INTRODUCTION

1. Our Peruvian authorities would like to express their gratitude to Management and the staff for the open and constructive policy dialogue, and for their excellent work. The report provides a fair and well-balanced description and analysis of recent economic developments and policy discussions. Our authorities are in broad agreement with the staff’s assessment and policy recommendations. We are grateful for the comprehensive set of selected issues papers, which provide interesting insights into relevant economic topics. We appreciate the focus on the consultation on the exit strategy from policy stimulus and the challenges to handle economic success, including possible large and sustained capital inflows. The authorities consent to the publication of the staff report.

2. Peru is looking for new and proactive ways to engage the Fund as a partner and as a client of the Fund’s accumulated cross-country experience. As a partner, Peru has volunteered to be part of pilot on innovating Article IV consultations to help improve the consultation process, including a timely Board discussion of the mission findings and timely disclosure to the markets. Peru is a very active participant in the Fund’s lending activities through the Financial Transaction Plan, and it has renewed its commitment to poorer countries by contributing to the Poverty Reduction and Growth Trust Fund. As a client, Peru is currently receiving technical assistance to strengthen the existing AML/CFT, and has requested a new FSAP update, scheduled for the fourth quarter of 2010 (Peru was one of the first countries to volunteer in the original FSAP pilot program back in 2000, and an FSAP update was undertaken in February 2005).

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

3. The Peruvian economy continued to perform well in 2009, despite the lingering effects of the worst financial crisis in recent history. Although growth was in the negative territory during the first half of the year, the successful implementation of contracyclical monetary and fiscal policies led to a fast recovery in the second half of the year ending in real GDP growth close to 1.0 percent. In the fourth quarter of 2009, the economy grew over 15 percent (seasonally adjusted and annualized). This was one of the shortest economic cycles in the last 30 years in Peru, both in entering into the crisis and exiting from it (a total of four quarters). Net international reserves grew to US$ 33 billion, equivalent to some 13 months of imports of goods and services, 80 percent of broad money, and 412 percent of short-term external debt on a maturity basis. In addition, despite the deterioration in the terms of trade, the external current account had a small surplus. FDI flows remained strong, more than compensating for portfolio and short-term outflows. In 2009, due to favorable market conditions, Peru issued a US$ 2 billion debt for pre-financing operations and repayment of Paris Club debt.

4. The authorities’ decisive and proactive fiscal response to the crisis was possible thanks to the strong buffers built in recent years during the economic boom. A substantial fiscal stimulus—equivalent to around 2½ percent of GDP—was largely financed with fiscal savings. Government expenditure was focused on infrastructure and poverty alleviation to boost growth potential, while preserving the gains attained in poverty reduction and employment creation. The authorities were successful in increasing public investment to close to 6 percent of GDP—up from an annual average of 3 percent in the last decade, with the additional impulse from the fiscal stimulus plan. Public investment is expected to remain at this level in the medium term, contributing to a higher potential output. The public debt is expected to continue its declining trend and reach a level below 20 percent by 2015, one of the lowest in the region and among emerging markets.

5. The Central Bank’s swift policy response was instrumental to limit spillovers from the global financial crisis. The central bank provided ample liquidity in soles and dollars, helping to maintain orderly financial conditions during the peak of the crisis, preventing a liquidity squeeze. It has also reduced its policy rate by 525 bps since early 2009 to a historic low level of 1¼ percent. Lending rates to the private sector also declined to historical low levels, in line with the policy rate. Inflation fell to near zero by end-2009, but core inflation declined to near 2 percent, the mid-point of the target range. As conditions have stabilized, the central bank has started to reverse some of the measures to inject liquidity.

6. The Free Trade Agreement with China went into effect on March 1, 2010 and similar arrangements with Korea, Japan, and other countries are underway. The agreement with the European Union is almost complete and final legal details are being revised. These new agreements, together with the FTA signed with the United States last year, are expected to continue to encourage investment, higher export growth and diversification.

