## _cr16235

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---

### Findings from VAR impulse-response analysis
- Primary expenditures:
  - Chile: a one standard deviation commodity price shock leads to a one percent decline in primary expenditure.
  - Peru: the same shock leads to an increase of 2 percent in primary expenditures.
  - Colombia: primary expenditures are insensitive to commodity price shocks after some initial volatility.
- Public revenues and real GDP growth:
  - Public revenues: Chile experiences the biggest increase of around 8 percent after 4 quarters; Colombia peaks at 4 percent after 3 quarters; Peru peaks at 1.5 percent after 3 quarters.
  - Real GDP growth: the initial response is broadly similar across the three countries up to two quarters; in the medium term Peru benefits most from a positive ToT shock.
- External sector (REER and current account):
  - A positive commodity price shock is associated with REER appreciation in Chile and Colombia, with a stronger appreciation in Colombia.
  - Peru shows a slight REER depreciation in the VAR estimates, possibly reflecting active intervention by the Central Reserve Bank of Peru.
  - The current account response is strongest in Colombia; Chile and Peru show similar initial adjustments during the first five quarters, with Chile showing larger improvement over the medium term.

### Forecast-error variance decomposition (quantitative contributions)
- Commodity-price shocks’ contribution to variance of primary expenditures (10-quarter horizon):
  - Chile: about 5 percent.
  - Peru: about 5 percent.
  - Colombia: about 2 percent.
- Commodity-price shocks’ contribution to variance of public revenue growth:
  - Chile: about 25 percent.
  - Peru: about 20 percent.
  - Colombia: roughly 3 percent.
- Commodity-price shocks’ contribution to variance of real GDP:
  - On average about 10 percent, broadly similar across Chile, Colombia, and Peru.
- Commodity-price shocks’ contribution to variance of the REER:
  - Around 34 percent in Chile and around 24 percent in Colombia; a sizable share but smaller in Peru.

### Event-study results on recent commodity price declines
- Timing and magnitude of shocks:
  - Copper (Chile and Peru): declined 45 percent over 18 quarters beginning in 2011.
  - Oil (Colombia): plunged by about 40 percent in 5 quarters beginning mid-2014.
- Exchange-rate and current-account adjustments:
  - Chile: real effective exchange rate depreciated by 5 percent by the end of its adjustment process; current account moved toward closure, with much adjustment coming from import contraction.
  - Colombia: sharp and fast real depreciation of around 18 percent; current account deteriorated due to oil price decline and has yet to reflect quantity adjustments.
  - Peru: minor real appreciation of about 6 percent, which could reflect Central Bank of Peru FX interventions; current account deficit deteriorated from 2 percent of GDP in 2011 to 4.4 percent of GDP in 2015.
- Adjustment composition:
  - Chile achieved current account correction mainly via import decline (imports fell from 35 to 30 percent of GDP) rather than a pickup in non-traditional exports.
  - Peru exhibited relatively stable non-traditional exports, imports, and FDI, consistent with a stickier current account deficit.

### Policy implications and observed policy responses
- Exchange-rate flexibility:
  - Flexible exchange rates are important to absorb terms-of-trade shocks.
  - Peru’s FX intervention delayed exchange-rate adjustment and correlated with a larger current-account deterioration.
- Monetary policy:
  - Currency depreciation increased inflationary pressures in all three countries, reducing room for countercyclical monetary easing.
  - Central banks in the three countries tightened policy (raised the policy rate) to contain inflationary pressures and sustain credibility of inflation-targeting regimes.
- Fiscal space:
  - Greater fiscal space (as in Chile and Peru) provides more room to accommodate terms-of-trade shocks.

---

### Fiscal balances, revenues, and expenditures (Section 16)
- Primary balances have deteriorated steadily in all three countries.
- The shock to commodity prices reduced commodity related revenues, reflected in lower growth rates of public revenues after the shock.
- Except for Colombia, the growth rate of public expenditures remained broadly stable.
- Colombia was already featuring a primary deficit when the shock hit; Chile and Peru exhibited surpluses, giving Chile and Peru more room to implement gradual fiscal adjustment that helped smooth the adjustment to the shock.
- Peru-specific fiscal statistics and measures:
  - Public investment spending as a percent of GDP increased from about 3 percent in the early 2000s to about 6 percent in 2013, before moderating in 2014–15.
  - Private investment jumped from 14¼ percent to 19¼ percent of GDP over the same period.
  - Over the last decade, public investment contributed 2¾ percentage points (21 percent) to the average annual growth in total real fixed capital investment of 12¾ percent.
  - Local investment spending increased from less than 1 percent of GDP in 2007 to 2½ percent of GDP in 2013; national and regional fixed investment spending rose from about 1½ percent to 3 percent of GDP.
  - Peru’s national infrastructure gap estimates: US$160 billion over 2016−25; for the next four years, the gap is about US$70 billion.
  - Peru: Anti-Crisis Fiscal Measures (2008-09) total: 4.17 percent of GDP (breakdown includes Support to construction sector 0.85; Public investment 1.37; Fund for Regional and Local Public Investment 0.63; others).
  - Peru: Selected Fiscal Stimulus Measures (aggregate): A. Taxes (2015) 0.7; B. Net expenditure (2014) 0.3; Bonuses and salary increases 0.3; C. Expenditure (2015) 0.9; Current expenditure 0.1; Capital expenditure 0.4; Repayment of debt in arrears 0.3; Social assistance 0.1; Total (A+B+C) 1.9 (In percent of GDP).
  - In response to the 2008 GFC, the government prepared fiscal measures equivalent to nearly 4 percent of GDP; the resulting fiscal impulse was around 3 percent of GDP over 2008−10.
  - In mid-2014, a fiscal stimulus plan equivalent to about 3 percent of GDP was designed; this contributed to an overall budget deficit of about 2 percent of GDP in 2015. Most of the 2014−15 stimulus came from tax measures—about 30 percent of a 2 percentage point decline in tax revenue came from tax rate reductions—and an increase in current spending rather than higher public investment, which was under-executed and dropped significantly in 2015 as percent of GDP.

### Domestic demand, GDP dynamics, and adjustment channels
- At the time the shock hit, all three countries experienced a slowdown in total domestic demand, with Colombia showing curious resilience despite a sharper shock.
- Initial slowdown in Chile and Peru was significantly more abrupt than in Colombia.
- In the final stages of the transition, Chile had a stronger adjustment in domestic demand than Peru, consistent with the current account adjustment.
- Real GDP growth dynamics:
  - In Chile and Peru, real GDP growth decreased continuously after the fall in their terms of trade.
  - Colombia’s GDP growth also declined after oil prices started plunging.
  - Strong policy frameworks allowed these countries to withstand large ToT shocks and still post positive growth rates.
  - GDP growth has already started to recover in Peru.

### Fiscal policy conclusions and recommendations
- Fiscal loosening, especially in Chile and Peru (which had larger fiscal space), contributed to smoothing the adjustment to the shock.
- Impulse-response analysis indicates:
  - Public spending tends to be more procyclical in Peru than in Chile.
  - Public spending does not react to ToT shocks in Colombia.
- Recommendation: maintain a fiscal buffer to smooth negative effects of external shocks, a key consideration for Peru.

