50250 URUGUAY Trade Reform and Economic Efficiency: Policies for Trade Promotion COUNTRY SUMMARY Background and Purpose from better resource allocation achieved through the 1974 reforms. Despite the considerable trade and Uruguay has a long history of protection dating fmancial expansion during the 1974-81 period, the back more than one hundred years. Such long expo economic collapse of 1982 provoked the suspension sure to protection in such a small country has made of a preannounced five-year trade reform program (el Uruguay a clear example of the typical consequences Programa de ReJorma Arancelaria del 1980) of of restrictive trade policies: distortionary costs planned gradual reductions of tariffs from 49 percent resulting from inefficiently allocated resources, and (unweighted average) to a basic rate of 35 percent by a loss of scale economies because of limited domestic 1985. markets. High protection of manufacturing was At the same time, a reference price system was maintained by taxing agriculture, the main activity in implemented in 1981 and a minimum export price which Uruguay has a strong comparative advantage. system in 1983. Both measures had the explicit The limits to this policy became clear throughout the purpose of protecting domestic production through post-World War II period when, on average, real the levying of input duties based on ntrigger~ prices GDP growth was less than one percent a year and per rather than on the d.f. import price. Important capita income remained nearly constant. sectors such as textiles received effective rates of In 1974, Uruguay began a sweeping reversal in protection under this system well above the nominal policies. Domestically controlled prices and interest rates: an average true tariff of 58 percent was applied rates were liberalized, quantitative restrictions were to textiles rather than the official duty of 40 percent. abolished, export taxes were removed, and a program Another important sector, automobile assembly and of tariff reductions was adopted in 1979. Through auto part production, which had not been liberalized such trade and financial reforms Uruguay hoped to in the 1970s, continued to receive exaggerated benefit from the substantial gains from trade and protection at rates approaching 100 percent in 1989 borrowing that are available to a small country from through duties and an elaborate domestic content and linking its prices and interest rates more closely to compensatory export requirement. international ones. In the trade reform, the maximum Some progress has been made since the collapse tariff rate fell from 300 percent in 1974 to 90 percent of 1982, however. Financial liberalization remains in 1979 and even lower by 1981, and mandatory successful and strong, but progress in trade liberaliza import deposits were abolished in 1975. In the tion has been more uneven. Five escalated tariff rates financial reform, interest rates were freed in 1974 were established in January 1983, ranging from a low and a system of preannounced exchange rate depreci of 10 percent on intermediate goods to a high of 55 ations known as the tabUta was adopted in 1979 to percent on final goods. A gradual lowering of the top stabilize inflation. tariff rates brought them down to 40 percent by May With the opening of the economy, capital flowed 1989. A broadening of bilateral trading agreements in, financing a construction and investment boom that with Argentina (the Convenio Argentino-Uruguayo de led to real growth in GDP averaging over 4 percent Cooperacion Economica of 1974) and Brazil (the annually from 1973 to 1981. Realized real rates of Protocoio de Expansion Comercial Uruguay-Brazil of interest, however, became unsustainably high in 1980 1975) has expanded regional trade through lowered as agents anticipated the collapse of the tabUla with bilateral protection, but in a distorted manner that the reduction in capital inflow. When interest rates promotes inefficiency. rose further worldwide in 1981 and non-petroleum Progress on trade expansion stalled in the 1980s, commodity prices fell, Uruguay suffered a debt crisis however, and the economy's degree of openness has and economic collapse of severe proportions - real reached only 30 percent in recent years, much lower GDP fell abruptly by 9 percent. tban the potential 60 percent estimated to be optimal The government's emphasis shifted toward short for an economy of the size and characteristics of term stabilization policies. At stake were the gains Uruguay. Despite further efforts at the resumption of 1 trade expansion since 1983, high true protection rates already high rate of inflation (about 100 percent a remain in important sectors such as textiles, automo year), it is urgent that Uruguay sustain contractionary biles, and sugar that amount to more than one-third fiscal measures to avoid financing the deficit through of value added in manufacturing. In addition, high monetary creation, which would seriously jeopardize transport costs and inefficient port facilities further macroeconomic stability. increase protection to domestic industries. Investment levels at about 8 percent of GOP are The macroeconomic situation of high inflation and very low, even by Uruguayan standards. These low low investment is another major obstacle to further levels are attributed to the combination of inadequate trade expansion. With the cessation of net capital protection of property rights, an exceedingly rigid inflows, increased external debt service payments structure of negotiations with labor unions, and were fmanced through trade surpluses after 1983, at adverse incentives created by the debt overhang. the expense of investment. Other obstacles, including Over a long historical period, investment