Abstract
The purpose of the study is to examine Peru’s effective interest spread through accounting decompositions, financial ratio analysis, and spread regressions. The government’s financial restructuring programs accelerated the banking sector consolidation process. Robustness of Peru’s credit system and interest rate decomposition has also been viewed. Three key financial ratios—return on equity (RoE), return on assets (RoA), and net interest margin (NIM)—focused by financial statements, have also been studied. Finally, the framework of Espino and Carrera used for the estimation of interest rate spreads has also been discussed.
Fiscal Objectives: Lower Debt or Higher Savings?1
A. Introduction
1. The current fiscal framework has served Peru well. Since the establishment of the Fiscal Responsibility and Transparency Law (FRTL) in 2001, the authorities have strengthened public finance management, with a significant reduction in public sector debt and some accumulation of public savings more recently. In improving public finances, Peru has also been profiting from elevated prices on its commodity exports (mainly mining). These savings proved very useful during the 2008–09 global financial crisis, as they served to implement successfully countercyclical fiscal policy to support economic activity.
2. In April 2012, the authorities announced the creation of a fiscal commission to help revamp the macro-fiscal framework. The Ministry of Economy and Finance (MEF) aims at increasing predictability and transparency in the conduct of fiscal policy. The timing is propitious, since Peru has relatively low public sector debt levels and one of the highest economic growth rates among emerging markets. The fiscal commission is technical in nature, formed by international and local experts, and is expected to provide recommendations on the fiscal framework that will shape future budget formulation. Challenges in the overall framework go beyond the fiscal rule and require a comprehensive strategy that cements the prudent management of non-renewable resources wealth and clarifies fiscal policy objectives, while avoiding pro-cyclicality. In this context, a relevant component is to develop a comprehensive strategy for public sector asset and liability management. This would help establish the optimal savings target going forward, which could then embed the formulation of the fiscal anchor.
3. This paper brings some consideration regarding a strategy for public savings and its management. It takes stock of the current fiscal framework (Section B), includes an analysis of fiscal sustainability and assesses the need to further reduce public sector debt (Section C), and discusses considerations for fiscal savings in Peru (Section D). Some concluding remarks are presented at the end (Section E).
B. Peru’s Current Fiscal Framework and Low Public Sector Debt
4. In the context of Peru’s low public sector debt, a comprehensive strategy on public sector savings and its management requires a view on the optimality of government debt. Such an assessment can be considered from two different perspectives. One is about debt sustainability and the other is about the optimal level of government debt per se. In theory, the optimal level of sovereign debt is determined at the point where the (declining) marginal benefit and the (increasing) marginal cost from the increase in sovereign debt coincide. In reality, however, it is difficult to accurately measure all the benefits and costs that arise from public debt.2 Discussion about sovereign debt has often been around how to verify whether the current debt level is sustainable over the long term, which is the approach followed in this paper.
5. Under the FRTL, the Peruvian authorities have shown a strong commitment to implement a prudent fiscal policy, resulting in significant debt reduction. The fiscal rule embedded in the FRTL (Box 1), with a combination of the current expenditure growth cap and a deficit limit, has served well to reduce public debt, including when comparing to other emerging economies. Solid macroeconomic performance and fiscal consolidation have led to a progressive reduction of public debt as percent of GDP, supported by elevated commodity prices and positive debt dynamics (Figure 1). Debt-to-GDP ratio fell from 47 percent in 2003 to 19 percent of GDP in 2012, one of the lowest in the region. The structure of debt is relatively positive; most of it is issued at long maturities.3 About half of the public debt is exposed to foreign exchange risks. However, the implementation of the macro-fiscal framework has not been conducive to counter-cyclical fiscal policy. When measured by the correlation between the change in the cyclical component of government expenditures and the output gap, Peru displays a high level of pro-cyclicality compared to other emerging economies (Box 1 of the accompanying staff report).
Peru: Debt Reduction with a Cross-Country Perspective (2000-11)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: WEO; and Fund staff estimates.1/ Excludes Emerging AsiaNote: LA5 includes Chile, Colombia, Brazil, Peru and Mexico.Peru: Debt Reduction with a Cross-Country Perspective (2000-11)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: WEO; and Fund staff estimates.1/ Excludes Emerging AsiaNote: LA5 includes Chile, Colombia, Brazil, Peru and Mexico.Peru: Debt Reduction with a Cross-Country Perspective (2000-11)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: WEO; and Fund staff estimates.1/ Excludes Emerging AsiaNote: LA5 includes Chile, Colombia, Brazil, Peru and Mexico.Peru’s Fiscal Institutional Framework in the FRTL
The Fiscal Responsibility and Transparency Law (FRTL, 2001) supports savings accumulation, other than in periods of low growth. It established a combination of a deficit target (of 1 percent of GDP) for the non-financial public sector, a ceiling on the increase of expenditures in real terms for the nonfinancial public sector (originally set at 2 percent, raised to 3 percent in 2004 and later changed to 4 percent), and limits to the debt increases for the non-financial public sector (equal to the overall fiscal deficit). The overall objective of the FRTL has been to reduce debt levels. However, the combination of provision for a modest deficit on the down-side, and an expenditure cap on the up-side, means that the FRL embodies some countercyclical elements.