### Exchange rate, current account, and monetary policy implications
- More exchange rate flexibility underpins faster current account adjustments to ToT shocks.
- Rapid depreciation in Chile likely drove full adjustment in its current account deficit.
- Peru did not experience comparable real depreciation, probably due to active FX intervention; Peru’s current account deficit remained elevated by 2015 at 4.4 percent of GDP.
- Looking ahead, a continued gradual real depreciation of the sol and an increase in mining exports are expected to halve the Peruvian current account deficit by 2021.
- Robust monetary frameworks limited inflation response; credible inflation targeting regimes used communication and policy rate hikes to contain inflationary pressure.
- In Chile and Peru, inflation is already moving back toward the target range; staff expects the same in Colombia.

---

### Peru: Fiscal multipliers, methodology, and implications for public investment
- Context:
  - With the end of the commodity super cycle, Peru’s potential growth has declined; public investment multipliers have a larger effect on growth than current spending or tax-related stimulus in the short and medium terms.
  - Peru’s low debt and financial savings grant fiscal space for increasing investment spending, conditional on efficiency, fiscal sustainability, PIM reforms, and decentralization changes.
- Public investment trends:
  - Peru leads regionally in PPPs and has high regional rankings for the quality of its framework.
  - Despite rising public investment, Peru’s capital stock per capita still lags emerging market economies, although it is at par with LAC.
- Multipliers background and prior estimates:
  - Peru fits into the country category with medium-size overall multipliers (0.4−0.6) in the first year of fiscal expansion.
  - Selected prior empirical estimates (short-term; medium-term; note: figures preserved as in source):
    - Central Reserve Bank of Peru (2012): short-term 0.24; 0.92 — medium-term 0.49; 1.42 (Current; capital spending, 1992Q1:2012Q1).
    - Rossini and others (2012): short-term 0.78; 1.36; -0.44 — medium-term 0.52; 2.63; -0.38 (Current; capital spending; current revenue).
    - Sanchez and Galindo (2013): short-term 1.3; 0.2 (Government spending; taxes, 1992Q1:2011Q4).
    - BBVA bank (2014): short-term 0.55; 0.6; -0.1 — medium-term 0.2; 1.6; -0.2 (current; capital spending; tax revenue).
    - Ministry of Economy and Finance (2015): downturn short-term 0.12; 0.55 — medium-term 0.95; 1.69; upturn short-term 0.13; 0.55 — medium-term 0.82; 1.74 (Central government current; capital spending) (1995Q1:2014Q4).
    - Central Reserve Bank of Peru (2014-15): downturn short-term 0.93; 1.42; -0.25 — upturn short-term 0.28; 0.73; 0.00 (Current; capital spending; current revenue).
- Methodology:
  - Fiscal multipliers estimated using a threshold vector autoregressive model (TVAR) capturing two regimes of the economic cycle.
  - Variables: real revenues, real current expenditures, real capital expenditures, real GDP growth rates.
  - Data: general government, 1995Q2 to 2015Q3; CPI used as deflator; series used as first differences of log levels.
  - TVAR specification: lag length = 1; threshold variable = GDP growth with threshold z* = 1.5 percent; time lag for threshold variable d = 3; upper regime defined by GDP growth above 1.5 percent.
  - Caveat: capital expenditures may take time to design and implement; PIM weaknesses can affect realized multipliers.

---

### Annex I: Nonlinear impact of fiscal policy on output and PIM findings
- Fiscal multipliers — nonlinear results:
  - One sol in capital spending will increase output by 0.5 soles in the first 4 quarters in the lower regime and slightly less in the upper regime.
  - Cumulative effects after 12 quarters: multipliers reach to 1.1 in the downturn and to 0.5 in expansion.
  - Current spending multipliers are insignificant in size in both cycles.
  - A Tsay test indicates a lag of 3 for the threshold variable is statistically significant at 90 percent confidence level.
- Public investment implementation and efficiency:
  - Fixed public investment spending is now about 80 percent of budgeted amounts—up 13 percentage points from 2007 (MEF 2016).
  - Implementation remains well below 100 percent, especially at regional and local levels.
  - Peru dropped by 7 spots to 112th place out of 140 countries for quality of overall infrastructure by the World Economic Forum; Peru is 17th of 22 countries in LAC.
- PIE-X findings:
  - Survey-based efficiency gap: "efficiency gap of 28 comparing to the average of 19 for LAC and EMs."
  - Physical indicator measure: "54 versus 39, respectively" (Peru versus peers).
- PIM assessment (PIMA):
  - Strengths: fiscal rules; national & sectoral planning; central-local coordination; management of PPPs; company regulation.
  - Weaknesses: multi-year budgeting absent as binding; no multiyear targets/ceilings on capital expenditure by ministry or program; projections published but not with annual projections over a three-to-five year horizon; no official record of future commitments from signed contracts.
  - Project implementation gaps: one-year project appropriations; unspent appropriations lapse at year-end; cash flow forecasts not prepared/updated regularly; delayed cash releases for project outlays; limited public access to procurement information.
- Sub-national framework:
  - Decentralization started in 2002 and is incomplete; local governments now account for more than 45 percent of total public investment in Peru.
  - Investment spending concentrated among a small group of local governments receiving large license fees and royalties.
  - Recent corruption investigations (2013−14) of several regional leaders contributed to worse investment execution at the local level by about 14 percent, on average, during 2014−15 (MEF, 2016).
  - Central government responses: Special Investment Monitoring Unit (EESI); 110 investment committees; training and technical assistance; tools for integrated management — but deep structural changes still needed.

### Conclusions and recommended reforms
- Need for a new engine for growth: non-mining investment and exports.
- Investment push:
  - Econometrics shows public investment multipliers outweigh current spending or tax stimulus in short and medium terms, especially during downturns.
  - "Weighting revenue and spending impulses by their respective multipliers, the impact of the fiscal impulse on the economy in 2015 was a negative 0.3 percent, despite the attempted measures."
  - "Had capital spending been executed as budgeted in 2015, real output growth would have been higher by 0.1 percentage point of GDP."
  - "if Peru increases investment to 6−6.5 percent of GDP, this could result in about 2-percentage-points increase in output growth."
- Fiscal sustainability:
  - Peru’s net debt is "7 percent of GDP."
  - To stabilize debt below 30 percent (starting from 2021), the budget would have to run primary balances of about 0.5 percent of GDP, given interest rates expected to be somewhat above nominal trend economic growth unless potential GDP growth rises significantly due to investment.
- PIM enhancements recommended:
  - Adopt a multi-year budget guaranteeing full execution of multi-year investments and documentation on scheduled commitments.
  - Improve cash flow management to minimize project delays.
  - Design an Information System to integrate planning, budgeting and investment; monitor major projects; publish external ex-post audits.
  - Update SNIP more timely, especially project execution stage at municipal level.
  - Centralize assessment and selection of projects and decentralize execution.
  - Develop a national infrastructure strategy.
- Decentralization recommendations:
  - Revisit assignment of natural resource revenues with transparent and equitable transfers.
  - Strengthen subnational capacity through training.
  - Consider merging jurisdictions and reallocating resources away from low-capacity districts.
  - Monitor major projects and ensure timely, transparent information at municipal level.