levels in the perceived precariousness of property rights Uruguay appear to be determined mostly by exoge following the obligatory refinancing of internal debt nous capital inflows. Increased debt service payments under the Mandatory Refinancing Law of 1985, have have been financed almost entirely through a reduc jeopardized lending in the domestic capital market, tion in investment expenditures. except for self-liquidating loans such as export credits. In addition, the economy is plagued by labor Openness market rigidities. A Senate act is required to dismiss any civil servant who has more than six months of To determine the trade expansion effects of the service, and trade union power in the economy has trade liberalization and other reforms initiated in increased since 1985, especially in the Port of Monte 1974, the degree of trade openness (the share in GOP video, one of the most labor intensive and strike of the sum of commodity exports and imports) of the prone ports in the world. Uruguayan economy was analyzed. Openness rose It is in this context that the Uruguay government significantly after the 1974 reforms, reaching a new invited the UNOP-World Bank Trade Expansion plateau of about 30 percent of GOP. However this Program (TEP) mission to identify areas of trade ratio has not increased significantly in the 1980s reform that could lead to further expansion of trade. despite further tariff reductions after 1983 and despite The commitment to trade reform appears genuine, the need to transfer more resources abroad to service and key areas are now under study, to be followed by external debt. Comparisons with other countries of decrees implementing the trade reform measures. the same market size and with similar endowments establish beyond doubt that the Uruguayan economy Key Findings remains relatively closed. Measuring export potential by export shares of similar economies, it is estimated The report assesses the effectiveness of Uruguay's that Uruguay's export potential is about twice that trade system and the macroeconomic and microeco achieved in recent years. nomic policies that affect the efficiency of the re forms under way. The main findings are summarized Barriers to Trade Expansion below. Despite a highly publicized tariff reduction Macroeconomy program that reduced the maximum tariff rate on final goods to 40 percent and tariffs on raw materials Uruguay's policy of pegging its currency to a and intermediate goods to 10-40 percent, many hid basket of foreign currencies to maintain a relatively den forms of protection remain. Also, import tariffs constant real exchange rate provides stability to the directly discourage exports by bidding resources away economy. But further tariff reductions or the disman from the export sector. This disincentive effect on tling of the reference and minimum price systems exports is estimated to be about two-thirds of the should be accompanied by devaluation of the real value of the tariff since some of the impact falls on exchange rate to ensure an export supply response. nontraded goods: that is, an import duty of 30 per Uruguay's precarious macroeconomic stability is cent is equivalent to an export tax of 20 percent. threatened by the recent law on social security Administrative (and hidden) import deterrence. benefits, which is projected to increase the fiscal Administrative protection in the form of tariff levies deficit by 2 percentage points of GOP. Given the based on a reference price or a minimum export price 2 rather than the c.i.f. import price leads to true tariffs estimates the protection afforded by this system. far higher than apparent tariffs. The true tariff is 18 Also, because the importer pays not only the duty percent greater than the apparent tariff for goods levied on the floor price but also the difference covered by the reference price system, and 7.5 between the floor price and the declared price when percent greater for goods covered by minimum the latter is lower, there is an incentive to declare a reference prices, although this latter rate vastly price at or near the floor price to avoid this extra underestimates the full extent of protection, as is charge. The minimum export price system is substan shown below. tially more protective than the reference price system Reference prices were established in 1981 in when applied, despite its apparently smaller magnifi response to the difficulty of implementing the anti cation effect. dumping and antisubsidy law ofJune 1981. Reference The system of protection that results from these prices exist for 54 types of products, particularly mechanisms is tailored to individual interests and textiles and apparel, which have 177 separate refer induces Uruguayan producers to specialize in low ence prices. The mechanism is a simple one: when quality products. This goes against Uruguay's natural the declared c.i.f. import price is less than the comparative advantage in high-quality products with reference price, the official duty is applied to the an intensive requirement for highly skilled labor. This reference price. The following example indicates the "distortion effect" of the administered price system is effect of this system on the true tariff rate: regressive in that it favors the production of cheap, low-quality goods in Uruguay while favoring the Rerereuce price example: carpets' consumption of expensive high-quality goods since reference prices apply only to imports with prices World price $3.22 Reference price $7.50 below the floor price. (This distortion effect on Duty of 40% of $7.50 $3.00 relative prices is reported in table 1.) Tariff-inclusive price $6.22 Many of the changes in incentives achieved by 15 years of tariff reduction have been eroded by the Effective