Nestled between two much larger neighbors with histories of economic instability, Uruguay has long been an offshore haven for both Argentine and Brazilian capital. Although this has led to growth in certain sectors — most notably banking and real estate — it has also been a source of considerable volatility.
By the end of 2011, capital flight in Argentina hit decade highs in response to a crisis of confidence in the economic policies of former Argentine President Nestor Kirchner and current President Cristina Fernandez de Kirchner. Outflows peaked at $21.5 billion, 10 percent of which made its way across the Rio de la Plata to neighboring Uruguay.
This capital flight led to an uptick in foreign direct investment in Uruguay (it reached an all-time high of $2.6 billion in 2011) and a surge in the banking sector, where dollar-denominated deposits reached $30 billion in 2012. Capital inflow has contributed to inflation of around 8 percent and strengthened the Uruguayan peso against the Argentine peso, leading to a decline in cost competitiveness. In response, the Uruguayan government implemented price controls on a number of foodstuffs and instituted a dollar-purchasing program aiming to weaken the currency. Nevertheless, due to Argentina's own price controls and the black market exchange rate, foodstuffs are still cheaper in Argentina than in Uruguay, and Uruguayans are crossing the border to shop. This practice harms Uruguayan businesses, and as a result the Uruguayan government is trying to restrict such trade at the border.
Because of the large amount of capital leaving Argentina, Fernandez and her economic team began implementing a series of capital controls aiming to reduce capital flight in late 2011, and by August 2012 the Central Bank of Uruguay announced that it would take steps to stop capital inflows. These controls reduced capital flight from $21.5 billion in 2011 to $3.4 billion in 2012, although capital flight probably still occurs through unreported back channels.
Although these capital controls had some success, they have created numerous new problems. First, these controls, combined with a recent amnesty program aiming to repatriate foreign currency and recent developments on the black market, have at least partially reversed the status quo, with dollars now leaving Uruguay for Argentina. In the first quarter of 2013, the amount of dollar deposits in Uruguay's banking system dropped from $30 billion to $27 billion. While these outflows are still relatively small, a rapid withdrawal of dollars before further controls are in place could pose a liquidity problem for Uruguayan banks, which have a significant amount of dollar-denominated liabilities.
Second, Argentines can convert their pesos into dollars in Uruguay, paying a higher rate than the official rate in Argentina (5.3 pesos to the dollar) due to fees but still considerably below the black market rate in Argentina (8.5 pesos to the dollar). This mechanism helps keep in check the spread between the official and unofficial exchange rate.
Finally, some people are taking advantage of arbitrage opportunities by bringing dollars from Uruguay into Argentina, selling them on the black market for pesos, and either spending the pesos in Argentina or converting the pesos back into dollars in Uruguay at the official rate and pocketing the difference.
Risks to the System
These facts are troubling for Uruguay because just more than a decade ago, the country went through a similar process that culminated in a massive financial crisis. In the lead-up to that crisis, which began in 1998 and caused gross domestic product to contract by more than 50 percent over five years, Uruguay had weak public banks, high foreign currency indebtedness and a sluggish economy due to real exchange rate appreciation with major trading partners. While neither Argentina's nor Uruguay's economy is at the crisis point — in both countries, banks are healthier and foreign debt is lower than in the 1990s — Uruguay is watching Argentina nervously.
One of the most persistent problems for Uruguay's offshore banking sector is a high level of dollarization — essentially, the percentage of the financial sector's deposits and loans that are dollar-denominated. Uruguay's dollarization is approximately 70 to 80 percent. Dollarization is extremely risky for Uruguay because it limits the central bank's ability to serve as a lender of last resort for its financial system. Because the central bank cannot print dollars, it must use its foreign currency reserves to bolster the financial system when faced with a liquidity crisis. And when these reserves are no longer sufficient to both pay off foreign debt obligations and support the domestic financial system, the country must rely on an outside body — likely either the United States or the International Monetary Fund — to provide support.
In December 2001, when Argentina imposed capital controls and a deposit freeze known as the "corralito," Argentines flocked to Uruguay to take their money out of the Uruguayan banks. From January 2002 until January 2003, foreign currency deposits in the banking system fell from $60 billion to around $14 billion. Uruguay's two main domestic private banks — Banco Galicia Uruguay and Banco Comercial — were the first to begin facing liquidity issues. Both banks' business models focused on taking Argentine deposits and reloaning those deposits to Argentine borrowers. With borrowers defaulting and depositors pulling out, by January 2002 both banks exhausted their liquidity and faced collapse. Ultimately, the government stepped in to prevent contagion by either encouraging or assisting with mergers or buying and recapitalizing the troubled banks.
Prior to the 2002 crisis, Uruguay had three types of financial institutions: two large public sector banks, the domestic private sector banks and a number of foreign private sector financial institutions. All three had high levels of dollarization, but the public sector banks and the foreign private sector banks were backed by the central government and the parent companies overseas, respectively, and thus were relatively more secure than the domestic private sector banks. After the crisis, a process of consolidation began, and between 2006 and 2011, bank concentration — the assets of the three largest commercial banks as a share of total commercial banking assets — increased by around 25 percentage points.
The crisis spread in May 2002, when Uruguayan nationals began taking their money out of the public banks. At this point, low foreign exchange reserves caused by servicing mounting external debt and backing the banks' foreign currency loans compelled the government to float the currency, causing a 27 percent devaluation overnight and prompting a five-day bank holiday. Credit seized up, causing a massive gross domestic product contraction. This effectively ended the crisis but left the Uruguayan economy in ruins.
Despite its best efforts at reform, Uruguay's financial sector remains highly dollarized, which exposes it to considerable spillover risk from Argentina. Because of this, Uruguay will be more cautiously assertive with its capital controls policy. Montevideo is wary of using capital controls because it aspires to have liberalized capital markets but will do so if the situation deteriorates and threatens to significantly undermine the economy's health. In 2012 when the inflows were skyrocketing, the Uruguayan government intervened. If inflows or outflows begin to grow, the government will intervene again. This will help prevent a crisis but will not solve the underlying issue of high dollarization, which Uruguay perhaps cannot avoid but wants to keep at a manageable level.