---

### Appendix I: Data, methodology, and GIRF implementation
- Data transformation and ordering:
  - Variables transformed as first differences of logs; ordering: real revenues, real current expenditures, real capital expenditures, real GDP growth.
  - Threshold value selected endogenously with minimum 35 percent observations per regime.
  - Unit root (ADF) test results:
    - Revenue: t-statistic -8.76; p-value 0.0000
    - Capital Expenditure: t-statistic -11.25; p-value 0.0001
    - Current Expenditure: t-statistic -9.065; p-value 0.0000
    - GDP: t-statistic -6.448; p-value 0.0000
- GIRF definition and implementation:
  - GIRF = E[X_{t+m} | ε_t, ε_{t+1}=0,...,ε_{t+m}=0, Ω_{t−1}] − E[X_{t+m} | ε_t=0, ε_{t+1}=0,...,ε_{t+m}=0, Ω_{t−1}]
  - Shock size set at 2 percent; forecasting horizon set at 20 quarters.
  - GIRFs incorporate regime switches; m is forecast horizon; Ω_{t−1} is history.
- Main empirical results:
  - Non-linear and statistically significant impact of fiscal policy on output.
  - Shock specifications: 2-percent positive shock to current and capital expenditures; 2-percent negative shock to revenues.
  - Key findings:
    - Fiscal multipliers for government consumption are generally smaller than multipliers for capital spending.
    - Consumption multipliers disappear faster and tend to be higher for the lower regime than the upper regime.
    - Positive shocks to capital spending can reach cumulative responses above 1 by 12 quarters in the lower regime and are much smaller during upturns (below 0.6).
  - Confidence bands used to test significance; results robust.

---

### Macro and micro-prudential policies to reduce dollarization (Section 8)
- Policy tools:
  - Differential reserve requirements on FX versus local currency deposits.
  - Stricter prudential requirements on FX liquidity and higher risk premia on deposit insurance for FX deposits.
  - Lower loan-to-value limits and/or stricter collateral evaluation limits.
  - Limits on open FX positions.
- Financial market deepening and indexation:
  - Liquid bond markets and credible indexation support de-dollarization.
  - Garcia-Escribano and Sosa (2011) find deeper local currency bond markets significantly affect de-dollarization.
  - Chile and Colombia cited as historical examples.
- Exchange rate flexibility:
  - Two-way exchange rate movements make FX risk apparent and incentivize lower dollarization and hedging instrument development.
  - Empirical support: Hardy and Pazarbasioglu (2006); Kokenyne et al. (2010); Garcia-Escribano and Sosa (2011).
- Peru policy context prior to new measures:
  - Two percent tax on checks denominated in FX.
  - Higher reserve requirements on FX deposits.
  - Higher loan-to-value ratios and risk weights on FX loans and FX mortgage credit.
  - Issuance of local currency bonds with sizeable maturities; presence of pension funds.
  - Exchange rate volatility in Peru remains much below that of peers with similar dollarization levels.
- Empirical two-stage panel approach:
  - Initial sample: 45 EMs (quarterly loan dollarization); excluding fixed/quasi-fixed regimes reduced sample to 33 countries spanning 1997−2015 (unbalanced panel).
  - First stage: exchange rate volatility regressed on q-o-q change in tot (lagged) and VIX; residual interpreted as policy-driven residual volatility.
  - Second stage: dedloan (percentage-point change in loan de-dollarization between Q4 year t and Q4 year t-1) regressed on resid t-1, loan dollarization level t-1, and controls Z.
  - Controls include inflvol, d_appr, irdiff, d_it, itresid, fraser_d.
- Endogeneity and multiple equilibria:
  - Low exchange rate volatility may both result from and encourage financial dollarization; distribution of dollarization levels is U-shaped consistent with multiple equilibria.
- Empirical results:
  - Residual exchange rate volatility was much higher for countries that subsequently reduced loan dollarization by at least 20 ppts to below 20 percent.
  - Residual volatility descriptive stats (Currency Volatility of EMs):
    - Mean: 0.50 (Countries Successful at De-Dollarizing), -0.04 (Countries that Remained Significantly Dollarized)
    - No. of Obs.: 96, 1431
  - First-stage regressions: VIX coefficient positive and significant: 0.02 (t-stat 14.63); FX Volatility of EM Currency coefficient 0.04 (t-stat 14.16).
  - Second-stage regressions — Residual ER Volatility, t-1 coefficients:
    - (1): -2.54 ** (t-stat -2.73)
    - (2): -2.58 ** (t-stat -2.91)
    - (3): -2.38 ** (t-stat -2.67)
    - (4): -2.91 ** (t-stat -2.99)
    - (5): -2.85 ** (t-stat -2.93)
  - Loan Dollarization Level, t-1 coefficient when included: -0.19 ** (t-stat -6.09).
  - Robustness: results robust to alternative volatility measures, sample restrictions, random effects, lagged inflation controls, and inclusion of appreciation periods.
- Costs and benefits of increasing exchange rate volatility:
  - Costs: excessive volatility can encourage herding, raise CDS spreads, and harm unhedged FX borrowers; historical balance-sheet effects were significant for Peru.
  - Quantified Peru considerations:
    - Balance-sheet effect explained 70 percent of Peru’s output and investment decline after the 1998 Russian crisis when dollarization reached about 70 percent (Gondo and Orrego, 2011).
    - Ramirez-Rondan (2015) estimates a critical threshold where negative balance-sheet effects dominate competitiveness gains: about 32 percent (of dollar lending), based on a panel of 69 Peruvian firms from 2003−13.
    - Peruvian firms have withstood a cumulative depreciation against the U.S. dollar since 2011 of some 30 percent.
    - Supervisory data: losses to banks from FX exposures on the total loan portfolio stand at a third of the dollarization ratio, or 11 percent of total loans.
    - For certain loan categories (as of end-February 2016), total FX exposure risks:
      - Mortgages: around 14 percent
      - Vehicles: around 20 percent
      - Loans to SMEs: around 24 percent
  - Benefit: a "dose of healthy volatility" can help reduce dollarization over time; residual exchange rate volatility is significantly related to reductions in loan dollarization.

---

### Benefits of exchange rate volatility and Peru’s FX interventions (Section 20)
- Benefits:
  - Rapid exchange rate adjustment engenders speedier REER adjustment and avoids inefficient resource allocations.
  - Removing implicit guarantees from limited exchange rate risk helps develop hedging markets.
  - Higher tolerance for volatility and faster trend changes may reduce the need for interventions.
- Peru’s use of FX intervention:
  - Peru has actively used FX intervention in both phases of the commodity price cycle, leaning against the wind while limiting volatility.
  - With commodity prices expected lower for longer and significant reserve sales so far, preserving the use of Peru’s still ample reserves has increased value.
- Empirical evidence:
  - Panel of 33 EMs: after controlling for terms-of-trade and global shocks, residual exchange rate volatility is positively associated with faster de-dollarization; result robust.
  - Policy implication: allowing greater day-to-day exchange rate volatility in Peru may accelerate de-dollarization.
- Measures of volatility in Peru:
  - Daily exchange rate volatility in Peru is still lower compared to a number of peers.
  - Headline volatility increased markedly since late 2015.
  - After controlling for tot shocks and global volatility, exchange rate volatility is currently above pre-taper tantrum mid-2013 levels or non-crisis periods in the past decade.
  - Spot intervention tapered despite high global volatility; evidence suggests Peruvian authorities have been gradually allowing greater exchange rate volatility.