The fiscal framework embedded in the FRTL allowed for escape clauses, with Congressional approval. Application of the fiscal rule may be waived (i) when domestic real GDP growth is negative or (ii) under domestic or international exceptional circumstances. In the first case, the deficit may not exceed 2.5 percent of GDP, and can be extended for three years only if real GDP has not fully recovered. In both cases, a transition rule defines the reversion to the original fiscal rules—requiring an annual reduction of the deficit by 0.5 percent of GDP.
The FRTL also specifies a fiscal stabilization fund (FEF). Resources of the FEF include any fiscal surpluses generated by the Treasury, 10 percent of privatization proceeds, and 10 percent of concessional revenues. These assets are deposited at the central bank or abroad but under similar management criteria as with international reserves. The FEF is subject to a cap of 4 percent of GDP, with any excess allocated to debt reduction. FEF resources may only be used when the revenue shortfall (in percent of GDP) is more than 0.3 percent the average ratio of the last 3 years or under specific escape clauses (i.e. emergency situation). However, no more than 40 percent of total funds can be used in a given year. As a result, FEF’s funds have not been used and the fund has worked mostly as a savings fund.
However, the parameters of the fiscal rule have changed frequently. The cap on expenditure growth was suspended during 2006. In 2007, the rule was re-established but applied only to consumption expenditure of the central government—defined as the sum of wages and expenses in goods and services. In 2008, the expenditure growth cap was increased from 3 percent to 4 percent, with consumption expenditure including also pensions. In the context of the fiscal stimulus package, the fiscal deficit ceiling was temporarily raised to 2 percent of GDP; and the expenditure growth ceilings shifted upwards to 10 and 8 percent in 2009 and 2010 respectively. During 2009–10, in the context of the global financial crisis, the application of the fiscal rule (as defined in 2008) was waived, and was to be re-imposed in 2011, but applied to central government. In April 2012, some categories of the expenditure growth rule were excluded (mainly maintenance expenditure and some social and military expenditures) and the transition rule was modified to ensure a structural balance rule over the medium from 2013 onwards, with a minimum structural balance adjustment of 0.2 percent of GDP. With the 2013 Budget Law and the small structural surplus achieved at the end-2012, the latter is not longer effective.
Additional fiscal rules for subnational governments have also been changed. According to the Pre-Electoral Report (MEF, 2011), most subnational governments do not face debt problems but they usually do not comply with the expenditure growth caps and primary balance limits. The primary balance rule is not met by 35 percent of regions and 70 percent of municipalities. As national government transfers have grown, the expenditure growth ceilings are now not fulfilled by almost 60 percent of subnational governments—almost 75 percent for local governments.
6. Public sector debt is well below prudent thresholds discussed in the literature. When comparing to other countries with natural resources, the debt-to-GDP ratio seems relatively high (i.e. Chile (11 percent of GDP), Russia (12 percent of GDP) and Kazakhstan (10½ percent of GDP), but is well below the parameters of debt adequacy reported in the literature. A debt-to-GDP ratio of 40 percent is often noted as a prudential limit for developing and emerging economies. This threshold is lower than in developed countries due to lower development in local capital markets and higher uncertainty about external financing conditions (Kumar and Woo (2010)). While there is a tendency to treat these benchmarks for debt-to-GDP ratios as “optimal” in the specific sense that crossing these thresholds poses threats to debt sustainability, this may not be necessarily the case. Debt intolerance would depend on many country-specific factors (growth dynamics, financing costs, exchange rate movements, among others). IMF (2003) noted that, based on past fiscal performance, the sustainable public debt level for a typical emerging market economy may range between 25 and 50 percent of GDP, depending on the approach considered. Emerging market economies have shown inability to generate adequate primary surpluses, in part due to weak revenue bases (with lower yields and higher volatility) and being less effective at controlling expenditures during economic upswings. Mendoza and Oviedo (2004) find that the sustainable level of debt for emerging market is around 45 percent of GDP. More recently, Reinhart and Rogoff (2010) notes that an increase in public debt above a certain “threshold” would affect negatively economic growth, feeding adversely back into debt sustainability. For emerging market economies, the authors found that central government debt in excess of 90 percent of GDP has typically been associated with mean growth of 1 percent versus 4–4½ percent when debt is low (under 30 percent of GDP).4 Additionally, there is evidence that countries with high debt levels are more likely to achieve lower economic growth, with a higher probability of facing an economic crisis.
