Peru: 2008 Article IV Consultation and Fourth Review and Inflation Consultation under the SBA Concluding Statement of the Mission
December 12, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Peru's strong economic performance owes much to prudent macroeconomic policies and reforms under a favorable external environment. Sustained fiscal surpluses have been the backbone of this success, supported favorable terms of trade and a prudent conduct of monetary policy, which while underpinned by inflation targeting, has also aimed at carefully balancing risks associated with high financial sector dollarization. Important structural reforms have been advanced to expedite public investment, entrench fiscal stability and public debt sustainability, enhance the resilience and depth of the financial system and capital markets, reduce labor market informality, and further open the economy to external trade and innovation. These efforts have helped reduce poverty and economic vulnerabilities significantly and have established the basis for high economic growth and a sustainable improvement in living standards, all of which have been recognized by the achievement of investment grade status.
2. The economy has been enjoying its longest expansion on record, with rising inflation. After posting a 10 percent increase in the first three quarters of 2008, recent indicators suggest that real GDP growth would decelerate in the fourth quarter of 2008, and would end at around 9½ percent for the year as a whole. Private investment and consumption have led most of the way, but a significant acceleration of public investment-particularly by subnational governments-has also been an important contributing factor. A deterioration in terms of trade and net exports should shift the external current account from a surplus of 1.4 percent of GDP in 2007 to a deficit of 3.3 percent of GDP in 2008. While still one of the lowest by regional standards, inflation has risen markedly this year and is projected at 6½ percent by end-year. Most price pressures have been external (imported inflation rose by 8½ percent in 2008), and more recently, the strong pace of domestic demand has pushed up core inflation (excluding food and fuels) to 3¾ percent.
3. Prudent policies have been essential to buttress the strong performance. For the third consecutive year, the nonfinancial public sector is projected to register a surplus, estimated at 2.1 percent of GDP in 2008. Notwithstanding a reduction in the pace of spending in the second half of the year, the fiscal stance was expansionary for the year as a whole-by about 1.3 percentage points of GDP. This was driven by an increase in public investment in real terms of about 50 percent to reduce the infrastructure gap and address social needs, as well as by the repayment of 0.6 percentage points of GDP of liabilities under the Fuel Price Stabilization Fund (FEPC). Fuel subsidies have been eliminated through adjustments to the band price and the sharp decline in imported fuel prices. The government has taken advantage of the decline in oil prices to increase excise taxes on selected domestic fuel prices substantially, unwinding reductions implemented when prices were rising in recent years. In response to rapidly expanding domestic demand and rising core inflation, monetary policy had been gradually tightened since mid-2007, through policy interest rate and higher reserve requirements. However, in response to the global financial crisis, the Central Reserve Bank of Peru (BCRP) has kept bank policy rates on hold since October, lowered reserve requirements, intervened in the foreign exchange market, and placed repos (up to one year) and swaps in order to maintain adequate levels of liquidity in the domestic banking system, and limit pressures on the domestic currency and risks from high dollarization.
4. These policies have also helped mitigate the impact of the global financial crisis on Peru. After peaking in October, interbank rates have returned to pre-crisis levels and credit to the private sector has continued growing robustly in the year to October. Credit to the private sector has accelerated in October, particularly for the corporate sector, partly as a result of tighter financing faced abroad and in domestic capital markets, and indicators for November confirm stable liquidity conditions and still rapid credit growth. The government yield curve has also returned to pre-crisis levels. Equity prices have also recovered somewhat, but remain 60 percent below end-2007 levels. Deposit dollarization has also increased in recent months, although it still remains on a declining path in the past two years. Large official reserves and strong financial soundness indicators for the banking system, along with banks' limited reliance on external funding (at about 15 percent of total assets and about two-thirds long term), have helped buffer Peru from the sharp financial sector turbulence witnessed in many other countries.
5. Medium-term prospects are favorable and require preserving prudent policies and dealing with long-standing structural challenges. With heightened risks stemming from the global economy, preserving the high quality of macroeconomic policies is essential to sustain high growth, low inflation, external stability, and poverty alleviation over the medium term. Peru has become a more open economy, and continued capital deepening should enhance productivity-necessary conditions to generate strong employment growth and higher real wages. These efforts should be further complemented by reducing high labor market informality and improving the quality of public investment and social spending across all government levels to alleviate infrastructure and social gaps, and thus support ongoing export diversification and poverty alleviation. Strengthening public institutions, advancing administrative simplification and education attainment, would also help boost human capital and entrench high total factor productivity growth.
