Statement by Oscar Hendrick, Alternative Executive Director for Peru, May 20, 2014

KEY ISSUES Context: Peru remains one of the best performing economies in Latin America, with solid macroeconomic fundamentals, strong policy frameworks, and visible gains in poverty reduction. Like most of the region, Peru faced a challenging external environment in 2014. External shocks were compounded by domestic supply disruptions and a drop in subnational public investment, and growth decelerated sharply. Headline inflation was slightly above the upper band of the central bank’s (BCRP) target range due to supply shocks, but expectations remained well anchored. The external current account deficit declined slightly despite weaker external conditions. Outlook and risks: Growth is expected to recover in 2015 and over the medium term, contingent on production at new mines approaching capacity, priority infrastructure projects advancing, and shocks to terms of trade fading. However, downside risks dominate. Externally, these include a surge in global financial volatility, further dollar appreciation, or lower commodity prices and external demand. Domestic downside risks include weaker investment, uncertainties surrounding 2016 Presidential elections, and persistent social conflicts. A faster unwinding of supply shocks or a more complete pass- through of lower food and fuel global prices constitute upside risks. Near-term policy mix: The policy mix is broadly adequate to support the recovery and maintain macroeconomic stability. The immediate priority is expediting the execution of public investment in line with government plans, while avoiding increases in non-priority current spending. Monetary policy should remain responsive to inflation expectations and external developments. Exchange rate flexibility should be the main line of defense against any additional external pressures. The timely use of macro-prudential tools and ongoing de-dollarization efforts should further solidify financial stability. Medium-term prospects: With the end of the commodity boom, a push to deepen structural reforms will be necessary to sustain potential growth and diversify the economy. Revenue losses would need to be offset to finance structural reforms, investment, and inclusion along a gradual fiscal consolidation path. Streamlining legal requirements and red tape is rightly a government reform priority and the ambitious education reform and inclusion polices should stay their course within the framework of fiscal discipline. Persevering with labor market reform remains important.

Abstract

KEY ISSUES Context: Peru remains one of the best performing economies in Latin America, with solid macroeconomic fundamentals, strong policy frameworks, and visible gains in poverty reduction. Like most of the region, Peru faced a challenging external environment in 2014. External shocks were compounded by domestic supply disruptions and a drop in subnational public investment, and growth decelerated sharply. Headline inflation was slightly above the upper band of the central bank’s (BCRP) target range due to supply shocks, but expectations remained well anchored. The external current account deficit declined slightly despite weaker external conditions. Outlook and risks: Growth is expected to recover in 2015 and over the medium term, contingent on production at new mines approaching capacity, priority infrastructure projects advancing, and shocks to terms of trade fading. However, downside risks dominate. Externally, these include a surge in global financial volatility, further dollar appreciation, or lower commodity prices and external demand. Domestic downside risks include weaker investment, uncertainties surrounding 2016 Presidential elections, and persistent social conflicts. A faster unwinding of supply shocks or a more complete pass- through of lower food and fuel global prices constitute upside risks. Near-term policy mix: The policy mix is broadly adequate to support the recovery and maintain macroeconomic stability. The immediate priority is expediting the execution of public investment in line with government plans, while avoiding increases in non-priority current spending. Monetary policy should remain responsive to inflation expectations and external developments. Exchange rate flexibility should be the main line of defense against any additional external pressures. The timely use of macro-prudential tools and ongoing de-dollarization efforts should further solidify financial stability. Medium-term prospects: With the end of the commodity boom, a push to deepen structural reforms will be necessary to sustain potential growth and diversify the economy. Revenue losses would need to be offset to finance structural reforms, investment, and inclusion along a gradual fiscal consolidation path. Streamlining legal requirements and red tape is rightly a government reform priority and the ambitious education reform and inclusion polices should stay their course within the framework of fiscal discipline. Persevering with labor market reform remains important.

Key Points

  • Peru remains one of the best performing economies in Lain America, maintaining a sustained period of economic growth, low inflation, and poverty reduction for more than a decade.

  • Economic growth averaged 6.2 percent in the 2003–13 period, and after a temporary decline in 2014, due mainly to exogenous shocks, growth is expected to recover to around 4 percent in 2015 and to reach growth rates above full potential of about 5.0 percent over the medium term in order to close output gap. It is worth noting that high frequency indicators in March-April 2015 already show a turning point, and suggest that economic activity in primary sectors started to accelerate.

  • Inflation expectations remain well anchored, and headline inflation in 2015 and beyond is expected to fluctuate around the mid-point of the inflation targeting range of 1–3 percent.