7. Strong fiscal performance and debt reduction have been supported by elevated commodity prices.5 Fiscal reliance on commodity related revenues have increased in recent years, in part because of hikes in commodity prices. Commodity–related revenues accounted for 4 percent of GDP in 2012. Additional revenues have facilitated the generation of fiscal surpluses and some accumulation of public sector savings—the latter accounting for about 15 percent of GDP. However, the fiscal framework in Peru only embodies some countercyclical elements in response to output or commodity-price shocks. The combination of a provision for a moderate deficit on the downside, and an expenditure cap on the upside, allows for some countercyclical policy. But it does not build in a fully countercyclical response in the face of shocks to output or commodity prices; nor does it incorporate intergenerational equity considerations specifically into fiscal policy formulation. In particular, the framework has no ex-ante direct mechanism for saving during long-lasting high commodity price cycles.
Peru: Commodity Revenues
(in percent of GDP)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: MEF and Fund staff estimates.Peru: Commodity Revenues
(in percent of GDP)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: MEF and Fund staff estimates.Peru: Commodity Revenues
(in percent of GDP)
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Sources: MEF and Fund staff estimates.8. Under the FRTL, prospects for further debt reduction remain positive. The debt-stabilizing primary balance stands at a deficit of 0.6 percent of GDP (see Table A2 of the accompanying staff report), against the prospects of maintaining small surpluses over the medium term. Further, the accumulation of funds at the FEF will reach 3.9 percent of GDP after the 2012 surplus, close to its legal cap of 4 percent of GDP, with additional surpluses in the Treasury account being devoted to debt reduction. There has also been additional deposit accumulation, and the authorities have recently announced their intentions to prepay debt during 2013. Going beyond the baseline scenario, Rial (2010) showed low risks for debt sustainability under the fiscal rule, using stochastic scenarios that took into account the historical distribution of shocks for Peru. Since the overall deficit cannot exceed 1 percent of GDP, the distribution is skewed towards the downside and the risk of debt increasing over 30 percent of GDP is low. Staff projects public debt to decline to 15 percent of GDP by 2017.
9. However, fiscal sustainability could be compromised by contingent liabilities. While it is unlikely that all contingent liabilities will materialize, they are relevant for Peru.6 One would need to make an assessment of the probability distribution that links the realization of contingent liabilities to fiscal costs. Beyond judicial claims, Peru is also prone to natural disasters that could put pressure on public expenditure, being mainly exposed to climate change and earthquakes. Cooper and Moron (2010) categorize natural disasters (earthquakes), according to their cost impact, by recurrent (up to 0.3 percent of GDP), severe (between 0.3 and 3 percent of GDP) and catastrophic (above 3 percent of GDP).7 Finally, the global financial crisis in advanced economies has shown that contingent liabilities arising from the financial sector could also be significant. Despite of a well-capitalized and profitable financial sector, Peru is still a highly dollarized economy and government debt is subject to exchange rate risk, as about half is foreign-currency denominated. Consideration needs to be given also to contingent financing needs that could rise as a result of a financial shock. In this regard, the authorities could start incorporating regular discussions of fiscal risks to get a better grasp on fiscal risks and increase public awareness. An application of the Value-at-Risk (VaR) methodology to the public sector balance sheet could provide a more comprehensive assessment of Peru’s fiscal sustainability. Among other things, fiscal risks are incorporated and may include interest and exchange rate movements, commodity price changes and output fluctuations. The VaR presents a numerical estimate of the potential loss in net worth the government could face over a given period of time if a “worst-case” scenario were to develop.
10. Current low debt levels do not fully guarantee fiscal sustainability going forward. Stress episodes that affect economic growth and access and cost to finance can change debt dynamics rapidly, as observed in some euro area countries since the 2008–09 global financial crisis. In part, this is due to the recognition of newly acquired contingent liabilities (e.g. financial sector bail-outs), but also because of detrimental growth dynamics. In this regard, one would need to take into account the fact that Peru is still a dollarized economy and that contingent liabilities could be higher at times of stress.
11. Despite these risks that could threaten fiscal sustainability, this is a good time for Peru to reconsider its debt reduction strategy. Given its low debt levels, and the positive outlook for public finances, one wonders whether continuing with the debt reduction strategy remains appropriate for Peru. While reducing indebtedness will improve the sovereign’s credit profile, Peru already compares positively to its peers in this category. In light of projected fiscal surpluses, the priority may need to shift toward building up fiscal assets. Barring significant policy changes, the economic outlook is positive, with strong demand dynamics driven by elevated commodity prices, strong capital inflows and investment. Growth is projected to hover around potential growth (at 6 percent) over the medium term, with inflation at around 2 percent. Net debt stands at about 3¾ percent of GDP, one of the lowest among emerging market economies. The strong fiscal position, with low gross public debt levels and some savings in the current environment of elevated commodity prices, provide also the opportunity to enhance the counter–cyclicality of the fiscal stance and to build further fiscal buffers in light of contingent liabilities and intergenerational equity considerations. Shifting towards asset accumulation will require implementing a comprehensive strategy for public sector asset and liability management, which will facilitate shifting towards a risk-based analysis of the public sector balance sheet.