6. Peru's outlook for 2009 remains favorable while subject to an unusual degree of uncertainty associated with the depth and duration of the global slowdown. Recent indicators suggest that the economy has begun to slow and the pace of economic growth is expected to slow through the first half of 2009. While the risks of a more sharp and sudden slowdown are difficult to gauge at this juncture, the economy's underlying strength and diversified growth base, along with the marked growth in public investment that has taken place in 2008-expected to be sustained in 2009-provide an important buffer. The Peruvian economy would continue to grow among the fastest in the world economy in 2009, with real GDP growth projected at 6 percent-reflecting a slowdown in private investment and net exports. With global price disinflation already underway and imported food prices expected to decline by 3½ percent in 2009, inflation should decelerate to 2.8 percent by end-2009, within the 1-3 percent target range. A more protracted and severe global slowdown would bring downside risks to growth, inflation, and the balance of payments, particularly in the second half of 2009 and early 2010.
7. Macroeconomic policies need to remain focused on achieving a soft-landing. This will require a delicate balancing act between the risks associated with the global slowdown and the economy's underlying growth momentum, to ensure that it translates into more sustainable growth and lower inflation. Staff is of the view that achieving a neutral fiscal stance in 2009 would enhance macroeconomic stability while still allowing for an important increase in public investment, and would be consistent with an overall surplus of about 0.7 percent of GDP. With global price disinflation underway, monetary policy should use the opportunity to re-anchor expectations and reduce inflation to the 1-3 percent range during 2009. While recent indicators confirm signs of disinflation, the path of domestic demand could delay this process in the near term.
8. The authorities' announced Plan for Sustaining Economic Growth, Employment, and Poverty Alleviation in a Global Crisis is an important step to bolster domestic business confidence. The authorities have announced a set of fiscal measures-equivalent to about 2½ percent of GDP targeted to support construction, micro and small enterprises, exporters, and social programs. These measures would be financed primarily by government deposits and credit lines from official creditors. In addition, the government has lined up access to contingent lines from official creditors that could amount up to $9¼ billion dollars, and would help boost economic growth by at least one percentage point. Staff is of the view that the Plan provides an important signaling of Peru's readiness to face the global crisis.
9. At this juncture, several of the measures contemplated by the authorities seem sufficient to buffer the economy from the global slowdown. As stated in the Plan, the authorities' decision to extend the execution of ongoing public investment projects through March 2009, as well as their intention to phase public investment more evenly throughout the year and boost resources under the FONIPREL (Fund for the Promotion of Regional and Local Public Investment), should help sustain a more expansionary fiscal policy in the first half of 2009. This, along with the recent reductions in reserve requirements and steady growth in credit to the private sector, should help ward off a sharp and sudden deterioration in private investment and net exports during this period. For 2009 as a whole, staff is of the view that a fiscal surplus of about 0.7 percent of GDP would allow automatic stabilizers to operate fully, while keeping growth in government consumption and public investment in line with the 2009 Budget. At present, a more aggressive discretionary countercyclical set of policies risks delaying some needed slowdown in domestic demand and a potentially sharper deceleration later on, with an ensuing weakening of credibility.
10. Were the global slowdown to be more severe and prolonged, the authorities would be in a position to implement cautious countercyclical measures. In particular, further reductions in reserve requirements and policy interest rates, along with further fiscal easing, reflecting automatic stabilizers, could be the first line of defense. The need for additional fiscal stimulus should be carefully contemplated and paced, and in the staff's view, a prudent stimulus could be financed with government savings accumulated in recent years. This policy response would be consistent with the authorities' intentions, as presented in their Plan.
11. The authorities' focus on strengthening the financial system and sustaining an orderly financial deepening is timely. Financial soundness indicators are strong and recent stress tests by the Superintendency of Banks confirm the financial system's overall resilience to a global slowdown, lower terms of trade, and market risks. Staff welcomes the authorities' decision to tighten prudential regulations on consumer loans and the implementation of new procyclical provisioning rules, given the risks stemming from still buoyant credit growth. Reforms to enhance the bank surveillance and intervention regimes, and to implement enhanced capitalization requirements in line with Basel II are also welcome and timely. Going forward, it will be important to continue monitoring the growth in nonperforming loans, particularly those to consumers and microenterprises, given the expected tightening of lending standards and the slowdown in economic activity. Priority should be given in 2009 to enacting the increase in minimum capital requirements for microfinance institutions to protect their strong capitalization, including for new entrants. The continued close monitoring of foreign operations of domestic banks more exposed to the global financial crisis is important. To address this risk and others related to large exposure to riskier operations (such as consumer and retail activities), consideration should be given to requiring financial institutions to increase their capital base, preferably with Tier-I contributions, as needed.
12. Staff welcomes the coordination between the Ministry of Finance, the Central Reserve Bank, and the Superintendency of Banks to strengthen the framework for crisis preparedness. The ongoing actions and plans to ensure adequate liquidity to the financial sector and capital markets are an important step forward to minimize systemic risks, and in the staff's view, should be complemented by a well-established mechanism and clear commitment to protect the central bank's balance sheet. Staff also encourages the authorities to recapitalize the Deposit Insurance Fund over the coming years through contributions by financial institutions. These measures could be supplemented by preparing contingency plans to deal with potential systemic solvency problems. Staff also encourages the authorities to align the supervisory framework for public financial institutions. Continuing with reforms to enhance the depth and resilience of the domestic capital markets, including through enhancing the coordination for their better oversight and improving competition for private pension funds will also be key.
