Macroeconomic background

Peru is one of the best performing economies in Latin America this century, due to a solid macroeconomic framework and an open trade policy (19 free trade agreements and an average tariff rate of 0.9 percent). GDP growth has been the second highest (5.1 percent on average after Panama) and inflation has been the second lowest (2.7 percent on average after El Salvador) in the region during 2001–2017. Moreover, general government gross debt is the lowest in the region (23.3 percent of GDP) and, consequently, sovereign rates in domestic currency (5.5 percent for a 10-year bond) are in the low range among EMEs. This solid macroeconomic framework was built together with deep structural reforms since the beginning of the 90s.

As a small open and commodity exporting economy, Peru’s economic cycle is correlated with the evolution of mineral prices. During the commodity boom period (2006–2013, except 2008), Peru created important buffers by running fiscal surpluses, building international reserves, raising reserve requirements, and establishing provisions to avoid credit booms and bubbles. These buffers allowed Peru to face periods of falling commodity prices during the onset of the Global Financial Crisis (GFC). As of 2017, Peru had experienced 19 years of uninterrupted economic expansion, with only three years of growth below 2 percent (1999, 2001, and 2009).

Recent macroeconomic developments

After a year of low growth, driven by the impact of the El Niño phenomenon and the Lava Jato corruption scandal, recent economic data point to a further strengthening of the economy. The Peruvian economy is already growing at 4.6 percent between January and May 2018. Formal employment in the private sector is growing at 3.8 percent in the first four months and the construction sector (a labor-intensive activity) has recovered after 2 years of contraction (2015 and 2016) or low growth (2.3 percent in 2017), reaching an expansion of 7 percent in January-May 2018. During a similar period, mortgage loans increased 8 percent and VAT collections grew 12 percent.

The current account deficit is sustainable, declining from −2.7 to −1.3 percent of GDP in 2016 and 2017, respectively, due to higher commodity prices and the weak economic cycle. Peru’s external debt is relatively low (35.7 percent of GDP) as most of the external financing has come as FDI. During the last years, international reserves have remained relatively stable at around 30 percent of GDP. Our authorities are comfortable with this level of reserves (built during the commodity boom periods), which proved to be very effective in facing macroeconomic and financial risks from financial dollarization (FD) when dealing with capital outflows at the peak of the GFC and in the latest taper tantrum episode, which coincided with a strong fall of commodity prices (2013–2015).

Monetary Policy

The Central Reserve Bank of Peru (BCRP) follows an inflation targeting (IT) regime that takes into account the financial risks created by partial dollarization (30 percent of loans are dollar-denominated). The real exchange rate plays an important role as a shock absorber, and Peru was the first country in the region to abandon its exchange rate peg in 1990. The BCRP was also the first economy with high FD to formally adopt IT in 2002. Forex intervention aims exclusively at preventing negative balance sheet effects with recessionary and financial stability risks on the economy. The frequency of forex intervention has been lower this year. In addition, higher reserve requirements for dollar deposits are used to discourage financial intermediation in foreign currency and promote faster de-dollarization. Higher reserve requirements also allow banks to build international liquidity buffers in periods of increased capital inflows and reduce liquidity pressures during capital outflow episodes. The latest reductions in reserve requirements are consistent with a path of normalization to a steady-state.

As of June 2018, headline inflation (1.4 percent) is within the BCRP inflation target range (1–3 percent) and below the mid-range (2 percent) due to the reversals of negative supply shocks. Core inflation (2.2 percent) is close to the mid-range and different indicators of the inflation trend show similar results.

Communication and consistency of monetary policy decisions have been crucial to guide financial markets on future monetary policy measures and to keep inflation expectations anchored. The monetary policy stance has been accommodative during the last years. The BCRP reduced the interest rate 6 times, from 4.25 percent in April 2017 to 2.75 percent in March 2018, as the output gap became negative (−1 percent) and forecasted inflation and inflation expectations (2.2 percent) remained within the inflation target. The recent monetary policy statements have highlighted that future changes in policy rate will depend on new information, in particular on the evolution of inflation expectations and on how fast the output gap approaches its neutral position. The experience over the last years has shown that market rates have responded in line with BCRP communication statements.

Fiscal Policy

The Government has enough space to implement a counter cyclical fiscal policy to support the cyclical economic recovery by increasing public investment this year and start a fiscal consolidation process in 2019 to achieve a fiscal deficit of 1 percent by 2021. The limit for the fiscal deficit has been raised to 3.5 percent of GDP in 2018 to face the infrastructure and reconstruction needs after El Niño; however, the forecasted deficit is likely to be close to 3 percent, given the recent increase in tax collections. The aim is to stabilize gross public debt at about 27 percent of GDP in the medium term, as the fiscal framework is consistent with a cap on public debt of 30 percent of GDP and a steady-state fiscal deficit of 1 percent of GDP. In addition, the Treasury has deposits in the financial system, mainly at the BCRP, equivalent to 15 percent of GDP, resulting in a net public debt of less than 10 percent of GDP.

The fiscal consolidation process will be achieved mainly by increasing revenues and streamlining expenditures. After 4 years of declining fiscal revenues, the figures as of June show a clear reversal of this trend, as economic activity starts to rebound and commodity prices have partially recovered. In the first half of 2018, fiscal revenues have increased 18 percent compared to the same period in 2017, reaching a 12-month ratio of 19 percent of GDP, higher in 1 percentage point.