duty 93% introduction of reference prices and minimum export '"NADI item 58020241, synthetic fibre, tufted. prices for imports since 1981. (This "erosion effect" of the trade liberalization program is indicated in The minimum export price system was created in table 1.) Overall, tariffs have been increased by early 1983, and now covers 75 types of imported about 5 percent for the entire tariff structure as a goods (35 of which were transferred from the refer result of this system. This impact underestimates the ence price system). The minimum export price overall degree of protection since the system also mechanism has a "moving surcharge whereby the M causes trade in products covered by the reference importer pays customs the difference between the price and minimum export price system to shrink. declared import price and the official minimum Over one-third of value added in manufactured is export price, plus the duty on the minimum export protected by these mechanisms, which particularly price, as the following example shows: affect the textile sector. Another form of administrative import deterrence Minimum export price example: automobile tires'" is achieved by the elaborate system of domestic content and compensatory export requirements in the World price $3.80 automobile industry. Importers of fully assembled Minimum export price $4.30 automobiles pay a 4O-percent tariff and must have Payment to customs $0.50 Duty of 40% of $4.30 $1.72 "compensating exports" of automobile industry prod Tariff inclusive price $6.02 ucts with a value added in Uruguay equal to 70 percent of the f.o.b. value of the fully assembled Effective duty 58% automobile. An importer of automobile assembly "kits" must pay a tariff rate of 10 percent, must '"NADI item 40110200. comply with domestic content requirements (a mini By declaring a price of $4.30, the domestic importer mum of 20 percent of the value of the product must or foreign exporter can save the $0.50 payment to be of national origin), and must have compensatory customs, so the measured effective duty might be less exports based on the f.o.b. value of the kit. With the than 58 percent. For this reason, the "magnification minimum domestic content of 20 percent, compensa effect" of minimum export prices (see table 1) under tory exports of 60 percent are required. For each 3 Table 1. Protection under the Reference Price and Minimum Export Price System, 1989 Magniflcation ef!!cl Distortion ef!!cl Erosion ef!!ct Apparent Real Before After Global Global Type of tariff tariff Difference RPIMP RPiMP Change Apparent weighted IInweighted protection (%) (%) (%) (ratio) (ratio) (%) (%) (%) (%) Reference price system 38.5 56.6 18.1 1.84 1.44 21.7 39.4 46.9 44.8 Minimum export price system 36.4 43.9 7.5 2.02 1.75 13.4 36.7 38.5 40.1 Textiles 40.0 58.3 18.3 2.72 1.89 30.5 NOle: See text for explanations of the various types of protection effects. RP is reference price system and MP is minimum export price system. percentage point increase in domestic content, com increase by an estimated one percentage point or pensatory exports required drop by two percentage more. points, so that, for example, with a 40-percent value Further protection and distortions are created by added content, required compensatory exports drop to bilateral trading arrangements with Argentina and 20 percent. Brazil. While these agreements have led to prefer In addition to being a hidden form of protection, ences for Uruguayan exports, their trade-creating this structure has the added disadvantage of being effects have been more than offset by the trade highly adapted to the interests of those engaged, diversion resulting from the purchase of high-cost directly or indirectly, in the automobile industry. imports from these trading partners, especially Evidence exists of extensive nonproductive rent Argentina. The bilateral trading arrangements may seeking and of possible extralegal activity in import have substantially retarded the resource reallocation and export declarations. The current system of expected from tariff reductions since the principal protection in the automobile industry imposes an source of export expansion in recent years has been estimated annual loss of from US$70 million to the protected neighboring markets. And fmally, the US$80 million on Uruguayan consumers. Of this arbitrary distribution of export and import rights loss, a transfer of US$32 to US$40 million goes to confers the scarcity profits to exporters and importers domestic assembly operations and components manu rather than to the government in the form of higher facturers. The annual net welfare loss to the economy revenues. is between US$18 million and US$35 million. The Labor markets. The relatively high level of cost to the consumer per car assembled is between education of the Uruguayan labor force is not exploit $6,000 and $7,000, and the net social cost is between ed to its full potential because of labor market imper $1,500 and $3,000 per automobile assembled. fections and policy-caused distortions that result in Additional hidden protection is provided by overemployment in a number of sectors. Adjustment inefficient port facilities, largely the result of labor to trade expansion may now be somewhat more union power. Retail trade margins on imported goods difficult than in the trade expansion episode of the are three to four times those for similar domestic 1970s since trade union power and social protection products (according to estimates based on national legislation have increased, particularly since 1985. accounts). Furthermore, inefficiencies and chronic During the 1974-81 liberalization experiment, there delays in transport cut into exporters' profit margins was no change in the real wage