7. The 2010 outlook is promising. Early economic indicators, such as electricity consumption and construction activity, point to a strong economic rebound in 2010. The latest WEO projection has real GDP growing at 6¼ percent in 2010 but the authorities have a somewhat more conservative forecast of 5½ percent, which is more in line with market expectations. The consolidation of the investment grade by the three major rating agencies is expected to further reduce the financing cost for the public and the private sector. Inflation expectations remain well anchored, and all market surveys point to an easy compliance with the central bank target of 2 percent in 2010 and beyond. The authorities concur with the staff that the balance of risks to growth is tilted to the upside, and that a new wave of capital inflows may take place. Nonetheless, they are confident that they have the toolkit to deal with it.

THE EXIT STRATEGY AND THE MEDIUM-TERM CHALLENGES

8. The Peruvian authorities agree with the staff on the timing and sequencing of the withdrawal of policy stimulus. In particular, they are already taking the first steps towards the consolidation of the fiscal stance, prior to the tightening of the monetary policy. However, they will carefully monitor the dynamics of the private sector activity to avoid undermining economic recovery. Under the baseline scenario, the authorities intent to gradually reduce the fiscal deficit, and return to the 1.0 percent of GDP deficit limit established by the Fiscal Responsibility and Transparency Law in 2011. They agree with the importance of safeguarding the quality of public investment projects, and the need to preserve the fiscal cushions. As the staff indicates, Peru has room for additional fiscal stimulus in case of the risk of a relapse in global growth.

9. On monetary and exchange rate policy, the central bank stands ready to adjust the current policy stance and use its toolkit in tandem with the speed of economic recovery. The credibility of the central bank has contributed significantly to the resilience and stability of the Peruvian economy. Among the option at its disposal, the reserve requirements have proved to be an effective tool in Peru’s dollarized economy during the period of abundant global liquidity and capital inflows. These measures were reversed during the global financial crisis (Appendix 2 of the staff report), and could again increase in tandem with expected higher economic activity. Although, the central bank has kept its policy rate at 1¼ percent in its recent March 2010 review, it will closely monitor developments for any signs of inflationary pressures, and will take action as needed. On the exchange rate, our authorities agree with the staff’s assessment that the real effective exchange rate is broadly in line with fundamentals. They underscored that the central bank is committed to a floating exchange rate and, as in the past, they noted that intervention policy has been focused on smoothing out volatility of the exchange rate, and the potential negative balance sheet effects in the context of a still highly dollarized economy.

10. The framework for crisis management and resolution has been strengthened, but the authorities are proactively taking steps to incorporate the lessons from the global financial crisis. Peru’s regulatory and supervisory framework includes features such as dynamic provisioning and risk management practices that are ahead of international standards. They have established additional capital requirements like the assessment (stress testing) and risk of borrowers’ foreign exchange credit risk, which will become effective in July 2010. Steps to improve macro-prudential supervision have been taken and the outcome is constantly being monitored by the Coordination Committee, comprising of senior officials from the Ministry of Finance, the central bank, and the Superintendency of Banks, Insurance and Pensions. The central bank is currently organizing a conference with local and international participants on Macro Prudential regulations scheduled to take place in July.

11. The authorities regard the development of domestic capital markets as a high priority. A liquid and well-developed domestic capital market will enhance the effectiveness in channeling resources in the economy. In particular, the development of instruments in domestic currency would be instrumental in reducing further financial dollarization, and creating room for greater exchange rate flexibility in the future. Our authorities are grateful for the Fund’s assistance in developing the mortgage market in local currency through the creation of a covered bond instrument, and repo and interest swap markets to further facilitate lending in domestic currency. The authorities are also revamping the functions of the Security and Exchange Commission to promote access to the domestic capital market.

12. Poverty reduction is still a challenge, despite the substantial progress attained so far, and the successful efforts to protect this gain in 2009 despite the marked decline in the rate of economic growth. The fiscal stimulus plan helped sustain employment and protected social spending. The authorities will continue with their social programs for poverty alleviation, but they are convinced that the best answer is to maintain the momentum of economic growth, persevere with sound economic policies, and continue working on their structural reform agenda.