  • The external and fiscal positions are very strong, with net international reserves equivalent to 30 percent of GDP. Fiscal savings, equivalent to 15 percent of GDP, accumulated during the peak of the economic cycle, provide a substantial buffer for future shocks and countercyclical policies. Unemployment rate is at historical low level of 5.9 percent by end-2014. The financial system remains very liquid, profitable, and well regulated. The net public debt is one of the lowest among emerging markets and industrialized countries, at only 5 percent of GDP.

  • These outstanding achievements reflect the authorities’ sustained commitment, during more than two decades, to sound macroeconomic policies and structural reforms; accompanied by social policies to ensure that the benefits of growth reach all segments of the society. The reduction in poverty rate from near 59 percent in 2004 to 23 percent in 2014, and the decline in the Gini coefficient to 44 percent by 2014, illustrates the progress in social and financial inclusion.

  • The main challenges ahead are how to sustain the economic recovery in the near term, and how to boost potential growth in the medium-term, given the uncertainty of economic growth among Peru’s main trading partners (U.S., China, Latam), and the evolution of commodity prices.

  • Authorities have designed a policy framework, based on three axis, to boost potential growth: i) building up human capital and reducing informality; ii) boosting investment to reduce the infrastructure gap; and, iii) reducing red tape and lowering cost overruns. This policy framework would be critical to provide better quality of labor force to the growth momentum, while reinforcing the process of the improvement in the standard of living of the population. In that sense, it is worth noting that, according to Moody’s, the Peruvian economy, along with Mexico and Chile, is the only one that shows continued momentum to adopt “second generation” reforms in order to improve long term growth.

Introduction

1. The staff has provided a well-balanced description and analysis of recent economic developments and policy discussions.1 My authorities are in broad agreement with the staff’s assessment and policy recommendations. We are also grateful for the in-depth analysis provided in the companion Selected Issues Paper, focusing on the current important topics of growth and investment dynamics, challenges in taxation, and the analysis of the Peruvian sol as a possible commodity currency. We appreciate the focus on the consultation on how to consolidate economic recovery and financial stability, while unlocking potential growth over the medium-term.

2. Peru enjoys a favorable business climate and continues to attract foreign direct investment (FDI), reinforcing the solid conditions for sustained economic growth. In percentage of GDP, Peru leads FDI in Latin America, followed by Chile, Brazil, Colombia, and Mexico. As explained in the staff report and in the Selected Issues chapter on Investment Dynamics in Peru, key structural reforms beginning in the 90s set the stage for the investment and growth boom during the last decade. According to the latest Doing Business report, in 2014, Peru was among the top 35 economies (out of 189) that improved business climate in the world, above Mexico and Chile. My authorities are mindful that with the end of the super commodity cycle, additional structural reforms are needed to maintain the growth momentum and enhance potential growth. The country risk premium continues well below the Latin American emerging markets, reflecting the strength and resilience of the Peruvian economy. For instance, Peru improved its credit rating even in periods of strong volatility in emerging markets (S&P: August 2013; Fitch: October 2013; Moody’s: July 2014). Moody’s rated Peru A3, while S&P and Fitch rated Peru BBB+.

LatAm: Sovereigns Rating1

(Long term debt in foreign currency)

article image

Sorted by Moody’s rating

Source: S&P, Fitch, Moody’s.
A05ufig1

Peru: Sovereign rating evolution

(Long term debt in foreign currency)

Citation: IMF Staff Country Reports 2015, 133; 10.5089/9781513539317.002.A005

A05ufig2

Country Risk Indicator

(Bps.)

Citation: IMF Staff Country Reports 2015, 133; 10.5089/9781513539317.002.A005

3. The resilience of the Peruvian economy is not only rooted in its strong economic fundamentals, but also in the ability of the institutional framework to operate under conditions of strain. It is worth underscoring that the impressive economic growth of an annual average of 6.2 percent during the period 2003-13, accompanied by the lowest inflation in the region of 2.9 percent during the same period, took place during three different administrations. In each of the Presidential elections there were different degrees of uncertainty related to the orientation of economic policies and the investment climate. Yet, uncertainty was short lived and investors maintained their confidence in the business climate and the institutional framework in place. In this context, we do not see the forthcoming 2016 elections as particularly worrisome in terms of affecting long-term investment decisions. We believe that any delay in new investment would be only temporary and the strong dynamics of investment and growth will continue with renovated strength in 2016. Moreover, after more than 20 years of sustained growth and low inflation, the society has learned to appreciate the value of economic stability and improvements in the standards of living, and this would be very difficult to change dramatically by any future administration. This may be perhaps the best guarantee for continued success in the implementation of sound economic policies.

