Abstract
This paper presents the staff report for Peru’s 2008 Article IV Consultation, Fourth Review and Inflation Consultation under the Stand-By Arrangement and request for waiver of applicability of performance criteria. Peru has been liberalizing external trade through tariff reductions in past years and has also been seeking enhanced market access through new bilateral agreements. There has been progress in simplifying administrative procedures and in enacting legislation to reduce labor market informality. The economy has been moderately affected by the global financial crisis.
Introduction
1. On behalf of our Peruvian authorities, we would like to convey our appreciation to Mr. Cerisola and his team for a constructive and candid policy dialogue during the Article IV Consultation and final review of the precautionary Stand-By Arrangement. They would also like to express their gratitude to the Executive Board and Management for their support and quality advice during close to 20 years of continued Fund-supported programs. The staff report and selected issues paper provide an in-depth analysis of the strong economic performance of the Peruvian economy and the challenges ahead. Our authorities are in broad agreement with the staff’s assessment and policy recommendations. We are pleased to inform the Board that Peru does not intend to seek an additional arrangement with the Fund.
2. The resilience of the Peruvian economy has been successfully tested once again. Despite the lingering effects of the worst financial crisis in recent history and adverse external shocks, Peru’s economic growth has been among the highest in the world and inflation remains among the lowest in the region. All end-September 2008 performance criteria were met with ample margins and most structural benchmarks have also been met. Given the strong performance under the Stand-By Arrangement, the authorities request completion of the fourth and final review. They consent to the publication of the staff report.
Recent Economic Developments and Outlook
3. The Peruvian economy continues to perform well, supported by strong economic fundamentals and the authorities’ commitment to sound macroeconomic policies. Consolidating the longest economic expansion on record, real GDP growth is expected to have reached 9.1 percent in 2008, the highest since 1994, with almost every economic activity showing a good pace, in particular the construction and commerce sectors. While private consumption is broadly growing at the same pace as GDP, private investment continues to grow for a third consecutive year, above 20 percent in real terms. The strong economic growth has contributed to a further reduction in the unemployment rate to 8.4 percent, while the poverty rate has continued to decline to 39.3 percent, reflecting the improvement in the standard of living of the population. The external position remains solid with a level of net international reserves equivalent to more than four times the short-term external debt on a residual maturity basis. The consolidated fiscal sector had a surplus for the third consecutive year, about 2.0 percent of GDP in 2008, while public debt declined further to 24.0 percent of GDP.
4. The Central Bank’s anti-inflationary stance has limited the pass-through from significant increases in international food and oil prices into domestic inflation. In 2008, mostly driven by higher international food and oil prices. The monetary authority reinforced its anti-inflationary stance to ensure a gradual return to inflation and inflation expectations to the target range. Accordingly, the Central Bank increased the policy interest rate several times by an accumulated 200 bps, from 4.5 percent in June 2007 to 6.5 percent in September 2008. These decisions were complemented by increases in reserve requirements on obligations in both domestic and foreign currency. The authorities are committed to taking additional actions if required and will continue to closely monitor the evolution of international prices and domestic demand.
5. The Free Trade Agreement with the United States will come into effect shortly and similar arrangements with China, the European Union, and other countries are underway. Presidents George W. Bush and Alan Garcia put the trade deal into effect on February 1, 2009, concluding a long process of trade negotiations and good will. The free trade agreement makes the special access to the U.S. market currently enjoyed under the Andean Trade Promotion and Drug Eradication Act permanent. The current two-way trade is about US$ 10.9 billion annually. The free trade agreement is expected to encourage higher export growth and diversification, as well as accelerate reforms that will further enhance the investment climate in Peru, already benefiting from foreign direct investment at historic highs. During the 2008 APEC Summit, important progress was made towards the free trade agreements with China.
