: Human Development Report 2014: Sustaining Human Progress, United Nations Development Programme, and 23 rd of 180: 2015 World Press Freedom Index, Reporters Without Borders, 6 Anuario Estadístico: 2015, Instituto Nacional de Estadística, 7 Uruguay: 2016 Article IV Consultation, International Monetary Fund, IMF Country Report No. 16/129, May 2016, pdf/4a6c35b3-eab1-4bf4-9fe1-e97ea36555b0. 8 Anuario Estadístico: 2015, Instituto Nacional de Estadística, 9 As of September Source: Bloomberg and Lazard estimates. 10 Uruguay: Staff Report for the 2014: Article IV Consultation, International Monetary Fund, IMF Country Report No. 15/81, March 2015, 11 Ibid. 12 Ibid. 13 Ibid. 458

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