4. Peru continues to make improvements with its socially inclusive growth strategy, expanding access to financial and social services. The reduction in poverty rate from near 59 percent in 2004 to 23 percent in 2014, and the decline in the Gini coefficient to 44 percent by 2014, illustrates the progress in social and financial inclusion. Unemployment rate maintains a historical low level of 5.9 percent by end-2014. The substantial expansion of the middle class (about one third of the population) had important and positive impact on domestic demand, which has been very helpful to partially compensate for the lower external demand. The authorities are working hard to make progress on education reform and financial inclusion, while enhancing the quantity and quality of the social programs, which currently cover over 5 million people, more than half focused on children and the elderly.

Recent Economic Developments and Outlook

5. After a temporary setback in 2014, economic growth is expected to recover in 2015 supported by countercyclical policies and the recovery of the primary sectors. Real GDP grew 2.4 percent in 2014, from 5.8 a year earlier. About half of the decline is explained by temporary supply shocks in fishing, mining, agriculture; and a more than expected drop in sub-national public investment that more than offset the strong fiscal stimulus from the Central Government (national public investment grew 17 percent). The lower than expected growth in China (Peru’s main trading partner), and the additional reduction in metal prices also contributed to a deceleration in economic activity. Against a widening negative output gap and stable inflation expectations, the authorities took timely fiscal and monetary countercyclical policy measures in 2014 and early 2015 to support domestic demand. The authorities are confident that these measures and the unwinding of temporary supply shocks will support economic recovery in 2015. Indeed, high-frequency indicators in April 2015 already show a turning point, and early indicators suggest that economic activity in primary sectors started to accelerate in March 2015. For instance, in March, GDP grew 2.7 percent, the highest record in the last 11 months. Furthermore, in April, electricity production grew 5.8 percent (y/y), the highest record in 13 months, and, according to BCRP, updated to 15th April, the credit in domestic currency grew 19.9 percent (y/y), the highest record in 9 months. On the fiscal side, in April 2015, the regional public investment grew 31.5 percemt, the highest record since February 2014.

6. Headline inflation was slightly above the 3 percent upper limit of the target band at some moments in 2014, but inflation is expected to remain within the target band in 2015 and beyond. A recent survey by the Central Bank shows that inflation expectations are well anchored within the band of 1-3 percent for 2015 and the following years. Core inflation has remained within the inflation target band. Headline inflation fell in April 2015 to 3.02 percent (y/y), close to the central bank’s target range. The Central Bank has the credibility and the toolbox to maintain inflation expectations within the target band, while providing the stimulus that the economy may need during the transition period.

7. Peru has a very strong external position and the real exchange rate is in line with fundamentals. Net international reserves grew to US$ 61.5 billion by May 5, 2015, equivalent to 30 percent of GDP. As explained by the staff in Appendix II, Peru: External Assessment; net international reserves are adequate by any metric, including the IMF composite adequacy metric, and Peru’s reserve adequacy is well above its regional peers. Our authorities feel comfortable with this policy, which proved to be very effective in dealing with the capital outflows during the peak of the crisis in 2008-09, and it is considered a source of strength by rating agencies, investment banks, and corporations interested in doing business in Peru. We agree with the staff’s assessment that the real exchange rate is in line with fundamentals. The authorities will continue to employ FX interventions and macro-prudential measures to contain excessive exchange rate volatility and avoid disorderly market conditions.

8. The Fiscal position remained strong in 2014 with an overall public sector deficit of 0.3 percent, despite the negative impact in tax revenues due to the lower commodity prices and the expansionary fiscal policy from the Central Government. As shown in table 2 of the staff report, the NFPS balance has been a surplus of an annual average of 1.7 percent of GDP during the 2011–13. Strong fiscal buffers coupled with a net public debt of only 5 percent of GDP, the lowest among emerging markets and industrialized countries; provide the authorities with a lot of room to maneuver in order to implement countercyclical policies when needed. Yet, the authorities are aware of the challenges ahead in terms of withdrawing the transitory fiscal stimulus and keeping the level of fiscal buffers, while increasing revenues as percentage of GDP in line with peer countries. This is clearly explained in the taxation chapter of the selected issues paper, as well as the government efforts to continue making improvements in tax administration through widening the tax base, streamlining exemptions, promoting formalization, boosting collection of local property taxes, and reviewing excise taxes to address negative externalities; while increasing the efficiency of public expenditure. In the last two weeks, the Ministry of Finance has taken additional actions to further stimulate domestic demand in 2015. A bill was submitted to Congress in April 2015 with several policies aimed at providing additional disposable income to the population,. Also, the Congress has already approved a law in order to accelerate the execution of 2015 budget through some budgetary reallocations and transfers, and a Supreme Decree was approved in order to issue bonds to finance important public investment projects. It is worth mentioning that the authorities also indicated that the Fiscal Council will be established in 2015 as a sign of commitment with the new fiscal framework.