---

### Transfer pricing for commodities, thin capitalization, and hedging (Section 9)
- Priority of the CUP method:
  - Peru’s Income Tax Law establishes a clear priority for the CUP method in the case of commodities; taxpayers cannot stray from actual market prices at their discretion and can opt only justifiably, as last resort, for another method.
  - OECD BEPS language is softer; implication: Peru’s rule is stricter and provides less taxpayer flexibility.
- Enforcement and anti-abuse:
  - MEs may apply adjustments or discounts to quoted prices or select contract dates to “cherry-pick” prices.
  - Several Latin American countries, including Peru, prevent backdating and restrict quoted price to the export’s shipping date.
  - OECD BEPS argues adjustments should be allowed and quoted price on shipping date can be the arm’s length price when no reliable evidence of transaction date exists.
- Recommended legislative improvements:
  - Allow reasonable and verifiable price adjustments when using CUP.
  - Eliminate the option to pick the quoted price by taxpayer contract date.
- Thin capitalization rules:
  - Peru currently uses a ratio of 3 to 1 controlling only intra-group debt.
  - Design problems: controls only related-party debt; base defined as ‘assets’ (formally includes debt); ratio measured at year’s end; exceptions required for financial sector.
  - Many countries moved to earning-stripping rules (e.g., up to 30 percent of EBIDTA) or limits based on global third party gearing.
  - Recommendation: Peru should tighten anti-abuse rules away from the 3 to 1 related-party-only rule toward broader earning-stripping or global gearing-based approaches.
- Hedging and related-party financial risk:
  - Hedging by extractive producers is common; related-party hedging raises transfer pricing concerns.
  - Some countries exclude financial risk management as an attributed function to extractive subsidiaries or apply schedular regimes.
  - Trend toward tighter control of related-party hedging; Peru advised to consider anti-abuse rules against related-party hedging in extractive industry.
- Overall tax policy guidance:
  - Strengthen international taxation to align regulations with complex cross-border operations and protect the tax base.
  - FAD assisted Peru; significant space to improve remains.
  - Principles: adapt broad international initiatives (e.g., OECD BEPS) to local realities; prefer simpler, objective rules that do not systematically err against taxpayer or tax authority.

*Source: IMF staff calculations and analysis as presented in _cr16235.*

### References _______________________________________________________________________________ 16

### _cr16235 - References

### Findings from VAR impulse-response analysis
- Primary expenditures:
  - Chile: a one standard deviation commodity price shock leads to a one percent decline in primary expenditure.
  - Peru: the same shock leads to an increase of 2 percent in primary expenditures.
  - Colombia: primary expenditures are insensitive to commodity price shocks after some initial volatility.
- Public revenues and real GDP growth:
  - Public revenues: Chile experiences the biggest increase of around 8 percent after 4 quarters; Colombia peaks at 4 percent after 3 quarters; Peru peaks at 1.5 percent after 3 quarters.
  - Real GDP growth: the initial response is broadly similar across the three countries up to two quarters; in the medium term Peru benefits most from a positive ToT shock.
- External sector (REER and current account):
  - A positive commodity price shock is associated with REER appreciation in Chile and Colombia, with a stronger appreciation in Colombia.
  - Peru shows a slight REER depreciation in the VAR estimates, possibly reflecting active intervention by the Central Reserve Bank of Peru.
  - The current account response is strongest in Colombia; Chile and Peru show similar initial adjustments during the first five quarters, with Chile showing larger improvement over the medium term.

### Forecast-error variance decomposition (quantitative contributions)
- Commodity-price shocks’ contribution to variance of primary expenditures (10-quarter horizon):
  - Chile: about 5 percent.
  - Peru: about 5 percent.
  - Colombia: about 2 percent.
- Commodity-price shocks’ contribution to variance of public revenue growth:
  - Chile: about 25 percent.
  - Peru: about 20 percent.
  - Colombia: roughly 3 percent.
- Commodity-price shocks’ contribution to variance of real GDP:
  - On average about 10 percent, broadly similar across Chile, Colombia, and Peru.
- Commodity-price shocks’ contribution to variance of the REER:
  - Around 34 percent in Chile and around 24 percent in Colombia; a sizable share but smaller in Peru.

### Event-study results on recent commodity price declines
- Timing and magnitude of shocks:
  - Copper (Chile and Peru): declined 45 percent over 18 quarters beginning in 2011.
  - Oil (Colombia): plunged by about 40 percent in 5 quarters beginning mid-2014.
- Exchange-rate and current-account adjustments:
  - Chile: real effective exchange rate depreciated by 5 percent by the end of its adjustment process; current account moved toward closure, with much adjustment coming from import contraction.
  - Colombia: sharp and fast real depreciation of around 18 percent; current account deteriorated due to oil price decline and has yet to reflect quantity adjustments.
  - Peru: minor real appreciation of about 6 percent, which could reflect Central Bank of Peru FX interventions; current account deficit deteriorated from 2 percent of GDP in 2011 to 4.4 percent of GDP in 2015.
- Adjustment composition:
  - Chile achieved current account correction mainly via import decline (imports fell from 35 to 30 percent of GDP) rather than a pickup in non-traditional exports.
  - Peru exhibited relatively stable non-traditional exports, imports, and FDI, consistent with a stickier current account deficit.

### Policy implications and observed policy responses
- Exchange-rate flexibility:
  - The experiences underscore the importance of flexible exchange rates to absorb terms-of-trade shocks.
  - Peru’s FX intervention delayed exchange-rate adjustment and correlated with a larger current-account deterioration.
- Monetary policy:
  - Currency depreciation increased inflationary pressures in all three countries, reducing room for countercyclical monetary easing.
  - Central banks in the three countries tightened policy (raised the policy rate) to contain inflationary pressures and sustain credibility of inflation-targeting regimes.
- Fiscal space:
  - Greater fiscal space (as in Chile and Peru) provides more room to accommodate terms-of-trade shocks.