12. There are also benefits to government debt, especially for countries like Peru with a presence in international capital markets. Peru’s presence in international capital markets helps build a broader investor base and facilitates access to international financing to the private sector. To serve as a reference, it is important to maintain relatively liquid markets. Following a strategy of further reducing gross debt could hamper access to international capital markets in the future, especially at times of financial stress, because of a reduced investor base. Therefore, the sovereign could start putting in place a strategy that goes beyond liability management and focuses on further accumulation of financial assets, as done by other resource–rich emerging market economies. This will encompass further reductions in net debt and the buildup of additional fiscal buffers that could address concerns about a worsened growth outlook given heightened uncertainty in the external environment.
C. Considerations to Define a Savings Target in Peru
13. In a resource-rich country like Peru, the fundamental challenge is to transform resource wealth into a portfolio of other assets to support sustained development.8 Two major questions for policy makers in natural resource-rich countries like Peru are: (i) how much of resource revenues to consume and how to save (invest) the remainder; and (ii) how to cope with the uncertainty and volatility of resource revenues.9 In the short and medium term, designing policies to cope with that uncertainty and volatility may be a more pressing challenge than dealing with the exhaustibility of the resources, especially where there is a relatively long extraction horizon. Uncertainty may relate to how large the resource reserves are, how much will be extracted in a given period, what prices will be on average and how volatile prices are likely to be in the short term. These factors complicate macroeconomic management and stimulate demand for precautionary savings to cope with unforeseen swings in resource envelopes and smooth consumption spending. Addressing volatility will require an adequate (minimum) level of reserves (savings) and the use of specific market-based instruments like over-the-counter forward contracts to lock in prices or hedge price risk with options.
14. Incorporating a savings target in Peru requires an assessment on how best to manage natural resources. In revamping the fiscal framework, two elements could be addressed to enhance fiscal policy management in Peru. First, the fiscal framework should maintain mechanisms to avoid the boom and bust cycles that stem from volatility in natural resource revenues. While the current fiscal framework in Peru contains some elements that reduce pro-cyclicality, the fiscal stance has not been sufficiently counter-cyclical.10 Despite elevated commodity prices, the public sector has generated relatively small structural surpluses. Thus a counter-cyclical policy would imply running higher fiscal surpluses. Second, over a longer time horizon, considerations related to intergenerational equity on the management of resource wealth could call for higher savings, depending on the resource horizon.
15. In order to bring the savings target into the fiscal framework, one possibility is to consider the non-resource primary balance (NRPB). The NRPB is anchored around the expenditure envelope that could be maintained over the long term and is consistent with the stabilization of the net resource wealth. The NRPB is defined as the difference between non-resource revenues minus primary expenditure. The overall fiscal balance can be decomposed into resource revenues and non-resource revenues, primary expenditure, income from the initial stock of financial assets and interest payments on the initial stock of liabilities. The overall fiscal balance is also equal to the change in the net financial assets. Over long horizons, the NPV of future resource revenues should be equal to the NPV of future non-resource primary balance deficits. Over shorter horizon, calculations should be done to maintain a stable level of net wealth.
16. In Peru, these considerations for savings need to be balanced against expenditure needs that could boost potential economic growth. Peru has pressing social needs (with elevated poverty in rural areas) and ranks relatively low in education and human capital. There are also large infrastructure investment needs that could enhance economic growth in the future (Box 2). On the other hand, Peru is faced with short- and medium-term capacity constraints that could hamper the effectiveness of public investment. It may be advisable to take a gradual approach to expanding spending and save more of the resource revenues in financial assets even if only temporarily. More of the resource revenue could then be saved in financial assets while investment capacity is build domestically. Berg et al (2012) propose a “sustainable investing” approach, in which public investment is scaled up gradually in line with institutional and absorptive capacity constraints. Sustainable investing can minimize the impact of volatile commodity prices on the domestic economy, mitigate Dutch disease, and reduce the costs of absorptive capacity constraints.
17. Alternative approaches take into account Peru’s development needs. An analysis of scenarios for the case of Peru could be premature, and would require an assessment of the investment needs and absorption capacity as well as an objective of precautionary savings to deal with uncertain resource horizons and revenue volatility as a result of large swings in commodity prices. These approaches could help anchor fiscal objectives over the medium term.
A modified permanent income hypothesis (MPIH). This approach builds on the permanent income hypothesis (PIH) but accommodates scaling-up of public investments, by “saving” less natural resource revenue on the basis that some frontloading of consumption spending could be welfare enhancing and that higher investment could have a lasting impact on development. This is the option most practiced (although the rate of failure is high), and in the case of Peru, the focus should be on higher investment rather than current expenditure. The higher capital spending would directly reduce the NRPB during the front-loading years.
Fiscal sustainability framework. This framework explicitly takes into account the intertemporal budget constraint and incorporates ex ante the expected impact of higher investment on growth and non-resource revenues. Therefore, it provides a long-run benchmark for the NRPB that gradually draws down net wealth. This approach therefore allows for a stabilization of net wealth at lower levels than with the PIH or MPIH framework. Higher investment is assumed to have a positive impact on growth, which generates higher non-resource revenues, but also leads to an increase in operation and maintenance expenditures. Both variables affect the NRPB, but the key feature is that his framework allows for a fiscally sustainable level of financial wealth that is lower than in the PIH or MPIH. The specific stabilizing target for net wealth (and the time horizon by which it is to be achieved) is country-specific since it involves estimating the interactions between government spending needs and non-resource growth.