Policy Issues and Objectives Going Forward

9. We share the staff’s assessment that Peru is in a strong position to respond to shocks, should the downside risks to the outlook dominate. The Peruvian financial system is very resilient to changes in output growth, exchange rate movements, volatility induced by the liftoff in the U.S. interest rates, and other factors. Severe stress tests scenarios suggest that the system as a whole can manage very large shocks. The “acid test” took place during the 2008-09 global financial crises. The Peruvian economy had positive growth and had a strong rebound in the following year. We do not see the 2016 Presidential elections as a relevant domestic risk. Stronger than expected El Niño weather phenomenon and continuing social tensions in mining regions could be important downside risks. Yet, the authorities are confident the ongoing infrastructure projects and more in the pipeline to be finance under private public partnership schemes would create the basis for additional private investment and increasing growth potential.

10. The Peruvian authorities value the staff’s policy advice and the helpful technical assistance in a range of key issues including the design of the new Fiscal Rule. As explained in Appendix III of the staff report, important changes were introduced to improve the old fiscal rules. The new methodology based on ex ante structural fiscal balance provides three years expenditure ceilings for the budget formulation. The authorities are assessing the staff’s suggestions to use conservative targets to preserve the hard won fiscal buffers. The temporary deviation from the fiscal rule has been done under escape clauses considered in the new Fiscal Rule, and a gradual consolidation will take place beginning in 2016.

11. There is continued gradual progress to further reduce dollarization in Peru, including a new set of measures introduced by the Central Bank in December 2014. Despite a successful inflation targeting framework, and having one of the lowest inflation in the region and in the world for more than a decade (less than 3 percent annual average), by end 2014 38 percent of credit and 43 percent of deposits were still denominated in U.S. dollars; down from about 80 percent of credits and deposits by the end of the 1990s. There are idiosyncratic factors associated with previous hyperinflation (i.e. 7,650 percent in 1990) that partially explain this apparent inconsistent behavior by market participants. To help accelerate the de-dollarization process and reduce the currency mismatch risk to balance sheets of households or corporate, the central bank has issued new repos in domestic currency to support the expansion of credit in nuevo soles and to substitute foreign currency loans with local currency loans. The monetary authority also increased the marginal reserve requirement on foreign currency deposits by 10 percentage points twice to 70 percent, effective in January and March 2015. The authorities are aware that deepening financial and capital markets could also be an effective way to achieve lasting de-dollarization. In fact, several missions from the Capital and Monetary Market Department have provided technical assistance in related issues, but this is a gradual process and it will take time to develop.

12. The authorities agree with the staff’s assessment that Peru’s macro-financial system is stable, with no signs of imminent systemic risks. As discussed above, high dollarization of financial assets and liabilities remain a key structural risk, but as recognized by the staff, risks are contained due to large buffers by the financial system. The regulatory and supervisory banking authority has built safeguard mechanisms by putting in place regulatory requirements above international standards. It is worth to underscore that banks’ direct exposure to the commodity sector is relatively low, with only about 10 percent of banks’ credit going to the agriculture and mining sectors. The 2010 FSAP second update found that the regulation, supervision, and safety net of the banking system are of high quality and well developed. Moreover, according to the FSAP report, Peru’s legal framework for bank resolution is in line with best practices.

13. Looking ahead, how will Peru keep sustained economic growth and further reduce poverty in order to transition from an emerging market to a more advanced economy? We need to continue creating the right conditions for private investments to lead economic expansion, while strengthening regulatory agencies to protect the public interest and the general public. Peru has made great progress in many areas including civil service, infrastructure, education, health, protection to private property, capital market, etc. However, much remains to be done and new generations of structural reforms are being implemented, as it is currently done in several areas such as: i) strengthening the human capital and reducing informality (higher public resources allocated to Education and Health sectors, civil service reform, Competitiveness Agenda 2014–2018, Productive Diversification Plan, etc.), ii) boosting the investment to reduce the infrastructure gap through a higher use of PPP schemes, and iii) reducing “red tape” and lowering cost overruns. My authorities are working in all fronts, including the planned incorporation to the OECD, which could provide the motivation and the adequate political economy framework, to make progress with the authorities’ strategy to consolidate sustained and inclusive growth, low inflation, and the modernization of the country. This will take additional time, but we need to remind ourselves that it has taken 25 years of continued implementation of sound economic policies to reach this point.

1

IMF, Staff Report, SM/15/103

Peru: 2015 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Peru
Author: International Monetary Fund. Western Hemisphere Dept.