in manufacturing, but while providing protection to producers competing a slight reduction in employment (less than half a with imported products. If the trade margins of the percent). A net capital inflow and increased invest Port of Montevideo were brought into line with those ment may have cushioned the adjustment, however. of comparable countries, Uruguayan GDP would 4 Explicit and implicit labor contracts are a major mlDlmum export prices should be converted into source of rigidity in the economy. Labor market reference prices, and tighter guidelines ought to be rigidities are also a likely factor in the country's low applied to the determination of floor prices and the investment rates. Requiring a Senate bill to dismiss a filing of complaints (which currently do not require civil servant with six months of employment is proof of injury). However, this alternative suffers equivalent to granting job tenure to civil servants, from many drawbacks, including the difficulty of thus removing the risk of dismissal as a discipline on finding appropriate price levels for each specific performance. For dismissal in the private sector, the import good - the elusive concept of "world prices" employer is required to pay a severance allowance proves difficult and costly to apply in practice. And equal to one month's wages for every year of em tightening the complaint process will at most elimi ployment. For temporary layoffs, the social security nate some of the price collusion effects of the two administration pays wages for up to a six-month systems without reducing their distortionary effects. period of layoff. In sum, the threat to trade liberalization posed by the reference price and minimum export price systems Specific Recommendations can be removed only by abolishing the systems. (Firms harmed by a surge in imports of their product Trade-related measures due to unforeseen developments or tariff concessions can apply for emergency safeguard relief under Reference price and mlDlmUID export price GATT Article 19.) system. The various mechanisms of protection in Transport. The second major impediment to Uruguay lead to a system of incentives that is ex trade expansion comes from another form of hidden tremely distorted and varies widely across activities. deterrence, that created by the inefficient handling of In such an environment, further steps toward uniform trade in the Port of Montevideo. Previous studies tariffs will have little or no effect, and their benefits have established the gross inefficiency of the port are likely to be illusory. compared with other ports in developing countries. Despite the harmonization of its tariff structure, Inefficient handling of imports and the distortions Uruguay's complicated system of regulations and created by the reference price and minimum export administrative rules impedes trade expansion. Distri price systems result in trade and commerce margins bution margins on imported products are three to four for imports far higher than comparable rates for times the equivalent rates for similar domestic prod domestic products. Also, tariffliberalization is eroded ucts. The reference price and minimum export price if goods cannot be transported without considerable systems, although ostensibly aimed at protection cost, delay, and uncertainty. It is therefore essential against unfair trading practices as allowed under the that reforms of port administration be introduced to GATT, has ended up eroding the effects of the trade reduce delays and boost productivity. A positive first liberalization measures introduced since 1986. In step would be to introduce the secret vote in the particular, the system has resulted in an escalation of proceedings of the port trade union. protection in the textile and apparel sector. Automobile industry protection. The system of Given the high cost of the reference price and protection in the automobile industry must rank minimum export price systems and their other nega among the most complicated systems of regulations tive side effects (difficult to administer, loss of and requirements in the country, if not the world. government tariff revenue), the systems ought to be Because the automobile industry purchases many abolished. This can be achieved with little disruption imported inputs, the distortionary effects of the by first substituting equivalent tariffs for the adminis system of domestic content restrictions and compen tered prices, and then gradually lowering and incor satory export requirements filter through the econ porating the new tariffs in the uniform tariff struc omy. Since the industry has been protected for ture. This would improve the transparency of the decades, eliminating the system overnight would lead system of incentives, provide government revenue by to adjustment problems; these could be avoided, how mopping up the rents now accruing to importers and ever, by gradual liberalization. foreign producers, and eliminate the incentive for To cushion adjustment costs, tariffs and domestic regressive specialization (that is, in favor of low content and compensatory export requirements could quality goods). be lowered in stages over time, say five years, to If the reference price and minimum export price allow gradual adjustment. The first, and immediate, systems cannot be eliminated, then at the very least step should be to eliminate the detailed provisions 5 specifying which components must be imported as inflation, trade reform could still take place for two separate items. In the progressive dismantling of compelling reasons. First, much of the implicit "tariff existing measures, care should be taken to avoid revenue" resulting from protection is collected by phasing out domestic content and