*Source: IMF staff calculations and analysis as presented in _cr16235 - References.*

### 16.      On the fiscal front, primary balances have deteriorated steadily in all three countries

### _cr16235 - 16.      On the fiscal front, primary balances have deteriorated steadily in all three countries

### Fiscal balances, revenues, and expenditures
- Primary balances have deteriorated steadily in all three countries (Figure 10).
- The shock to commodity prices reduced commodity related revenues, reflected in lower growth rates of public revenues after the shock (Figure 11).
- Except for Colombia, the growth rate of public expenditures remained broadly stable (Figure 11).
- Colombia was already featuring a primary deficit when the shock hit, while Chile and Peru exhibited surpluses, giving Chile and Peru more room to implement gradual fiscal adjustment that helped smooth the adjustment to the shock.
- Peru-specific fiscal statistics and measures:
  - Public investment spending as a percent of GDP increased from about 3 percent in the early 2000s to about 6 percent in 2013, before moderating in 2014–15.
  - Private investment jumped from 14¼ percent to 19¼ percent of GDP over the same period.
  - Over the last decade, public investment contributed 2¾ percentage points (21 percent) to the average annual growth in total real fixed capital investment of 12¾ percent.
  - Local investment spending increased from less than 1 percent of GDP in 2007 to 2½ percent of GDP in 2013; national and regional fixed investment spending rose from about 1½ percent to 3 percent of GDP.
  - Peru’s national infrastructure gap estimates: US$160 billion over 2016−25; for the next four years, the gap is about US$70 billion.
  - Peru: Anti-Crisis Fiscal Measures (2008-09) total: 4.17 percent of GDP (breakdown includes Support to construction sector 0.85; Public investment 1.37; Fund for Regional and Local Public Investment 0.63; others).
  - Peru: Selected Fiscal Stimulus Measures (aggregate): A. Taxes (2015) 0.7; B. Net expenditure (2014) 0.3; Bonuses and salary increases 0.3; C. Expenditure (2015) 0.9; Current expenditure 0.1; Capital expenditure 0.4; Repayment of debt in arrears 0.3; Social assistance 0.1; Total (A+B+C) 1.9 (In percent of GDP).
  - In response to the 2008 GFC, the government prepared fiscal measures equivalent to nearly 4 percent of GDP; the resulting fiscal impulse was around 3 percent of GDP over 2008−10.
  - In mid-2014, a fiscal stimulus plan equivalent to about 3 percent of GDP was designed; this contributed to an overall budget deficit of about 2 percent of GDP in 2015. Most of the 2014−15 stimulus came from tax measures—about 30 percent of a 2 percentage point decline in tax revenue came from tax rate reductions—and an increase in current spending rather than higher public investment, which was under-executed and dropped significantly in 2015 as percent of GDP.

### Domestic demand, GDP dynamics, and adjustment channels
- At the time the shock hit, all three countries experienced a slowdown in total domestic demand, with Colombia showing curious resilience despite a sharper shock (Figure 12).
- Initial slowdown in Chile and Peru was significantly more abrupt than in Colombia, despite the shock being more acute in Colombia.
- In the final stages of the transition, Chile had a stronger adjustment in domestic demand than Peru, consistent with the current account adjustment.
- Real GDP growth dynamics:
  - In Chile and Peru, real GDP growth decreased continuously after the fall in their terms of trade.
  - Colombia’s GDP growth also declined after oil prices started plunging.
  - Strong policy frameworks allowed these countries to withstand large terms of trade (ToT) shocks and still post positive growth rates.
  - GDP growth has already started to recover in Peru.

### Conclusions, policy implications, and adjustments
- Overall assessment:
  - Despite a slowdown in activity, GDP growth remained resilient to the ToT shocks in the three countries, reflecting sound policy frameworks.
  - GDP growth declined in all three countries in the past couple of years but remained positive and is already recovering in Peru.
- Fiscal policy:
  - Fiscal loosening, especially in Chile and Peru (which had larger fiscal space), contributed to smoothing the adjustment to the shock.
  - The impulse-response analysis indicates systematic differences in public spending behavior after ToT shocks:
    - Public spending tends to be more procyclical in Peru than in Chile.
    - Public spending does not react to ToT shocks in Colombia.
  - Recommendation: The importance of having a fiscal buffer to smooth negative effects of external shocks should remain a key consideration for fiscal policy in Peru going forward.
- Exchange rate and current account adjustments:
  - More exchange rate flexibility underpins faster current account adjustments to ToT shocks.
  - A rapid depreciation of the currency in Chile is likely the biggest factor behind the full adjustment in its current account deficit.
  - In real effective terms, Peru did not experience comparable depreciation, probably due to active FX intervention by the central bank to smooth volatility.
  - As a result, Peru’s current account deficit remained elevated by 2015 at 4.4 percent of GDP.
  - Looking ahead, a continued gradual real depreciation of the sol and an increase in mining exports are expected to halve the Peruvian current account deficit by 2021.
- Monetary policy and inflation:
  - Robust monetary frameworks limited the response of inflation to ToT shocks.
  - Credible inflation targeting regimes limited inflationary pressure through strong communication and hikes in the policy rate.
  - In Chile and Peru, where the ToT shocks started about five years ago, inflation is already moving back toward the target range, and staff expects the same to happen in Colombia.

### Peru: Fiscal multipliers, methodology, and implications for public investment
- Context and motivation:
  - With the end of the commodity super cycle, Peru’s potential growth has declined, prompting evaluation of government policy options to boost growth.
  - The chapter shows public investment multipliers have a larger effect on growth than current spending or tax-related stimulus in the short and medium terms.
  - Peru’s low debt and financial savings grant fiscal space for increasing investment spending, conditional on efficiency, fiscal sustainability, PIM reforms, and decentralization changes.
- Public investment trends and capitalization:
  - Peru leads regionally in PPPs and has high regional rankings for the quality of its framework.
  - Despite rising public investment, Peru’s capital stock per capita still lags emerging market economies, although it is at par with LAC.
- Multipliers background:
  - Fiscal multipliers measure the effect of discretionary fiscal policy on output; a multiplier (in absolute terms) exceeding one indicates a large impact on growth.
  - Peru fits into the country category with medium-size overall multipliers (0.4−0.6) in the first year of fiscal expansion (reference to literature).
  - Prior empirical estimates for Peru (selected):
    - Central Reserve Bank of Peru (2012): short-term 0.24; 0.92 — medium-term 0.49; 1.42 (Current; capital spending, 1992Q1:2012Q1).
    - Rossini and others (2012): short-term 0.78; 1.36; -0.44 — medium-term 0.52; 2.63; -0.38 (Current; capital spending; current revenue).
    - Sanchez and Galindo (2013): short-term 1.3; 0.2 (Government spending; taxes, 1992Q1:2011Q4).
    - BBVA bank (2014): short-term 0.55; 0.6; -0.1 — medium-term 0.2; 1.6; -0.2 (current; capital spending; tax revenue).
    - Ministry of Economy and Finance (2015): downturn short-term 0.12; 0.55 — medium-term 0.95; 1.69; upturn short-term 0.13; 0.55 — medium-term 0.82; 1.74 (Central government current; capital spending) (1995Q1:2014Q4).
    - Central Reserve Bank of Peru (2014-15): downturn short-term 0.93; 1.42; -0.25 — upturn short-term 0.28; 0.73; 0.00 (Current; capital spending; current revenue).
- Methodology and key estimation details:
  - Fiscal multipliers are estimated using a threshold vector autoregressive model (TVAR) to capture asymmetric responses across two regimes of the economic cycle.
  - Variables in the TVAR: real revenues, real current expenditures, real capital expenditures, and real GDP growth rates.
  - Data: general government, period from 1995Q2 to 2015Q3; consumer price index used as deflator; data seasonally adjusted except series already adjusted by authorities; series used as first differences of log levels.
  - TVAR specification details:
    - Lag length: set at 1 (from Schwarz information criterion in linear VAR).
    - Threshold variable: GDP growth, estimated endogenously with threshold value z* = 1.5 percent.
    - Time lag for threshold variable d is set to 3.
    - Interpretation: upper regime uses quarters where GDP growth is above 1.5 percent.
  - Caveats: capital expenditures may take time to design and implement, potentially reducing effectiveness for time-sensitive stimulus; PIM weaknesses can affect realized multipliers.