The Challenges of Closing the Infrastructure Gap1
Despite recording high economic growth in the last decade, Peru has a significant infrastructure gap that could hinder maintaining high growth in the future. According to Instituto Peruano de Economía (IPE, 2009), as of 2008, the infrastructure gap was estimated at about 30 percent of GDP for the next decade. The assessment was based on Peru reaching Chile’s infrastructure level in 2018. The study is based on coverage indicators for sanitation and water supply, density for phone lines and electricity coverage, and incorporates targets that evolve over time, according to population growth and economic activity projected by 2018.
Peru: Infrastructure Gap Estimates in 2008
Peru: Infrastructure Gap Estimates in 2008
| Sector | 2008 Gap (in percent of GDP) | In percent of total |
|---|---|---|
| Transportation | 11.0 | 37.0 |
| Water sanitation | 5.0 | 16.7 |
| Electricity | 6.6 | 22.0 |
| Natural Gas | 2.9 | 9.9 |
| Telecommunications | 4.3 | 14.4 |
| Total | 29.8 | 100.0 |
Peru: Infrastructure Gap Estimates in 2008
| Sector | 2008 Gap (in percent of GDP) | In percent of total |
|---|---|---|
| Transportation | 11.0 | 37.0 |
| Water sanitation | 5.0 | 16.7 |
| Electricity | 6.6 | 22.0 |
| Natural Gas | 2.9 | 9.9 |
| Telecommunications | 4.3 | 14.4 |
| Total | 29.8 | 100.0 |
Despite progress in infrastructure investment in the last decade, the infrastructure gap is increasing as needs are rising rapidly. The gap is largest for the transportation sector, which concentrates 37 percent of the total infrastructure gap. This may reflect delays in channeling projects through Proinversión, Peru’s private investment promotion agency and the lack of public investment in this sector. Peru lags behind other countries in the region with regards paved roads (which amount to about 14 percent of total roads in 2006 according to the World Bank Development indicators) and the quality of road infrastructure (ranking 99th out of 134 countries, according to World Economic Forum).The deficiency noted on electricity and natural gas is mainly due to higher domestic demand, which may generate supply pressure in the coming year. Water sanitation represents only 17 percent of the total infrastructure gap, bearing in mind that the study only takes into account the gap in coverage, without taking into account replacement efforts, continuity, and tariff adjustment, among other elements.
Adequate infrastructure will be crucial to ensure sustained high economic growth going forward. In order to ensure that Peru can close its infrastructure gap, it will be important to define a national investment strategy that identifies priorities and resources, defines the extent of private sector involvement in projects, and establishes adequate control mechanisms that ensure the quality of investment. Pairing these efforts with additional ones to boost human capital will help support trade openness and enhance competitiveness, which in turn will enhance Peru’s economic growth.
1/ This box is based on IPE (2009).18. The savings target should be chosen to support government policy objectives as effectively as possible, with as little distortion to the fiscal framework and as little administrative cost as possible. Once the objectives have been defined, the next question is how to manage savings. A popular vehicle for managing public savings has been the Sovereign Wealth Fund (SWF). For any such funds, the most fundamental design element is the specification of the rules governing inflows to and outflows from it. These rules are key, not only because they define the size and nature of the SWF, but also because they can ensure or undermine its consistency with the rest of the fiscal framework. Further design provisions can also contribute to ensuring that the SWF supports rather than inadvertently supplants normal fiscal policy channels. Finally, one aspect of SWF design is to ensure that it is a fully integrated element of the over-arching public financial management system.
19. The calculation of the optimal savings level will depend on the structure of the public finances, the rest of the fiscal architecture, the macro-environment, and the nature of the shocks hitting Peru. The maintenance of an adequate stabilization buffer to deal with volatility in resource revenues will in turn define the scope for pursuing a long-term savings objective. Also, in the short term, higher savings may be warranted in light of capacity bottlenecks. Any redistribution of assets between the ‘savings tranche’ and the ‘stabilization tranche’ (say, after a run of negative shocks that depletes the stabilization buffer) will come out of a rebalancing exercise that reconstitutes the optimal buffer.11
D. A Proposed Framework for Managing Public Savings
20. In managing public savings, sovereign wealth funds (SWFs) have become popular. SWFs are, in essence, organizational tools for public financial managers. Their spreading popularity reflects the desire of the authorities to have a better-defined mechanism for managing public financial assets, with a variety of rules governing financial inflows and outflows (Box 3). Thus, a critical component of implementing an SWF is the integration of its operations with the rest of the treasury function. Since SWFs are fed by government savings, and since the exercise of any SWF stabilization function will require flows between the SWF and the budget, the operational and institutional arrangements for incorporating the fund into the public financial management (PFM) system need to be clearly articulated. Similarly, the legislative framework surrounding the SWF needs to be robust in order for it to interface smoothly with the ordinary business activities of government.
