Mission Concluding Statement 

Peru: Staff Concluding Statement of the 2021 Article IV Mission

February 12, 2021

Washington, DC: 

Recent Developments, Outlook, and Risks

1. Peru was hit hard by the COVID-19 pandemic in 2020. At the onset of the pandemic, the limited capacity of the health system forced the authorities to impose a very strict lockdown. With sizable contact-intensive sectors and limited teleworking capacity, the containment measures crippled the economy, causing a deep recession despite a strong policy stimulus. The same measures, however, could not halt soaring infections. Combined with weaknesses in the health system, this caused a surge in fatalities, with Peru recording one of the highest mortality rates globally.

2. The broad-based fiscal policy response was essential in limiting the impact of the pandemic. The policy package included measures of direct support to the health system, households, and businesses, and a sizable credit-guarantee program to support lending to businesses (Reactiva Perú). The latter was very successful in providing a lifeline to many businesses, including small ones. Support to household incomes was, however, limited and its delivery initially hampered by administrative problems. Other measures, such as allowing withdrawals from individual accounts in private pension funds, were not as effective in providing relief to most vulnerable groups while at the same time they compromised the integrity of the pension system.

3. Swift monetary accommodation helped stabilize financial markets. The Banco Central de Reserva del Perú (BCRP) reduced the benchmark rate to a record low and provided ample liquidity mainly by implementing guaranteed-credit repo operations under the Reactiva Perú program, extending the amount and maturity of security and currency repo operations, fostering credit reprogramming through repo operations, and lowering reserve requirements. In addition, the BCRP made available foreign currency liquidity during periods of stress and concluded an agreement with the New York Fed to access a dollar repo line. Together with the approval of the FCL by the IMF in May, these measures helped reassure markets, limiting the increase in risk spreads and the depreciation of the exchange rate.

4. Peru is currently experiencing a second wave of the pandemic that is likely to dampen the economic recovery. Infections began rising again in January 2021, with excess deaths climbing to levels last seen in May 2020. The health system’s capacity is being stretched again, and the authorities are taking targeted measures to contain infections with a more limited impact on economic activity. If the health emergency is brought under control by end-March, restrictions could be gradually eased in the second quarter, and activity could regain momentum led by domestic demand and historically favorable terms of trade. Under these assumptions, GDP growth would reach 8.5 percent in 2021. The crisis is leaving significant scars, with output returning to its pre-pandemic level only in 2022. A large negative output gap is expected to persist, dampening inflation pressures. After recording a mild surplus in 2020, the current account balance is projected to return to a deficit of 1.6 percent of GDP in the medium term.

5. The outlook is highly uncertain and downside risks prevail, but policy buffers are ample. The second wave of the pandemic could be more acute and more prolonged than expected, reflecting persisting weaknesses in the health system and delays in vaccination plans, requiring broader and stricter containment measures. Political uncertainty and social unrest could dampen investment, while changes to the institutional framework could weaken policies, with significant medium-term implications. Externally, main risks include a global reversal in trade integration, a sudden change in foreign investors’ sentiment, and the intensification of natural disasters in the medium term owing to climate change. A significant increase in public investment execution is an upside risk. Peru has ample buffers to mitigate these risks, including sizable international reserves (over 37 percent of GDP), low public debt, access to a two-year Flexible Credit Line (FCL) arrangement with the IMF and other funding sources, and a strong financial sector.

Policy Recommendations

The heightened health risks and reduced economic activity require continuing supportive macroeconomic policies. Using the ample fiscal space that is available, fiscal policy should address the new health emergency and continue sustaining household incomes to reduce poverty and ensure against downside risks to growth. With no inflationary pressures, monetary conditions should remain accommodative. Structural reforms should target the weaknesses exposed by the pandemic, focusing on policies that enhance productivity, improve governance, and strengthen the social safety net.

Fiscal Policy

6. Despite its deterioration in 2020, the fiscal position remains strong. The fiscal deficit is expected to fall from 9 percent of GDP to 5.2 percent of GDP in 2021. Public debt would peak at about 38 percent of GDP in 2025 before declining steadily toward the 30-percent-of-GDP ceiling. Gross debt and debt burden indicators are well below the corresponding benchmarks for emerging economies and are expected to remain sustainable under standard shocks. Market access is ample as evidenced by the century-bond issuance in November. According to standard metrics, Peru has fiscal space to provide more support.

7. Given substantial fiscal space, policy support should be maintained until the pandemic is entirely under control and the economic recovery is consolidated. The second wave of the pandemic and large downside risks surrounding the outlook argue against a premature withdrawal of the fiscal stimulus. Moreover, additional support to households is necessary to soften the impact of the pandemic on most vulnerable groups. According to the World Bank’s preliminary estimates, poverty increased significantly in 2020. A third round of the Bono Universal would help reduce poverty to pre-pandemic levels. Moreover, the government should prepare contingency measures in the event potential downside risks to growth materialized, including by accelerating further the execution of the public investment budget, which played a significant role in driving the rebound of economic activity in the second half of 2020. In particular, the authorities should finalize as soon as possible the special projects undertaken in the health sector. Similar vehicles could be considered for investment in water, sanitation, and housing.

