Statement by Javier Silva-Ruete, Alternate Executive Director for Peru and Carlos Pereyra, Advisor to Executive Director

The staff report for the First Review Under the Stand-By Arrangement and Requests for Waiver of Performance Criterion and Waiver for Nonobservance of Performance Criterion highlights Peru’s policy discussions and staff appraisal. A draft law was prepared with a view to establishing sanctions for noncompliance with the law’s fiscal deficit target. Monetary policy continues to be managed prudently within the inflation-targeting framework. The central bank expects dollarization to gradually decline as a result of sound economic policies and strong bank supervision.


The staff report for the First Review Under the Stand-By Arrangement and Requests for Waiver of Performance Criterion and Waiver for Nonobservance of Performance Criterion highlights Peru’s policy discussions and staff appraisal. A draft law was prepared with a view to establishing sanctions for noncompliance with the law’s fiscal deficit target. Monetary policy continues to be managed prudently within the inflation-targeting framework. The central bank expects dollarization to gradually decline as a result of sound economic policies and strong bank supervision.

1. Adherence to the program under the Stand-By Arrangement continues to result in strong economic performance. Growth has accelerated beyond projections, inflation is expected to remain within the annual target, and progress has been made to further diminish vulnerabilities. All end-September quantitative performance criteria were met. The authorities’ reform program stresses the need to enhance competitiveness and improve the business climate, with the aim of ensuring sustained and equitable growth and facing the demands arising from greater trade openness. Delays in reform implementation are due solely to unexpected or technical factors—as explained in the authorities’ request to reschedule the 2004 structural performance criteria—but the authorities’ commitment remains intact. The domestic political debate is considerable, but the authorities’ determination to push ahead with consistent policies is proving to have a much greater impact on market confidence. The recent approval by Congress of a constitutional amendment for the elimination of the preferential public pension regime reflects their ability to muster consensus around the main features of the reform program.

Macroeconomic Developments

2. GDP growth has exceeded program projections, and is now expected to be at least 4.5 percent for the year. The pickup in economic activity continues to be led by strong private investment and exports—with estimated growth rates of 6.5 percent and 17.8 percent, respectively, in the third quarter. Greater productive capacity and a growing presence in foreign markets enhance Peru’s potential for broad–based, sustainable growth, free of inflationary and balance-of-payments pressures. Investment has grown steadily since the second half of 2002 on the back of important mining and energy projects, increasing corporate profits, and lower financial costs. Global recovery and favorable terms of trade continue to boost commodity exports—mainly mining products—and textile exports are expanding at unprecedented rates—35.7 percent year-on-year in the third quarter, in dollar terms.

3. The authorities remain committed to improving fiscal performance and strengthening debt sustainability. The balanced fiscal result as of September (-0.2 percent of GDP) is explained by buoyant collection performance associated with the level of economic activity, the continuation of administrative improvements—mainly the extension of the withholding tax system to a wider range of products and to imports—and tax measures introduced since the second half of last year—including the tax reform completed in early 2004. On the expenditure side, wages in the education sector and social expenditures increased above initial projections, but were offset, among other factors, by delays in the devolution of functions to sub–national governments. Measures to secure implementation of the latter will contribute to reverting the overperformance towards the end of the year, but the fiscal target of 1.4 percent of GDP will be achieved comfortably, and the 3 percent limit for real expenditure growth established in the Fiscal Responsibility and Transparency Law (FRTL) will be respected. The authorities’ medium–term macroeconomic framework envisages a decline in the fiscal deficit as a percentage of GDP to 1 percent in 2005, 0.9 percent in 2006 and 0.7 percent in 2007, and public debt would decrease from 45 percent of GDP in 2004 to around 39 percent in 2007.

4. Peru has maintained access to international capital markets, and sovereign spreads remain among the lowest in the Latin American region. Progress in public finances and a level of international reserves well above program projections—2.5 times short-term debt—have contributed to this positive outlook. In October, Peru issued a ten-year bond for 650 million euros—Peru’s first in the euro–denominated market—with the aim of diversifying and increasing demand for Peruvian paper and completing financing needs for 2005. In order to reduce rollover and currency risks, the authorities continue to expand placements in longer–term local currency instruments through the primary dealer system initiated in March 2003. Thanks to greater market confidence, they are succeeding in extending maturities and flattening the yield curve for local–currency paper. As part of their strategy to improve Peru’s debt profile, the authorities’ are also considering a plan to pre–pay Paris Club creditors.

5. The inflation targeting framework adopted in 2002 aims at a 2.5 percent medium–term inflation target within a ± 1 percent range, in the context of a floating exchange rate regime. Supply shocks, mainly increases in world oil prices and weak agricultural crops, generated a rise in inflation. Given the temporary nature of these pressures, the monetary authorities maintained their policy stance until July. However, in August and October they increased the central bank’s reference interest rates to ensure meeting the inflation target in the medium–run through the reduction of monetary stimulus. Inflation has decreased to rates close to zero in the last three months, and twelve–month inflation is expected to converge to the upper bound of the target range (3.5 percent) at end-2004. The authorities are confident to bring inflation back to the mid-point (2.5 percent) in 2005.

6. Favorable balance of payments developments—mainly high international prices and growing export volumes—in addition to improving investor sentiment towards emerging markets and decreasing dollarization of the financial system, resulted in a clear appreciatory pressure on the currency since mid–2004. In this context, central bank interventions in the foreign exchange market were limited to those needed to confront excessive exchange rate volatility, without an implicit or explicit commitment to any given exchange rate level. This year the nominal exchange rate has appreciated by 5 percent, consistent with the favorable external accounts. Forex intervention has also contributed to increasing international reserves and thus reducing the probability of financial volatility in the runup to the next electoral period. The monetary policy setting has been instrumental in maintaining a stable interbank rate and in promoting bank intermediation.