6. Looking forward, the outlook for the Peruvian economy remains favorable, despite the heightened risks stemming from the global economic slowdown. Real GDP growth is expected to reach 6.0 percent in 2009, one of the highest in the world according to the latest revised WEO. Inflation is expected to decline below 3.0 percent, returning to the Central Bank’s target range. The consolidated public sector balance will be in surplus, albeit at a lower level than previous years to allow for the automatic stabilizers to operate in full. The financial system has not been affected by the global financial crisis, as underscored by very strong financial soundness indicators, including bank liquidity and capital adequacy ratios. The authorities concur with the staff’s assessment that the current level of official reserves provides an important buffer to preserve economic growth, external stability, and poverty alleviation.
7. Nonetheless, to protect the hard-earned gains, the government has announced an “anti-crisis” plan to avoid the risk of a sudden and sharp slowdown of economic activity. The main objective of the plan is to achieve a “soft landing” by maintaining the growth momentum—within long-term sustainable levels—and ensuring an adequate liquidity level in the financial system. The Ministry of Finance has already taken actions, extending the execution of public investment projects budgeted in 2008 through March 2009 and increasing resources to the Fund for Regional and Local Public Investment. The Central Bank, in coordination with the Ministry of Finance and the Superintendency of Banks and Insurance (SBS), is evaluating policies to strengthen the framework for providing adequate liquidity to all financial entities. Additionally, actions to strengthen the prudential and regulatory framework have already been implemented. The authorities are confident that the fiscal savings allocated to finance the anti-crisis plan, equivalent to 2.5 percent of GDP, should be adequate. However, should the crisis be worse than envisaged, they are ready to take additional actions to stimulate the economy. If the fiscal savings are not enough, the government will access available financing from multilateral organizations.
Taking stock of the last two decades
8. Peru continues to be a success story, but it is fair and important to recognize that many challenges remain ahead. It has taken almost two decades of continued implementation of sound economic policies—despite temporary setbacks—and a strong political commitment to modernize the country and improve the standard of living of the population. Peru’s strong macroeconomic performance was underpinned by wide-ranging structural reforms to improve the functioning of markets, foster private sector participation, and modernize the role of the state. In the early 1990s, Peru was one of the first emerging countries to undertake a simultaneous trade and capital account liberalization, accompanied by a flexible exchange rate regime and a deep reform of the financial system. Among several important transformations aimed at enhancing external competitiveness and investor confidence, Peru modernized the civil service, reformed the labor market, strengthened the rule of Law, and revamped the judiciary system. Our authorities remain committed to prudent financial policies to preserve the hard-earned macroeconomic stability and a further deepening of structural reforms to sustain growth and entrench poverty reduction.
9. In the 1990s, while most other financially-dollarized economies chose an exchange rate anchor, Peru was the only highly-dollarized country that enforced an independent monetary policy. The strategy was based on (i) legal and effective Central Bank autonomy; (ii) enhanced monetary policy credibility through an annual inflation target—in place since 1994 and currently 2 percent, the lowest in the region; (iii) policies to address financial dollarization risks, including high reserve requirements for foreign currency deposits, preemptive reserve requirements on dollar liabilities, and foreign exchange intervention to smooth excessive exchange rate volatility without affecting the trend.
10. In the course of the current decade, inflation has been 2.3 percent on average, one of the lowest in the region. The low inflation has helped to regain confidence in the domestic currency, which has been reflected in a clearly voluntary dedollarization process. Thus, dollarization has decreased from 71 percent in 2000 to 46 percent in 2008. In addition, Peru and Mexico’s nominal bonds in domestic currency have the longest maturities in the region (up to 30 years) and provide a benchmark for private sector issuances. Access to financial markets has been enhanced by the investment grade rating received from Fitch and Standard & Poor’s last year.