compensatory domestic automobile assemblers in the form of export requirements on kits faster than on fmished transfers or by foreign exporters under the minimum automobiles to avoid temporarily increasing the costs export price system. Some of it is lost entirely of protection. because of the prohibitive nature of some duties, as Bilateral trade agreements. The coupon mecha in textiles, or the free distribution of cupos to pre nism known as the cupo, through which export rights ferred exporters, as under the bilateral trade agree to Argentina and Brazil are allocated preferentially ments. The recommended reforms would divert some among producers, encourages the survival of outdated of these revenues to the government rather than to production patterns since companies receive the cupos rent-seeking individuals and companies. Second, the on an automatic, historical basis. lowering of implicit tariffs on trade will expand the Given the indications that the bilateral accords volume of trade. If trade is sufficiently elastic, serve to cushion the adjustments required to achieve revenues would not suffer except in the very short a more competitive domestic structure, cupos should run. be allocated on a competitive basis. Either of two Any of the trade expansion measures suggested alternative approaches could be used to achieve this above should be accompanied by a depreciation of the result: an auction system for bidding and paying for real exchange rate, to cushion the effects on employ cupos, which would force some competition and ment in industries receiving less protection and to provide government revenue; or an interim two-tier ensure an appropriate export response. auction quota system, in which one tier of the quota Trade liberalization measures should be imple allocation would depend on extraregional sales, mented before wage bargaining rounds to facilitate thereby encouraging diversification of sales beyond the alignment of real wages to the new rates of the regional market. The other tier would depend on protection. It would be desirable to establish maxi regional sales. mum authorized wage adjustments for implementation by the national wage councils. Compiemelltary measures to suppon trade expansion The disincentives to invest that result from the poorly functioning system of judicial protection of The success of reforms aimed at expanding trade property rights should be eliminated. The current depends on appropriate supporting macroeconomic extremely low levels of investment willjeopardize the policies and well-functioning labor markets. While success of trade measures taken to expand trade. macroeconomic policies in Uruguay are relatively Table 2 summarizes the recommendations for stable, at least when viewed from a regional perspec reform over the short, medium, and long term for tive, they would benefit from the extra constraints each major policy area. imposed by a more liberal and transparent trade regime. Factor markets, however, especially the labor market, are not sufficiently flexible to allow for the optimum resource allocation called for by a greater expansion of trade. Despite some current problems with stabilization measures aimed at reducing the fiscal deficit and 6 Table 2. Matrix of Short-, Medium-, and Long-Term Policy Recommendations for Trade Promotion in Uruguay Policy area Short tenn (6-12 months) Medium tenn (1-3 years) Longtenn (3-5 years) Macroeconomic policies Sustain fiscal and monetary Maintain fiscal restraint Continue fiscal restraint restraint with support of IMP and World Bank Devalue the real peso to Maintain exchange rate Continue real exchange rate compensate for trade liber competitiveness competitiveness alization Maintain an open capital Maintain an open capital Maintain open capital market and market-deter market and market-deter market and market-deter mined interest rate mined interest rates mined interest rates Set maximum wage in Ensure freely determined Ensure freely determined crease target before wage wage settlements wage settlements bargaining rounds Export incentives Restore the rebate of indi Maintain the rebate of rect taxes on exports indirect taxes on exports Devalue the real peso to Maintain exchange rate Continue real exchange rate compensate for trade liber competitiveness competitiveness alization Import regulations Convert reference and Reduce the highest protec Reduce the highest tariffs mInImum export prices to tion levels to 40% on final to a maximum rate of 30% equivalent tariffs goods Eliminate compensatory Lower duties on automo export requirements for biles and automobile kits to importers of automobiles 30% and automobile kits Harmonize all duties on automobiles and automobile kits at 30% Adopt a uniform 30 % do Reduce the domestic con Reduce the domestic con mestic content requirement tent requirement for auto tent requirement for auto for automobile kits mobile kits to 20% mobile kits to 10% in the third year, then abolish it by the end of the fifth year Reform the bilateral trade Abandon the similar nacio Adopt uniform duties on all agreements with Argentina nal concept, which bars goods from Argentina and and Brazil, including distri tariff concessions on goods Brazil bution of export rights by also produced domestically competitive bidding Eliminate the cupo system 7 Table 2. Matrix of Short-. Medium-. and Long-Term Policy Recommendations for Trade Promotion in Uruguay (cont.) Policy area Short term (6-12 months) Medium term (1-3 years) Long term (3-5 years) Trade infrastructure Privatize port activities by leasing concessions Legal framework Reform legal framework to support the enforcement of contracts and property rights Institutional export support Establish a quasi-private trade promotion organiza tion 8