Sovereign Wealth Funds, by Type of Funding Rule
SWFs can be broadly classified in three groups according to the rules governing their financial inflows and outflows:
Contingent funds have price- or revenue-contingent deposit or withdrawal rules. Many oil stabilization funds (e.g., in Algeria, Mexico, and Trinidad and Tobago) specify a threshold price (say for example US$70 per barrel) or oil revenue, with any excess/shortfall above/below the threshold being transferred to/from the fund.
Revenue share funds, in this case, the SWF is fed by a predetermined share of revenue. Some saving funds (e.g., the Fund for Future Generations in Gabon and Kuwait; the fund in Kazakhstan) operate under this modality. Peru’s FEF receives (inter alia) a share of privatization and concession receipts.
Financing funds link their inflows/outflows directly to the government’s overall balance (net inflows should be equivalent to the overall fiscal balance), making them mirror images of the fiscal position. The Chilean Fund for Economic and Social Stabilization and Norway’s Government Pension Fund-Global (GPF-G) operate under this modality. Norway’s GPF-G follows a bird-in-the-hand rule. The fiscal position (to be financed by the fund) is restricted to the income earned from the assets already in the fund.
21. Given Peru’s economic situation, public savings should be used for both stabilization and wealth accumulation purposes. Its economic characteristics and environment are comparable to that of other countries with natural resource-based sovereign wealth funds. Notably, Chile and Norway are both small open economies which benefited from resource windfalls, and channeled some of the earnings into SWFs. Both countries used their SWFs as vehicles to build up enough fiscal resources to allow fiscal policy to smooth the impact of the economic and commodity cycles. Both also designed funds to accumulate savings over the long term, to compensate for the eventual depletion of their natural resources. Peru is in a comparable position, although resource revenues are less important for the public finances and real economy.
On fiscal and macro-stabilization, Peru equally needs to address the impact of the volatility and uncertainty of mineral revenues on inflation, the real exchange rate, and real GDP growth. The fact that regional and local governments are so heavily dependent on mineral revenues is an added argument for smoothing the impact of volatility, since these are typically less able to adjust than is the central government. More generally, Peru shares the same characteristics of being a small open economy, where output swings can be dramatic, since domestic cycles are augmented by terms of trade shocks and other external spillovers.
On building up financial savings, like Norway and Chile, Peru can benefit from provisioning for the exhaustion of mineral resources, particularly since there is uncertainty about how long the current high prices will persist and how long resources will last. Moreover, a main concern for Peru is that contingent liabilities or natural disasters could exceed those it had to pay for during its benign recent history. While full provisioning for rare ‘black swan’ events is unlikely to be optimal, there is a case for at least some precautionary savings beyond the buffer needed for predicted stabilization needs.
22. The success of SWFs with stabilization and savings objectives has been mixed, highlighting the importance of consistency between SWF operations and fiscal policy, and their operational flexibility. In general, the experience of countries suggests that an SWF is most likely to survive when the government always has sufficient resources to finance required transfers from the budget to the fund (in high-cycle periods or for saving) and from the fund to the budget (for counter-cyclical policy in a down-swing or to pay for emergencies), and if the fund’s arrangements are flexible enough to respond to changing circumstances. If not, the government might have to borrow to meet its specified objectives, pressures will build up to change or bypass the fund’s operational rules, and the credibility of the stabilization and savings frameworks becomes undermined.
23. Considering financing-fund operational arrangements, budget balances could flow through a stabilization buffer held within the SWF. For this reason, operation of the stabilization buffer will be closely linked to the MEF’s central government cash management process. In Peru, where cash flow forecasting and active cash management continues to be developed, the budget department operates a commitment control mechanism whereby spending units are provided with monthly budget releases at the start of each quarter. The treasury single account (TSA) is relatively well established and has reasonable coverage of central government business. It would be appropriate, therefore, to retain a targeted buffer level of cash in the TSA for daily fluctuations in revenue and expenditure mismatches. Where the actual level of cash in the TSA is above or below the target, the difference should be passed to, or from, the SWF stabilization buffer. (Figure 2).
Interface of SWF with Budget Execution and Cash Management
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Interface of SWF with Budget Execution and Cash Management
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
Interface of SWF with Budget Execution and Cash Management
Citation: IMF Staff Country Reports 2013, 046; 10.5089/9781475582604.002.A001
24. The financing fund model of a SWF minimizes operational rules for inflows and outflows through the stabilization buffer to the TSA. Where the principal source of structural revenue variation derives from movements in commodity prices, these can automatically be accommodated through the stabilization buffer as budget execution proceeds. When commodity prices are higher than budgeted, the corresponding surplus revenue flows into the stabilization buffer as the TSA is rebalanced periodically. Similarly, when prices are lower, the required extra resources are furnished by withdrawals from the stabilization buffer. Earmarking of stabilization buffer funds is not permitted since they are destined for general budget support through the TSA as required. If it is necessary to amend budget plans to maintain the fiscal target during the year, this should be performed by means of supplementary budgets which amend budgeted expenditure as required. Thus, if there is a shortage of non-structural (or non-commodity) revenue during the fiscal year for reasons such as lower inflation or general economic activity, this must be met through reduced expenditures and not by an extra resource inflow from the stabilization buffer.