*Source: _cr16235 - 16.      On the fiscal front, primary balances have deteriorated steadily in all three countries*

### Annex I for further details).

### Appendix I. Background on Data and Methodology

### Appendix I. Background on Data and Methodology

### Data transformation, ordering, and stationarity
- Variables in the model are transformed as first differences of the logarithm; results of the first difference of the logarithm for the variables in the model appear in the charts in the source.
- Changes in real revenues were ordered first, followed by changes in current and capital spending, and real GDP growth.
- The threshold value is selected endogenously over a search of possible values while keeping a minimum of 35 percent observations in each regime.
- Results from unit root tests were also conducted for the transformed variables and do not indicate the presence of non-stationary series.
- Ordering rationale: “The data are arranged in increasing order on the basis of the threshold variable (z) this means from less dependent variables to more dependent variables. We decided the ordering to be first of revenues, then current expenditures, and lastly capital expenditures, as the latter will be more dependent on the level of current expenditures and revenues at a certain budgeted outcome, and in the case of Peru, expenditure is a residual determined by fiscal rules.”
- Caveat on interpretation: “As the ordering of variables with respect to revenues has been under debate due to a perceived failure of capturing exogenous policy changes correctly (see Baum et al for an overview of criticisms), the responses of output to revenue shocks thus should be interpreted cautiously, however, our results are in line with other estimates for Peru (perhaps subject to the same criticisms). Multipliers are also small even without disaggregation to control for all cyclical factors.”

### Unit root (ADF) test results (as reported)
- ADF test — t-statistic and p-value (Unit Root Test):
  - Revenue: t-statistic -8.76; p-value 0.0000
  - Capital Expenditure: t-statistic -11.25; p-value 0.0001
  - Current Expenditure: t-statistic -9.065; p-value 0.0000
  - GDP: t-statistic -6.448; p-value 0.0000
- Source: Fund staff estimates

### Generalized impulse response functions (GIRFs) — definitions and implementation
- Rationale: In nonlinear models and particularly for TVAR models, GIRFs depend on whether the system is in one regime or the other, and the specific time in which the shock takes place; GIRFs are data dependent.
- GIRF definition used (text formula preserved):  
  GIRF = E[X_{t+m} | ε_t, ε_{t+1}=0,...,ε_{t+m}=0, Ω_{t−1}] − E[X_{t+m} | ε_t=0, ε_{t+1}=0,...,ε_{t+m}=0, Ω_{t−1}]
- Notation and implementation details:
  - ε_t is an exogenous shock of a determined size.
  - Ω_{t−1} is the history available at time t−1 before the shock in time t.
  - m is the horizon for the forecast period.
  - In the model, the size of the shock is set at 2 percent and the forecasting horizon is set at 20 quarters.
- Additional GIRF feature: GIRFs incorporate regime switches; after a shock takes place, the system is allowed to change from one regime to another.
- Methodological reference: Koop, et. al (1996) proposal to estimate GIRFs based on the difference between the estimations of the path of variables with a shock and without the shock to a specific variable.

### Main empirical results and interpretations
- Overall finding: “We find a non-linear and statistically significant impact of fiscal policy on output.”
- Shock specifications applied in results:
  - A 2-percent positive shock was applied to current and capital expenditures.
  - A 2-percent negative shock was applied to revenues.
- Key empirical findings (text preserved):
  - “We find evidence that fiscal multipliers for government consumption are, in general, smaller than multipliers for capital spending.”
  - “Consumption multipliers tend to disappear faster and tend to be higher for the lower regime than the upper regime.”
  - “Positive shocks to capital spending can reach cumulative responses above 1 by 12 quarters in the future for the lower regime and are much smaller during upturns where they are below 0.6.”
- Statistical inference: “Confidence bands in non-linear models are used to test significance of the shock results. Results remain robust for the shocks in current and capital spending and revenues.”

### Figures and graphical results (as described)
- Fiscal multipliers: Fiscal expansion — cumulative response graphs are presented separately for:
  - Current Expenditure Shock — Lower Regime
  - Capital Expenditure Shock — Lower Regime
  - Revenue Shock — Lower Regime
  - Current Expenditure Shock — Upper Regime
  - Capital Expenditure Shock — Upper Regime
  - Revenue Shock — Upper Regime
- Note in figures: “A 2 percent positive shock was applied for current and capital expenditures and a 2 percent negative shock to revenues.”
- Forecast horizon for plotted cumulative responses: 2 through 20 quarters.

### Methodological and interpretative caveats highlighted by the authors
- Ordering of variables can affect identification, especially responses of output to revenue shocks; therefore, revenue-shock responses should be interpreted cautiously.
- Multipliers reported are generally small even without disaggregation to control for all cyclical factors.

### Select methodological references cited in this appendix
- Koop, Gary, Hashem Pesaran, and Simon Potter, 1996, “Impulse Response Analysis in Nonlinear Multivariate Models,” Journal of Econometrics, Vol. 74(1), pp. 119−47.
- Baum, Anja, Marcos Poplawski-Ribeiro, and Anke Weber, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper No. 12/286.
- Batini, Nicoletta, and others, 2014, “Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections,” IMF Technical Guidance Note.
- Hansen, Bruce, 2011, “Threshold Autoregression in Economics,” Statistics and Its Interface, Volume 4, pp. 123–27 (February).
- Additional references listed in the source for background and related empirical work.

*Source: _cr16235 - Appendix I. Background on Data and Methodology*

### 8.      Macro and micro-prudential policies can also help reduce dollarization over time.

### 8.      Macro and micro-prudential policies can also help reduce dollarization over time.

### Macro- and micro-prudential policy tools and effects
- Policy tools identified:
  - Differential treatment of reserve requirements on FX versus local currency deposits (e.g. higher reserve requirements on FX deposits, different remuneration, or requiring reserve requirements on FX deposits to be in local currency).
  - Stricter prudential requirements (e.g. higher liquidity ratios on FX liquidity, charging higher risk premia on deposit insurance for FX deposits).
  - Lower loan-to-value limits and/or stricter limits on collateral evaluation or requirements.
  - Limits on open FX positions.
- Linkages and empirical evidence:
  - Reductions in deposit dollarization help speed up credit de-dollarization (Luca and Petrova, 2007).
  - Kokenyne et al. (2010) provides empirical support for the effectiveness of micro-prudential measures.
  - Garcia-Escribano and Sosa (2011) show macro-prudential regulations (especially reserve requirements and prudential regulations) contributed to credit de-dollarization in four Latin American countries (including Peru), but had a more limited impact on deposit de-dollarization.
  - Lower insurance for FX deposits can lead to lower financial intermediation (Moron and Castro, 2003).

### Deepening local currency financial markets and indexation
- Mechanisms:
  - Liquid bond markets offering a range of savings instruments act as alternatives to dollar deposits, including the ability for the public to invest directly in local currency government bonds and to extend the yield curve.
  - Credible indexation can provide a bridge to promote investments in local currency-denominated assets and be gradually phased out as confidence increases.
- Empirical finding:
  - Garcia-Escribano and Sosa (2011) find the effect of deeper local currency bond markets on de-dollarization to be significant.
- Historical examples cited:
  - Chile and Colombia as cases where indexation was phased out as confidence in local currency assets increased.