Structural Reforms

7. The concession of a major copper project was successfully completed in August, and currently the authorities are pressing forward to bridge Peru’s significant infrastructure deficit. They will continue to explore innovative financial mechanisms to enhance public investment in a way that is fully consistent with fiscal targets and debt sustainability, and that ensures economic and social spillover effects on the economy, in line with the declaration issued on November 5, 2004 at the 18th Summit Meeting of Heads of State and Government of the Rio Group. The authorities also expect that the final report of the mission on public investment and fiscal policy will include an assessment of the long-term impact of infrastructure investment on fiscal accounts and output, as well as a deeper analysis of state-owned enterprises.

8. Crucially, the authorities will continue to promote greater private sector participation in this field:

  • The authorities have called for bids to award in concession the operation and maintenance of several airports and have completed the legal and regulatory process for the concession of a new port terminal in 2005.

  • The award of concession contracts or the establishment of public-private partnerships (PPPs) for the construction of two main roads—an end-December performance criterion—has been delayed by a few months due to technical factors, including mandatory environmental impact assessments. Therefore, the authorities request moving it to April 30, 2005. Altogether, concessions or PPPs for a total of four major roads would be completed over the next year.

9. On November 11, 2004, Congress approved the constitutional amendment needed to phase out the preferential public pension regime (Cédula Viva)—including the establishment of a maximum pension, the closure to new entrants, and the elimination of the costly link between wage increases and pensions. Effective political coordination and an adequate communications policy paved the way for the passage of the amendment in two legislative periods, as required by law. The reform will eliminate sharp inequities among pensioners and reinforce fiscal sustainability. Additionally, a draft plan for reforming the pension regimes of the police and the military has been completed by the Ministry of Economy and Finance. Inter–ministerial discussions to further elaborate this plan are now underway and are expected to be completed by end-December.

10. Greater transparency and accountability is expected to enhance market confidence in the authorities’ commitment to fiscal discipline. A census of civil servants (end-September benchmark), which will help improve government resource management, has been completed. Also, the authorities have the intention to include sanctions in the Fiscal Responsibility and Transparency Law (FRTL) for officials responsible for meeting fiscal targets. With the aim of assessing the quality of expenditure, they are planning to put in place a system of performance indicators, which in a first stage will cover the education, health and transport sectors. They are also working towards implementing quarterly reporting of fiscal performance in 2005. These efforts are part of the strategy to create room for higher social and poverty–reduction spending over the medium–term.

11. In October, Congress approved legislation to eliminate the special wage tax (IES). Even though the tax had been gradually lowered over the last years, it continued to represent a significant labor cost. The authorities intend to offset the fiscal effect of the measure through improved VAT and income tax collections. Phasing out regional and sectoral exemptions has proved challenging, but the authorities continue to negotiate with sub– national governments and press for congressional support.

12. The authorities continue to strengthen the legal framework for decentralization. Solid progress has been made towards the implementation of the law on the certification of subnational governments’ administrative capacity by year–end. Regarding the implementation of a law clarifying shared responsibilities among the national, regional, and local governments (end-December benchmark), the authorities prefer to shift to an approach intended to secure consensus. Thus, they intend to clarify gradually such responsibilities through congressional approval of sectoral legislation or annual devolution plans and budgets. Consistent with the principles of the reform, they will adopt safeguards to avoid discontinuities in the provision of public services and will keep a close balance between resource constraints and responsibilities devolved. Adequate accountability mechanisms are crucial to ensure a gradual and fiscally neutral decentralization process, and towards this end the authorities plan to include procedures in the FRL to penalize or intervene sub–national governments that do not comply with fiscal rules.

13. The strategy to improve the business climate hinges crucially on increasing the transparency and efficiency of the legal system. Along these lines, a commercial court module to defend property rights, settle commercial disputes, and speed up contract enforcement will begin operating in December. Originally fixed as an end-September performance criterion, establishment of the court was delayed by unanticipated events—including a protracted judiciary strike. The authorities therefore request a waiver of non-observance, with a resetting to end-December.

14. In the financial sector: (i) the preparation and announcement of a plan to centralize the information of collateral registries has been delayed, but the government is committed to do so by end-December; (ii) progress is underway to ensure compliance by the Superintendence of Banks and Insurance Companies with the implementation by year-end of a system to measure currency risks; and (iii) the significant resources handled by private pension funds are critical for developing the domestic capital market. After raising the limits for private pension funds’ investments abroad from 7.5 to 9 percent last year and to 10.5 percent this year, for the moment the authorities have reservations about raising them again. The follow–up FSAP mission will further analyze the private pension system.

15. The authorities are engaged in actively pursuing regional and bilateral free–trade agreements (FTAs). Steps have been taken to further the FTA with Thailand, and Peru is part of the recent agreement between Mercosur and the Andean Community. The authorities have continued negotiations for an FTA with the U.S., and aim at completing discussions by early 2005. The FTA is expected to make permanent the benefits reaped under the Andean Trade Promotion and Drug Eradication Act (ATPDEA) with the U.S. Particularly, it will encourage export diversification and provide a platform for accelerating critical reforms geared to attract private investment.

16. The authorities are firmly committed to achieving the program’s goals. While they agree that political economy developments should be given due consideration, in their opinion there is no clear evidence of significant risks to program implementation associated with political uncertainty. Therefore, they suggest that political risks be put in proper perspective to provide a balanced assessment.

Peru: First Review Under the Stand-By Arrangement and Requests for Modification of Performance Criterion and Waiver for Nonobservance of Performance Criterion
Author: International Monetary Fund