25. Internationally, many examples of SWFs have started with the objective of fiscal stabilization and have grown into large savings funds. The FEF has worked de facto as a savings fund as its rules proved too stringent for stabilization—mainly because two quarters of declining GDP are needed before funds can be used, and they are then capped. The FEF was not used for the fiscal stimulus package, mainly because discretion regarding the timing of inflows to the FEF allowed the government to apply adequately the Treasury surplus to the stimulus. Savings accumulation should be allowed under the structure of a SWF, should commodity prices maintain their current strength and trend. This structure requires operational rules which (i) allow excess funds in the stabilization buffer to be transferred to the savings tier, and (ii) restrict flows back into the stabilization buffer to long-term planning or contingency situations. Any excess funds in the stabilization buffer should be transferred to savings assets for longer term investment.
26. Savings assets may need to be mobilized to support the stabilization objective in case of a sustained negative commodities revenue shock. Consideration could be given to smoothing the decline of the stabilization buffer once it reaches a certain threshold to avoid the need to take costly spending adjustments or to borrow expensively. However, this mechanism would need to be accompanied by assurances that fiscal adjustment is being introduced in response to a (permanent) change, or else the savings component may also succumb to rapid depletion. The calculation of the stabilization buffer is based on the premise that there is a low probability it could be depleted under historically-based shocks. Unless its level becomes abnormally low, it should be replenished by inflows from budget surpluses. Therefore short-term requirements other than those specifically considered to be contingencies should not be met by withdrawals from the savings assets. For day-to-day cash shortages when the stabilization buffer is low, use should be made of expenditure restrictions and/or short-term borrowings to replenish the TSA buffer.
27. Saving entails the long-term investment of assets and any alternative use of these funds entails careful consideration. The authorities will need to decide the circumstances under which it will allow savings assets to be used to top up the stabilization buffer if required in the rebalancing process. These circumstances may be specifically of a long-term nature, such as covering pension liabilities already incurred, or short-term and contingent, such as financial relief from natural disasters including earthquake, tsunami, or El Niño effects. The current and proposed fiscal frameworks encompass situations such as these, which allow for escape procedures from the fiscal rule implementation.
28. It will be critical to ensure the legitimacy, performance, and accountability of an SWF. There is no single formulation that fits all cases given the variety of economic, legal, and institutional arrangements across countries (Box 4). The design and implementation of institutional arrangements will have to be tailored to the specifics of Peru. However, there are some stylized elements that can serve as a guide. Robust accountability and transparency provisions—in line with international best practices—are critical to enhance the legitimacy of the SWF and prevent misuse of resources framework. Government decisions on utilizing savings assets for short-term contingencies should be consistent with this aspect of fiscal rule implementation—and will be ultimately based on a cost-benefit analysis.
Institutional Arrangements, Transparency and Accountability of SWFs.
The organizational structure of a SWF should clearly distinguish decision making by the owner (i.e., the authorities), and operational implementation. The setup would apply whether the SWF was established as an autonomous body (such as Temasek in Singapore), or as an account at the central bank or other operational manager (e.g., as in Norway or Chile). General directives could be provided by a governing council representing the authorities, while more detailed policy formulation and management of the SWF are carried out by a supervisory committee.
In line with best practice, the authorities should, in principle, be responsible for the investment policy, which includes the strategic asset allocation (SAA) of the fund. In practice, different models exist, with the SAA determined by either the governing council or the supervisory committee. The choice between governing council and committee reflects the trade-off between ownership and representation on the one hand, and efficiency in decision-making on the other.
The success of a SWF will depend in large part on the quality of the fund’s management, proper oversight, and the transparency of its operations. Accountability provisions need to cover various dimensions, including accounting, internal control and audit, external audit, and general oversight. The specific arrangements vary country by country, depending on the precise legal and institutional frameworks in place. The oversight of SWF operations should involve complementary and reinforcing work of agencies and operational units.
Transparency and disclosure through frequent reporting is critical to show that the SWF is fully accountable. In line with the Santiago Principles (2008), any laws and regulations governing the SWF, including the corporate governance arrangements that frame the SWF’s operations and relationship with other public institutions and SWF operational rules and investment/risk strategies should be disclosed. In terms of transparency, the requirements for a SWF should be similar to those of other entities that are responsible for government financial functions as summarized in guidelines by the IMF and OECD. SWFs should disclose the size and type of financial assets and the gross flows of revenue and spending (e.g. management fees). Audited balance sheets and statements on operations and performance should be regularly published. In addition, an annual report should also include investment performance statements. Quarterly reports could include unaudited balance sheet and profit & loss statement, inflows and outflows, and expenses.