8. Anchoring fiscal policy to a credible medium-term framework remains essential. Following the 2020-21 suspension of the fiscal rules, converging back to the targets will take time, in a situation initially dominated by extreme uncertainty. A new Marco Macroeconómico Multianual (MMM) based on conservative growth projections and underpinned by adequate measures will be essential to guide the adoption of the 2022 budget. The new MMM should also identify contingency measures based on the analysis of risks. The pandemic has highlighted spending needs in the medium term in several areas, including healthcare, social safety net, pension, digital and other infrastructure. In this regard, it will be important to close the revenue gap of 0.7 percent of GDP identified in the recent Informe Pre-Electoral by outlining specific tax policy, revenue administration, and spending rationalization measures.

Monetary and Exchange Rate Policies

9. Monetary conditions should remain supportive. In its December forward-guidance, the BCRP has highlighted that easy conditions are likely to persist for an extended period. In the absence of inflationary pressures, continued monetary accommodation would facilitate a gradual return to normality as the impact of the extraordinary measures taken in 2020 dissipates. In addition, the BCRP has created new security repos conditional on the expansion of long-term lending, which can enhance the transmission of monetary policy and allow further easing of monetary conditions if necessary.

10. The central bank will continue to smooth excess volatility in foreign exchange markets, but the need to intervene is likely to decline in the medium term. With reserve levels adequate for precautionary purposes, the BCRP has intervened on both sides of the foreign currency market since the beginning of the pandemic, without preventing the exchange rate from depreciating but contributing to reducing its volatility relative to Peru’s regional peers. As dollarization continues to decline, the need for foreign exchange intervention will also weaken, leaving more room for the exchange rate to play a role as shock absorber and for financial markets to develop further.

Financial Sector Policies

11. The authorities have taken significant steps to strengthen financial sector oversight, but vulnerabilities have increased in some segments. Reforms that have been fully or partially implemented include expanding financial co-operatives’ oversight by Superintendencia de Bancos, Seguros y AFPs (SBS), monitoring of banks’ off-balance-sheet exposures, introducing new risk-monitoring tools, implementing risk-based supervision for all insurers and brokers, strengthening crisis preparedness and management, and enhancing the emergency liquidity assistance framework. Several measures are being prepared, including higher capital surcharges for systemically important banks, enhanced supervision of financial groups, and requirements for recovery and resolution planning for domestic systemically important banks and financial groups. Top-down stress tests point to a resilient financial system and limited solvency problems even under adverse scenarios. Nevertheless, default rates are expected to rise significantly in the microfinance sector. While weakening in 2020, Peru’s corporate sector performance has remained robust, notably relative to global and regional trends.

12. Macroprudential policies may start shifting focus by encouraging banks to put more emphasis on the viability of clients. At the onset of the pandemic, the SBS reduced the countercyclical capital buffer for financial institutions and allowed them to adjust the terms of lending to households and enterprises without changing loan classification. Considering the credit cycle and financial vulnerabilities, macroprudential policies could start encouraging banks to focus on corporates' viability and direct resources to viable but illiquid firms. For unviable ones, efficient bankruptcy frameworks will be needed. In this regard, the authorities should aim to reduce lengthy administrative proceedings and encourage out-of-court restructurings.

Structural Reforms

13. Priorities in the reform agenda should be informed by the important structural fragilities exposed by the pandemic. Weaknesses in health care contributed to high mortality, requiring stringent containment measures that seriously affected economic growth. Poverty, low financial inclusion, high informality, and political instability hampered the authorities’ efforts to provide relief to households and contain the contagion. Low digitalization, combined with a large share of contact-intensive industries and limited teleworking, aggravated the economic impact of the lockdown. Against this background, a multi-pronged strategy to address these fragilities should focus on:

a) boosting productivity , including by improving health and education, enhancing infrastructure, facilitating labor reallocation, and improving the business climate, in line with the National Plan for Competitiveness and Productivity launched in 2019. The new agriculture promotion law and its regulations, while gradually removing fiscal incentives to create a level-playing field, should preserve the flexibility in labor contracts that has been a key ingredient in the success of the agro-export sector.

b) enhancing social protection while reducing incentives to informality from the tax-benefit system. Investment in health care, education, and adequate social security, including pensions, is key but moving to universal health care should be accompanied by measures that reduce its adverse impact on incentives.

c) strengthening governance . Additional transparency in the public sector, including at the local level, and stronger anti-corruption enforcement would improve the business climate. Sufficient resources and adequate training for the newly created Offices of Institutional Integrity would be important in this regard.

The mission would like to thank the authorities for their generous hospitality and the candid and constructive discussions that took place during January 18–29, 2021.