In addition, the new administration has taken steps to enhance revenues. The Government raised excise taxes (0.4 percent of GDP) on goods with negative externalities (diesel fuel, cigarettes, alcoholic beverages, sugary drinks, etc.). In the short term, the focus will be on reforming the tax administration, including by improving fiscal databases. The information from the recent repatriation tax at the end of last year has extended the tax base for income taxes. The Superintendence of Tax Administration (SUNAT) is working on the full digitalization of the VAT payment process by 2019.

Furthermore, Peru signed an agreement with 122 countries in the context of the BEPS (Base Erosion and Profit Shifting) plan led by the OECD. The agreement aims to fight fiscal evasion by accessing international information, including on tax havens, and promoting investment by reducing double taxation.

Regarding public expenditure, the Government approved measures aimed at reducing non-critical expenses equal to 0.3 percent of GDP. The adjustment will be governed by guidelines for optimizing rental expenditures and the purchase and use of vehicles, among others. In addition, the special legislative powers granted by Congress include the ability to introduce measures for strengthening the efficiency and sustainability of the Fuel Price Stabilization Fund (FEPC). Changes in the FEPC are expected to create annual savings up to 0.2 percent of GDP.

The Peruvian Congress passed a law in March 2018 to provide more clarity on civil damages in corruption cases, to allow the normal continuity of public investment projects equivalent to 4.5 percent of GDP. The law establishes rules for asset transfers by construction companies that are under investigation or those already indicted. Hence, the law reduces uncertainty for the construction sector and for banks in their risk assessment process.

The implementation of public investment has taken longer than planned but finally there is a clear recovery. The new administration, in coordination with local governments, has taken several actions to revert a 4-year declining trend in public investment. The Government signed a cooperation agreement with the UK to build the infrastructure needed for the 2019 Lima Pan-American Games, based on the experience of the 2012 London Olympics (New Engineering Contract, NEC 3).

Reforms and high potential GDP growth

Congress granted special legislative powers to the new administration with the aim of reaching higher potential GDP growth and fiscal consolidation, thus sending a strong signal of political consensus on key reforms. The areas covered are tax policy and administration (including BEPS); competitiveness (include SME regulation and customs procedures); post-El Niño reconstruction; anti-corruption measures (including requiring conflict of interest statements from public officials); protection of vulnerable groups; and modernization of the state.

The new administration is committed to implementing reforms to improve governance and to fight corruption. The recent legislative powers provide an opportunity to review legislation and procedures to reduce corruption risks. The authorities welcome the next Fund mission on Governance and Corruption in collaboration with the World Bank. The mission is part of the anti-corruption pilot initiatives under the recent update and more operational framework approved by the Board.

Another group of reforms is geared to enhance high productivity sectors. The Government has committed to empowering the “Consejo Nacional de Competitividad y Formalización” (National Council for Competitiveness and Formalization) and continuing the implementation of “Mesas Ejecutivas” (Executive Bureaus). The former measure seeks to completely reform the Council by providing it with powers for articulating policies among various economic sectors (e.g., elimination of unnecessary rules and design of efficient incentive schemes). The latter measure looks to establish a space of agreement between private and public actors to overcome development barriers in strategic sectors (e.g., aquaculture and forestry).

Peru continues to have a substantial infrastructure gap, but solid long-term fiscal sustainability enables the Government to implement an ambitious investment program. This year, several important infrastructure projects will take place, such as the expansion of the international airport and the restart of the second line of the Lima metro.

The current economic recovery presents an opportunity to address a reform of the state to provide more and better quality of basic public services such as education, security, and health. Despite impressive economic growth during this century, Peru’s social needs are persistent. The authorities are cognizant that it is a medium-term task, as human and material capacity constraints are significant challenges in improving the efficiency of the public sector.

Financial Sector

The development of the financial system is a key driver of higher potential GDP growth. The expansion of credit to the private sector has been impressive in this century, escalating from 28 percent of GDP in 2000 to 40 percent in 2017. The number of borrowers has increased from 1 million to 7 million during the same period (Peru’s population is 31 million). Nevertheless, the financial system is still underdeveloped in comparison with other economies in the region. The main goals of Financial Inclusion 2021 are focused on achieving greater depth in financial markets, broadening the coverage of financial services to promote higher use of digital payments, and creating adequate financial ecosystems for the population.

The financial system has become increasingly resilient and the Superintendence of Banks and Insurance Companies (SBS) has made progress in strengthening financial supervision and regulation. Congress passed a new law extending the SBS supervision perimeter to include cooperatives. The banking system is very well capitalized and profitable and credit developments do not suggest broad-based risks. Banks remain highly resilient to negative shocks, including a deep recession, as suggested by the FSAP stress tests. The banking sector is also highly resilient to liquidity shocks due to reserve requirements. The SBS is working on additional measures to increase the capital buffers of domestic systemic banks and to implement the Net Stable Funding Ratio (NSFR).

The FSAP assessment is that Peru’s financial sector remains solid since the previous evaluation (2011) and has adequate buffers to manage severe shocks. The banking sector stress test found that profits and previously accumulated countercyclical buffers would be instrumental to withstand a negative cumulative GDP growth shock of 9.5 over a three-year period. Similar satisfactory results were found for the corporate sensitivity analysis. We welcome the use in Peru’s FSAP of the new Growth-at-Risk (GaR) methodology, which was published in the last Global Financial Stability Report (GFSR).

Conclusion

Peru has enjoyed almost two decades of economic expansion with prudent macroeconomic policies. Looking ahead, the base scenario shows a clear economic recovery in a low inflation environment, with a sustainable fiscal position and very healthy balance of payment. The Peruvian economy has ample buffers to face negative shocks in case of a deterioration of the international conditions.