Uruguay – small can be beautiful

After Brazil and Argentina, we continue our Market Update mini-series on South America with Uruguay. Named after the river that marks its border with Argentina, the second-smallest country of the continent is yet another by-product of the 19th century world order. Like Belgium in Europe, it was created as a buffer state to contain the hegemonic ambitions of its powerful neighbors (Brazil and Argentina in Uruguay’s case).

Until its independence, the country was a tumultuous military battleground for the then superpowers of the time. The five decades following the independence were characterized by extended periods of high tensions (and intermittent civil wars) between rural conservatives (Blancos) and urban liberals (Colorados). It is therefore remarkable how nowadays Uruguay stands out for its strong democratic governance culture, peaceful social dialogue, and commitment for sustainable economic development.

The curse of commodities

Like most of the legacy countries from the old Spanish Empire, Uruguay had its own national hero, referred to as the "the father of Uruguayan nationhood” José Gervasio Artigas, but the statesman who was the most instrumental in shaping modern Uruguay was José Batlle y Ordóñez (president from 1903-07 and 1911-15), who pioneered an era of progressivism and a broad social safety net. Inspired by his extended travels in Europe, he is known for his visionary social reforms (the most iconic ones being the abolition of the death penalty, the separation of state and church, the legalization of divorce, and the eight-hour workday), but also for the establishment of a welfare state and even an attempt to organize the executive power in a collegiate system similar to the Swiss Federal Council. Of course, some large parts of the “Batllist” reform agenda were met with fierce resistance, not only from the internal opposition (the Blanco party) but also from the foreign (mostly British) investor community. Batlle’s legacy was left on a long hibernation by the Great Depression and the ensuing 1930s Latin American wave of authoritarianism.

But the worst enemy of the economic development of a commodity-rich developing country like Uruguay can be the infamous “Dutch Disease” (a classic phenomenon when attractive commodity terms of trade bring in so much foreign capital that the currency becomes overvalued and the external debt unsustainable). Unfortunately, commodities are often a curse for developing countries. Not only do they make the economic development unstable with extended periods of debt crisis and value destruction, but they also favor endemic corruption and are an obstacle to the emergence of political rights and civil liberties. There are too many examples of this in Latin America and Africa. But Uruguay almost always managed to avoid that curse.

A multi-decade period of well-above average prosperity, mostly driven by meat and wool exports but also by import-substitution industrialization, which unraveled amidst the Great Depression when the demand for agrarian commodities shrunk, and then in the mid-1950s when the industrialization of the country met a bottleneck due to a combination of over-protectionist policies, a welfare state living beyond its means, and hazardous monetary experiments. The following 20 years of economic stagflation were aggravated by ill-implemented Batllist policies and the emergence of the far-left guerrilla group Tupamaros that ended up eroding the political stability of the country. And in 1973, Uruguay joined its neighbors in the throes of the military dictatorship and civil unrest.

Despite the notorious failures of the South American dictatorships in running their respective economies, it is fair to recognize that a couple of them managed to intermittently achieve transitory successes. One of them was the “Brazilian miracle” of 1969-73 when then finance minister Antônio Delfim Netto successfully broke the vicious stagflation circle with a massive industrialization plan. Another one would be the results achieved by the Uruguayan military regime to rein in inflation and financial liberalization of the economy between 1973 and 1981. However, let’s be clear: any of the partial, transitory successes achieved under those military regimes were dwarfed, and more than darkened, by the systemic violation of human rights (including the intensive use of torture), no political freedom and an aggravation of social inequalities. Furthermore, from a pure economic perspective, the wider trade and financial openness brought about a major banking and debt crisis in 1982 anyway. Being a small open economy, there was nowhere to hide when the Latin American debt crisis burst the whole continent in flames.