Policy Issues and Objectives Going Forward
A. Surviving the Worst Global Economic Crisis Since the Great Depression
11. Financial sector contagion has been limited. Initially, Peru’s sovereign spread increased to 620 bps in late October 2008, but in December 2008 the sovereign yield curve returned to the “pre-crisis” level. The Central Bank’s decisive actions to limit market and exchange rate volatility included: (i) easing reserve requirements—previously increased to contain speculative capital inflows; (ii) the placement of repos and swaps in nuevos soles and U.S. dollars; and (iii) the use of international reserves accumulated during the first half of the year. The Central Bank held the policy rate unchanged during this period. In 2009, economic growth will be driven by a still strong domestic demand, which will compensate for the substantial expected decline in external demand.
B. Policies to Face Current and Prospective Challenges
12. The authorities’ main priority in the short term is to maintain the growth momentum and help the economy to transition in an orderly fashion to a lower level of economic activity. To this end, monetary policy will continue to ensure the gradual return to the inflation target range in 2009 and it will only ease reserve requirements and reduce the policy rate when clear evidence of a declining trend in prices is in place. Fiscal policy will be aimed at achieving a neutral fiscal stance for the year as a whole, but the balance between achieving a soft landing and addressing infrastructure and social needs would be biased towards the second goal. As clearly indicated in the Debt Sustainability Analysis, public debt is on a solid declining path, the fiscal position is strong, and government deposits amounted to 7 percent of GDP by end-December 2008. This provides a strong buffer to manage different levels of “fiscal stimulus”, as needed, without resorting to public debt.
13. Strengthening and closely monitoring the Financial System remains a priority. The authorities have permanently updated prudential regulations and the regulatory framework and the banks have learned to be conservative and prudent in their financing and lending activities. The banking system has a relatively low dependence of external credit lines, higher liquidity, and lower ratios of non-performing loans and a high level of provisions. The SBS has recently updated credit risks and exchange risk stress tests and the system remains resilient to most foreseeable shocks, even under extreme adverse assumptions. The SBS has recently begun to tighten lending standards (effective as of January 2009); issued more restrictive rules for granting credit card loans; introduced provisioning requirements for all consumer loans; and established procyclical provisioning (effective as of December 1, 2008). Foreign banks account for about half of total assets. They are in a solid position and continue to rely mostly on domestic funding. No banks pose any systemic risks.
C. The Fund Program and Future Fund Relations
14. Peru has maintained a long relationship with the Fund under “program mode”. Peru has benefited significantly from Fund advice and the “seal of approval” from Fund-supported programs, and it has also one of the best records of compliance with original program targets. The other side of the coin is that after almost two decades of continuing in program mode, it requires a certain creativity from the staff and the authorities to envisage every year for almost two consecutive decades, new structural reforms and suitable benchmarks. Perhaps Peru was one of the cases that inspired the need for streamlined conditionality and Management’s recommendation to distinguish desirable from essential structural conditionality. It is also worth mentioning that in all these years, all arrangements with the Fund were precautionary, with the exception of the initial Right Accumulation Program back in 1991.
15. The current Stand-By Arrangement was completed with flying colors, but a few structural benchmarks were missing. On January 16, 2009, legislation was passed for the issuance of methodological guidelines to assess tax exemptions. The authorities remain committed to delivering on the remaining benchmarks as soon as it is feasible. Regarding the Single Treasury Account (STA), it is worth mentioning that more than 85 percent of public sector transactions are already in the STA and a higher percentage is managed in a centralized manner by the Treasury, although it is not formally recorded in the TSA. Finally, regarding the benchmark to reconcile subnational government spending limits with those for the central government—the difference is only one percentage point, as indicated by the staff—, the authorities now believe that it would be better to address this issue within a comprehensive review of the decentralization process; and that this is perhaps not the right time for submitting such a proposal to Congress.
16. Looking ahead, Peru will maintain a close dialogue with the Fund and it will continue to engage in the policy discussions and institutional changes through the relevant internal channels and other international fora. The authorities would like to share their experience with other countries, help shape future Fund conditionality and lending activities, and contribute to the Fund’s operational budget. Taking into account Peru’s strong external position, it has been included for the upcoming February–April 2009 Financial Transaction Plan.