E. Concluding Remarks
29. This is a good time to evaluate the public sector debt reduction strategy embedded in the FRTL. Peru currently has relatively low public sector debt levels, well below prudent levels recommended by the literature, and has started accumulating assets. Despite the uncertain external outlook, the macroeconomic outlook remains positive, in the context of elevated commodity prices. To enhance the management of the public sector balance sheet, the authorities could then shift their focus toward defining a comprehensive strategy for asset and liability management. This will facilitate incorporating savings management in the fiscal framework. The fiscal commission created to help revamp the macro–fiscal framework should take the opportunity to clarify fiscal objectives in such direction.
30. In a resource-rich country like Peru, the fundamental challenge is to transform resource wealth into a portfolio of other assets to support sustained development. Two major questions for policy makers in natural resource-rich countries like Peru are: (i) how much of resource revenues to consume and how to save (invest) the remainder; and (ii) how to cope with the uncertainty and volatility of resource revenues. In this regard, incorporating a savings target in Peru requires an assessment on how best to manage natural resources. The current framework is procyclical, especially at times of commodity price booms; and there is a need to incorporate intergenerational equity considerations in the management of resource wealth. In Peru, these considerations for savings need to be balanced against expenditure needs that could boost potential economic growth. In turn, those need to be balanced with capacity absorption constraints that may hinder the quality of investment in the short-term.
31. In managing public savings, Peru could consider a sovereign wealth fund (SWF), which has become popular across resource rich countries. Given Peru’s economic situation, public savings should be used for both stabilization and wealth accumulation purposes. Peru equally needs to address the impact of the volatility and uncertainty of mineral revenues and can benefit from provisioning for the exhaustion of mineral resources. Operationally, a proposed financing fund model ensures consistency of the SWF fund with the fiscal framework while minimizing the operational rules for inflows and outflows through the stabilization buffer to the TSA. Budget balances could flow through a stabilization buffer held within the SWF. Funds accumulated beyond stabilization purposes will then be dedicated to long-term savings. To make the SWF a successful tool within the fiscal framework, it will be critical to ensure the legitimacy, performance, and accountability of an SWF.
References
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Prepared by M. Vera Martin (WHD). The author is grateful for research assistance from Zulima Leal. Sections C and D benefited from extensive discussions and previous work with A. Cheasty, J. Gardner, I. Rial, and M. Villafuerte (all IMF).
Applying the optimal capital structure theory of corporate finance to public finance, the optimal level of debt that maximizes social welfare could exist at a point where the marginal benefit from an increase in sovereign debt equals its marginal cost. One could then argue that, given the low costs of financing debt under current conditions, a higher debt level would be advisable to close the infrastructure and social gaps and enhance potential growth. Although this consideration is relevant in the context of Peru, the paper does not address this issue.
The authorities have also been proactive with debt management operations to improve the risk profile. For details, see Box 15 of MEF (2011).
The authors also show that growth thresholds for external debt (public and private) are considerably lower than the thresholds for total public debt. Growth deteriorates markedly at external debt levels over 60 percent of GDP, and further when external debt levels exceed 90 percent of GDP.
For details on the role of commodity prices in export performance, see accompanying paper “Peru: Trade Patterns and Policy Challenges”. For an overview of recent experience in Latin America, see Villafuerte et al. (2010).
In Appendix D of MEF (2011), the authorities reported fiscal contingent liabilities for US$4.5 billion, mostly from nonfinancial guarantees associated with PPPs.
The authors suggest that recurrent events (up to 0.3 percent of GDP) could be financed through the budget; and more severe events (up to 1 percent of GDP) could be financed through a contingency reserve that builds up buffers with additional sources from the fiscal stabilization fund. For more severe and catastrophic events (up to 4 percent of GDP), the authors suggest debt financing as long as long-term sustainability is ensured. More catastrophic events could be covered through insurance or the issuance of catastrophic bonds.
For a comprehensive discussion on the management of resource revenues and macroeconomic policy frameworks for resource rich developing countries, please see IMF (2012). See also Box 11 of MEF (2011) for a stocktaking of the role of natural resources in the Peruvian economy.
According to IMF (2012), the volatility of total expenditure is over 60 percent higher in resource–rich countries than in comparators and, while fiscal policy has become less pro-cyclical over the last decade, the boom-bust cycle has not been eliminated.
Managing Peru’s mineral wealth is complex because of decentralization arrangements giving regional and local governments a claim on mining revenues. Subnational governments generate only marginal own revenues, with their main source of income being transfers from natural resource revenues. Subnational governments receive 50 percent of the canon. All royalties paid by mining companies are transferred to the region where exploration takes place. Hydrocarbon exploration companies also pay royalties (about 25 percent of production), half of which are transfers to subnational governments. Furthermore, transfers from mining revenue can be used only for capital spending, which is usually under-executed and results in subnational governments’ accumulating financial assets despite running overall deficits.
The precise specification of an appropriate investment strategy for accumulated financial assets goes beyond the scope of this paper.