13. There is also scope to further solidify the policy framework and the economy's ability to buffer shocks. To further bolster the credibility of the inflation targeting framework, priority could be given to enacting legislation that delinks the appointment of the central bank president and board members from the presidential cycle. In addition, the authorities' decision to reduce reserve requirements is appropriate, which would also help strengthen the signaling of the policy interest rate. Staff is of the view that the stronger macroeconomic fundamentals and improved balance sheets in the economy provide scope for greater exchange rate flexibility ahead, as external conditions permit. For this, it will also be critical to advance reforms that facilitate hedging in the economy, such as the issuance of regulations regarding the tax treatment of derivatives.
14. It will be important to begin the work toward institutionalizing the prudent fiscal policy of recent years. An important step in this direction would be adopting a medium-term expenditure framework that would also help improve expenditure management. Staff also encourages the authorities to prioritize the alignment of the expenditure limits in the FRTL and the Decentralization Law, in line with commitments under the program. At the same time, the adoption of a structural fiscal rule would formalize the broadly neutral fiscal stance of recent years and strengthen the credibility of fiscal policy by ensuring a balanced budget over the economic cycle. The formal adoption of such a rule could be gradual and brought explicitly into the budget process before it is formalized. To alleviate concerns on assessing the stage of the economic cycle, the authorities could consider establishing independent expert panels.
15. Efforts to strengthen the fiscal policy framework have been significant and it will be important that fiscal risks remain contained. Reforms to minimize fiscal risks, including the legal framework for Public-Private Partnerships, the alignment of the budget classification with international standards and the significant steps to enhance the comprehensiveness of the Treasury Single Account (TSA) are welcome. Going forward, it will be important to finalize the implementation of the TSA, as envisaged in the program, ensure a better integration of the budgetary process and implementing the recently approved fiscal accounting for PPPs. It will also be important to ensure that the reforms to the National System of Public Investment to facilitate project evaluation and execution do not undermine the quality of public investment, particularly at the subnational government level. Staff also sees potential fiscal risks on public finances stemming from a broad use of the Build & Transfer program, and encourages the authorities to issue pertinent accounting norms. It will be important that the PPP framework and other initiatives involving the private sector maintain an adequate balance of risks between private and public sectors. In addition, to reduce fiscal risks associated with the FEPC, consideration should be given to making the price-band adjustment and settlement of liabilities more automatic or even liberalizing fuel prices over the medium term.
16. Broadening the tax base remains an important challenge ahead. With Peru's tax-to-GDP ratio low by regional standards and highly exposed to commodity revenues, it will be key to press ahead with reforms that broaden the tax base, including the taxation of capital gains. It is also critical to proceed with the 2007 reform of the tax exemptions planned for March 2009. Given the recent completion of the methodological guidelines for the assessment of such exemptions, staff encourages the Ministry of Finance to issue them promptly, in line with commitments under the program, and take the lead in advancing the assessment required by the law 977 to Ministries and other public agencies. Efforts to protect the integrity of the tax administration, including of indirect domestic taxes, and to strengthen auditing procedures and setting targets for noncompliance need to be sustained. In the current external environment, staff supports the authorities' intention to fully unwind the reduction in fuel excise taxes implemented since 2004 in line with environmental considerations.
17. Sustaining poverty alleviation would require continued efforts to improve the effectiveness of social programs. Despite the significant decline in poverty, staff analysis based on the National Household Survey confirms the reports of limited improvements in the targeting of several social programs. Staff welcomes the commitment in the 2009 Budget to link allocated spending to concrete improvements in social programs, as well as the intention to assess the successful cash transfer program Juntos and other large social programs, to further strengthen their effectiveness. It will also be important to prepare an assessment of universal programs, in line with the poverty strategy of March 2007. Regional disparities remain an important challenge, and the expansion of FONIPREL and the methodological changes to the allocation coefficients of FONCOR (Regional Compensation Fund) are a welcome step that should be complemented by reforms toward institutionalizing an equalization scheme.
18. Much has been accomplished in enhancing the business environment, but important challenges remain. Staff welcomes the implementation of the Micro and Small Business law, an important step towards reducing labor market informality. The reduction in tariffs in recent years and the free trade agreements with the United States and other countries, and those under negotiation are commendable and should support medium term growth. These efforts should be complemented by further administrative simplification and reduced costs for opening and closing businesses, construction permits, as well as tax payments and external trade. Recent reforms, including the Positive Administrative Silence law, the one-step window for external trade, and the government pilot project to complete several important procedures electronically bode well for enhancing the business environment.
The mission would like to thank the authorities and senior officials at the Central Reserve Bank, Ministry of Finance, Superintendency of Banks, and other public agencies and ministries, for their cooperation and frank and cordial discussions.