The Switzerland of South America prospers again

The return to democracy in 1985 raised a lot of hopes but it took more than 15 years for Uruguay to reduce its macroeconomic fragilities. But it worked beyond all expectations, despite a major banking crisis and a sovereign debt default in 2002 after which the country experienced almost two decades of uninterrupted, sustainable growth; something unseen since the beginning of the 20th century when the country was coined the “Switzerland of South America”. The early rebound was probably mostly a base effect after the 2002 crisis. However, a quick and drastic fiscal consolidation process, stricter banking regulations and supervision, the adoption of an inflation-targeting framework and the creation of a professional debt management office were instrumental factors of the success story, along with a tradition of peaceful social dialogue and political stability perhaps bequeathed from President Batlle y Ordóñez’s legacy. What was also vital was the rise of China as a trading partner, which reduced the impact of the external shocks from Argentina and Brazil. In addition, Uruguay’s external accounts have been benefiting from massive foreign direct investments (FDI) from Finnish paper giants UPM and Stora Enso. UPM have a eucalyptus pulp mill in operation since 2007 in Fray Bentos on the Uruguay river, and they are now developing a new one in Durazno in Central Uruguay. Stora have one near the estuary of Rio de la Plata since 2014. The future UPM 2 will bring in approximately USD 5 billion (equivalent to almost 10% of the GDP), which is simply the largest foreign investment ever made in the history of the country.

All in all, it looks like everything is fine but there are a few cracks in the walls that need plastering: a return of primary fiscal deficits, a costly state apparatus and expensive social security system, a high real-wage rigidity, and a still high level of dollarization limiting the efficiency of the monetary policy. We believe this should not be a major source of concern for investors given the strong creditworthiness of the country’s balance sheet and external accounts, especially the high level of foreign exchange reserves. But still, it remains that inflation in Uruguay is a fiscal phenomenon that is particularly complicated to tackle given the poor transmission mechanisms of the budget and monetary policies.

What Uruguay can offer to EM investors

Starting with the easy part: Uruguay is a good sovereign credit and its hard currency debt is priced as such, meaning there is barely any juice left in the credit spread paid on the external debt. Indeed, today Uruguay has the lowest EMBI spread in LATAM, even below higher-rated peers.

The local-currency debt, however, is a different story for a number of reasons:

• Investors have the choice between global nominal bonds (paying a fixed coupon) and inflation-linked global bonds; the latter offer some protection against the currency fluctuation risk. Both types of bonds are “Euroclearable”.
• Two of the global fixed-rate nominal bonds are included in the main EM local bond benchmark (JP Morgan’s GBI-EM Global Diversified Index), which ensures a decent access channel for foreign investors.
• Uruguay is one of the few investment grade countries in the world where most nominal bonds yield more than the current headline inflation (= real yields are positive).
• Another interesting aspect of the inflation-linked bonds is that the main holders are the local pension funds which guarantees a decent liquidity despite their absence from the benchmarks. They are also less prone to sudden outflows and price dislocations given the low foreign participation.
• Given the high level of FX reserves and the credibility of the central bank, the Uruguayan peso (UYU) is a lot less volatile than its regional peers – the Brazilian real and Argentine peso in particular. The stability of the currency, especially during risk-off episodes, in a way reflects the stability of the country. For a crossover investor, it is therefore a convenient way to gain exposure to the “Southern Cone” with limited volatility and drawdown risks. The only caveat is that the low volatility is also a consequence of the tiny size of the domestic securities exchange and the shallowness of the local derivative market.

As EM-dedicated investors, we like Uruguay for its sound fundamentals, the quality of the people in command, and their commitment for sustainable development (in fact, by the end of October 2021, Uruguay ranked first in JPMorgan´s ESG score across 65 EM countries). We also like the pro-business and fiscally responsible attitude of the current government. President Luis Lacalle Pou (from the Partido Nacional, legacy party of the Blancos) came into office two years ago after 15 years of the Frente Amplio (center-left) administration, and only two weeks before the Covid-19 outbreak. It did an outstanding job in managing the country out of the COVID crisis without imposing a mandatory lockdown and without losing the rein on the fiscal side. While such a virtuous combination is reflected in relatively expensive valuations in dollar debt, we still see the local debt as cheap and we especially like the long end of the nominal curve, FX-unhedged.