### Exchange rate flexibility and de-dollarization
- Conceptual link:
  - Allowing two-way exchange rate movements makes foreign exchange risk more apparent and introduces incentives for lower dollarization or the development of hedging instruments.
- Empirical evidence:
  - Hardy and Pazarbasioglu (2006) argue two-way movements encourage lower dollarization.
  - Kokenyne et al. (2010) show empirical evidence for the link between exchange rate flexibility and de-dollarization.
  - Garcia-Escribano and Sosa (2011) find the effect significant in two out of four Latin American countries studied.

### Peru: policy context prior to new de-dollarization measures
- Existing policies and features:
  - Two percent tax on checks denominated in FX.
  - Higher reserve requirements on FX deposits.
  - Higher loan-to-value ratios and risk weights on FX loans and mortgage credit denominated in FX.
  - Issuance of local currency bonds with sizeable maturities.
  - Presence of pension funds providing opportunities to deepen liquidity and longer-term savings instruments.
- Key observation:
  - Exchange rate volatility in Peru remains much below that of peers with similar dollarization levels.

### Empirical methodology (two-stage panel approach)
- Sample and period:
  - Initial sample: quarterly loan dollarization for a sample of 45 emerging market economies.
  - Excluding fixed or quasi-fixed exchange rate regimes reduced the sample to 33 countries, spanning the period 1997−2015 (unbalanced panel).
- First stage:
  - Exchange rate volatility (deri) measured as the standard deviation of daily percentage changes in the standardized bilateral exchange rate to the relevant FX currency (U.S.$, Swiss Franc, or Euro).
  - Regressed on q-o-q change in terms-of-trade (tot, one period lagged) and a measure of global volatility (VIX average during quarter t), with country fixed effects; residual interpreted as policy-driven residual volatility (resid).
- Second stage:
  - Dependent variable: dedloan, the percentage-point change in loan de-dollarization between Q4 of year t and Q4 of year t-1 (negative sign indicating reduction in dollarization).
  - Regressed on resid t-1, loan dollarization level t-1 (controls for mean reversion), and vector Z of controls in a panel fixed effects specification.
- Controls tested (vector Z):
  - Inflvol: average volatility of q-o-q CPI inflation.
  - D_appr: dummy for periods of appreciation of the bilateral exchange rate.
  - Irdiff: real interest rate differential between local currency and foreign currency loans.
  - D_it: dummy for presence of inflation targeting.
  - Itresid: interaction of inflation targeting with residual exchange rate volatility.
  - Fraser_d: change in the Fraser index (proxy for institutional quality/trust).

### Endogeneity, equilibria, and distributional features
- Endogeneity concern:
  - Low exchange rate volatility may be both a result and a cause of financial dollarization; smoothing can encourage FX risk-taking, reinforcing dollarization.
- Multiple equilibria conjecture:
  - Possible multiple stable states: high dollarization with low exchange rate volatility vs. low dollarization with higher tolerance for exchange rate flexibility.
  - Dollarization is persistent; distribution of dollarization levels in sample is U-shaped, consistent with stable equilibria at extremes.
- Peru’s objective:
  - Peru aims to move from one equilibrium (high dollarization/low volatility) to the other.

### Empirical results — descriptive and regression findings
- Descriptive:
  - Residual exchange rate volatility was much higher for countries that subsequently reduced loan dollarization by at least 20 ppts to below 20 percent.
- Residual volatility descriptive statistics (prior to becoming successful at de-dollarization):
  - Using Currency Volatility of EMs:
    - Mean: 0.50 (Countries Successful at De-Dollarizing), -0.04 (Countries that Remained Significantly Dollarized)
    - 25th Percentile: 0.18, -0.32
    - 50th Percentile: 0.30, -0.14
    - 75th Percentile: 0.68, 0.11
    - No. of Obs.: 96, 1431
  - Using VIX:
    - Mean: 0.49, -0.05
    - 25th Percentile: 0.17, -0.32
    - 50th Percentile: 0.34, -0.16
    - 75th Percentile: 0.67, 0.12
    - No. of Obs.: 77, 1109
- First-stage regressions (selected):
  - VIX coefficient positive and significant: 0.02 (t-stat 14.63) in specification (1) with FE; comparable coefficients across multiple FE specifications.
  - FX Volatility of EM Currency coefficient positive and significant: 0.04 (t-stat 14.16) in specifications using that measure.
  - No. of Countries in first-stage regressions: 40; No. of Obs. varied (e.g., 2394, 2357, 2268, 1980).
- Second-stage regressions — Dependent variable: PPT Change in Loan Dollarization (Table 3, selected columns):
  - Residual ER Volatility, t-1 coefficients:
    - (1): -2.54 ** (t-stat -2.73)
    - (2): -2.58 ** (t-stat -2.91)
    - (3): -2.38 ** (t-stat -2.67)
    - (4): -2.91 ** (t-stat -2.99)
    - (5): -2.85 ** (t-stat -2.93)
  - Loan Dollarization Level, t-1 coefficient when included:
    - -0.19 ** (t-stat -6.09) in column (2) and similar in columns (3)-(5).
  - IR Diff. LC and FX Loans, country-specific:
    - 0.13 ** (t-stat 2.22) in column (3)
    - 0.11 * (t-stat 1.85) in column (5)
  - Constants reported (e.g., -0.69 ** in column (1); 4.72 ** in column (2); see table for exact values).
  - Fixed effects used; No. of Countries typically 31−33 in these specifications; No. of Obs. around 357−374.
- Robustness:
  - Results robust when using emerging market currency volatility instead of VIX, restricting the sample to countries with higher dollarization (at least 25 percent at one point), using random effects, introducing lagged values for inflation and inflation volatility, and including periods of appreciation.

### Costs and benefits of increasing exchange rate volatility to promote de-dollarization
- Costs / caveats:
  - Excessive volatility under disorderly market conditions can encourage herding behavior and destabilize markets rather than promote healthy price discovery.
  - Exchange rate volatility may raise CDS spreads; sudden changes can affect financial conditions (IMF (2016) analysis referenced).
  - Exchange rate volatility poses higher risks to unhedged FX borrowers; balance-sheet effects were historically significant for Peru.
- Quantified considerations for Peru:
  - Balance-sheet effect explained 70 percent of Peru’s output and investment decline after the 1998 Russian crisis, when dollarization reached about 70 percent (Gondo and Orrego, 2011).
  - Ramirez-Rondan (2015) estimates a critical threshold when negative balance-sheet effects dominate competitiveness gains: about 32 percent (of dollar lending), based on a panel of 69 Peruvian firms from 2003−13.
  - Peruvian firms have withstood a cumulative depreciation against the U.S. dollar since 2011 of some 30 percent.
  - Supervisory data: losses to banks from FX exposures on the total loan portfolio stand at a third of the dollarization ratio, or 11 percent of total loans.
  - For certain loan categories (as of end-February 2016), total FX exposure risks:
    - Mortgages: around 14 percent
    - Vehicles: around 20 percent
    - Loans to SMEs: around 24 percent
- Benefit highlighted:
  - A "dose of healthy volatility" can help reduce dollarization over time, supported by the empirical findings that policy-driven residual exchange rate volatility is significantly related to reductions in loan dollarization.

*Source: _cr16235 - 8.      Macro and micro-prudential policies can also help reduce dollarization over time.*

### 20.      The benefits of exchange rate

### 20.      The benefits of exchange rate

### Benefits of exchange rate volatility and flexibility
- A rapid adjustment of the exchange rate should engender speedier adjustment of the REER and avoid the creation of inefficient allocation of resources.
- By removing notions of implicit guarantees provided by limited exchange rate risk, volatility may help develop a market for hedging.
- A higher tolerance for volatility and the speed of trend changes may reduce the need for exchange rate interventions.

### Peru’s use of FX intervention and reserves considerations
- Peru has actively used FX intervention in both phases of the commodity prices cycle—when copper prices rose and when they fell—leaning against the wind while limiting volatility.
- With commodity prices expected to stay lower for longer and taking into account the significant sales of reserves so far, the value of preserving the use of Peru’s still ample reserves seems to have increased.

### Empirical evidence on volatility and de-dollarization
- Using a panel of 33 emerging market countries, after controlling for terms-of-trade and global shocks, residual exchange rate volatility is positively associated with faster de-dollarization.
- This result is robust to a number of alternative specifications.
- Policy implication: allowing greater day-to-day volatility of the exchange rate in Peru may help to accelerate the de-dollarization process in Peru.

### Measures of exchange rate volatility in Peru
- Daily exchange rate volatility in Peru is still lower compared to a number of peers.
- Headline volatility has increased markedly since late 2015.
- After controlling for terms–of–trade shocks and global volatility, exchange rate volatility is currently also above that in the pre-taper tantrum episode of mid-2013 or non-crisis periods in the past decade.
- Spot intervention also tapered despite high global volatility.
- Controlling for the impact of the electoral cycle, exchange rate volatility also seems to have increased.
- Together, the available evidence suggests that Peruvian authorities have been gradually allowing greater exchange rate volatility.

*Source: _cr16235 - 20.      The benefits of exchange rate*

### 9.      Peru has a strict rule. The Income Tax Law establishes a clear priority for the CUP method

### _cr16235 - 9.      Peru has a strict rule. The Income Tax Law establishes a clear priority for the CUP method

### Priority of the CUP method for commodities
- Peru’s Income Tax Law establishes a clear priority for the CUP method in the case of commodities, so that taxpayers cannot stray away from actual market prices at their discretion and can opt only justifiably, as last resort, for another method.
- OECD BEPS final report language is softer: “… the CUP method would generally be an appropriate transfer pricing method for commodity transactions between associated enterprises...”
- Implication: Peru’s rule is stricter than the OECD wording and provides less flexibility for taxpayers to adopt methods different from CUP in pricing commodities.

### Enforcement and anti-abuse considerations for commodity pricing
- Choosing the most appropriate method is only the first hurdle; MEs may:
  - apply a number of adjustments or discounts to a quoted price for a diversity of circumstances or functions performed by the foreign affiliate, which may be hard to verify; or
  - select a contract date that “cherry-picks” quoted prices when they are lowest within a given period.
- Several Latin American countries, including Peru, have specific rules preventing MEs from backdating contracts and restricting the quoted price to be that on the export’s shipping date.
- OECD BEPS final report on commodity transfer pricing argues:
  - (i) adjustments should be allowed; and
  - (ii) the quoted price on shipping date can be deemed to be the arm’s length price when no reliable evidence as to the date of the transaction is available.

### Price adjustments, shipping date rule, and recommended improvements
- Reasonable and verifiable adjustments to the quoted price are difficult to object to; disallowing them could systematically err against the taxpayer.
- Using the quoted price on shipping date as a default rule shifts the burden of proof to the tax authority when objective evidence is hard to find; as the only option it is, on average, unbiased.
- Current Peru legislation permits shipping date (or an average of prices around that date) and the contract date; allowing contract date undermines the anti-abuse purpose aimed at eliminating manipulation of contract dates.
- Recommended legislative improvements for Peru:
  - allow price adjustments generally when using CUP to price commodities; and
  - eliminate the option to pick the quoted price according to the date of the taxpayer’s contract.

### Thin capitalization (“Thin Cap”) rules and interest deduction
- Traditional thin cap rules disallow interest deduction above a certain debt-to-equity ratio; historical typical ratio was 3 to 1; many countries now use lower ratios, many 1.5 to 1. Peru currently uses a ratio of 3 to 1.
- Design problems in Peru’s thin cap rule:
  - it controls only intra-group (related party) debt, allowing taxpayers to incur maximum independent-lender debt and still deduct additional related-party interest up to three times equity, likely shifting profits;
  - the law defines the base of the ratio as ‘assets’, which formally includes debt, making it much wider than intended;
  - the ratio is measured at year’s end (may not be representative) rather than using annual average of net assets; administrative corrections to ‘net assets’ may not be effective;
  - exceptions are required for sectors such as the financial sector.
- Many countries have moved to stricter rules as recommended by OECD BEPS final report:
  - an ‘earning stripping’ rule allowing interest deductions up to a certain percentage of EBIDTA (30 percent in some countries);
  - limits based on a proportion of the global third party gearing ratio of the ME.
- Recommendation: Peru could and should tighten anti-abuse rules given increasing exposure to private sector debt, but such anti-abuse rules should not be treated as transfer pricing ‘safe harbors’ for interest deductions. Compliance with those rules does not necessarily imply arm’s length treatment, particularly for financing structures such as ‘streaming’ and ‘royalty’ finance.

### Hedging and related-party financial risk management
- Hedging by extractive producers is common to manage commodity price volatility, but hedging with an affiliate raises transfer pricing concerns because it may not reduce risk for the global enterprise while altering profit allocation within the group.
- Some countries limit functions imputed to an extractive subsidiary, excluding financial risk management as a function for transfer pricing purposes and allowing only spot market pricing, or apply schedular regimes so hedging losses can be deducted only from gains of the same kind.
- Trend: countries are moving toward tighter control of related-party hedging; Peru is advised to consider adopting anti-abuse rules against related-party hedging in the extractive industry.

### Concluding observations and policy guidance
- Peru needs to strengthen its international taxation system to align regulations with complex cross-border business operations and protect the tax base from aggressive cross-border tax planning.
- FAD has assisted Peru in analyzing priorities and recommending policies and administrative measures, yet significant space to improve remains.
- Specific areas for improvement:
  - tighten rules to price intra-group commodity exports (retain strict CUP priority but permit reasonable adjustments and remove contract-date loophole);
  - prevent thin capitalization by moving away from the current 3 to 1 related-party-only rule toward broader earning-stripping or global gearing-based approaches;
  - introduce safeguards against spurious related-party hedging in the extractive industry.
- Principle: broad international initiatives (e.g., OECD BEPS) should be adapted to realities on the ground; simpler and objective rules that do not systematically err against either taxpayer or tax authority are justified where administrative resources are insufficient.

*Source: _cr16235 - 9.      Peru has a strict rule. The Income Tax Law establishes a clear priority for the CUP method*

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