- Rapid GDP growth under the program largely reflected a stable macroeconomic environment and expanding export base.
- Consistent policies and reduced external vulnerability have resulted in declining sovereign spreads and continuing access to international markets.
- Monetary policy in consistency with the inflation target has led to a declining trend in interest rates. Interventions in the foreign exchange market are a tool for monetary policy aimed at preventing deflationary pressures arising from currency appreciation.
- The primary dealer system for domestic public debt has been instrumental in promoting financial de-dollarization through the development of a fixed-income market in domestic currency,
- The tax reform and the objective of refining expenditure control underpin the authorities’ commitment to fiscal sustainability.
- Progress in structural reform included: (i) completing the legal framework for decentralization; (ii) advancing trade negotiations both within the framework of regional trading blocs and bilaterally; (Hi) relaunching the Private Investment Promotion Program (PIPP); and (iv) pursuing a reform of the state.
- Engagement with the Fund has strengthened program implementation through close policy collaboration, creditable performance, and almost no financial implications. Going forward, the authorities concur that a successor program should focus on further fiscal consolidation, de-dollarization, and confronting institutional weaknesses.
1. The Peruvian authorities wish to thank the staff and management for their advice and support provided under the 2002-03 Stand-By Arrangement (SBA), which now comes to a close. During the program, growth has accelerated to one of the highest rates in the Western Hemisphere, inflation has been kept within the target, and progress has been attained in advancing structural reform. Going forward, the authorities will continue their efforts to strengthen political support for their agenda, further improve resilience against external shocks, increase competitiveness, and consolidate investor confidence to enhance growth and attain a significant reduction in the incidence of poverty. As indicated by the staff, all end-December performance criteria were met, with the exception of a small overrun on the limit for external debt contracting. This was originated by a pre-financing operation for the 2004 budget, performed to benefit from favorable financial conditions. Our authorities, therefore, request a waiver of noncompliance.
Real Sector and External Position
2. Rapid GDP growth under the program—4.9 percent in 2002 and 4.0 percent in 2003—was partly based on the sustained increase in domestic aggregate demand, largely reflecting a stable macroeconomic environment. The dynamism of consumption has been sustained and private investment grew 5.2 percent in real terms in 2003, vis-à-vis 0.2 percent in 2002, mainly in response to major mining and natural gas projects. Moreover, an increasingly favorable external environment has fostered robust growth in exports—6.8 percent in 2002 and 5.0 percent in 2003 in real terms—further widening the trade surplus. It should be noted that the export base is also rapidly expanding to sectors such as textiles and agriculture, hi particular, the Andean Trade Promotion and Drug Eradication Act (ATPDEA) with the U.S. has promoted a very strong expansion in textile exports, and our authorities consider regional and bilateral trade agreements as a vehicle for developing the country’s productive potential, with exports as the driving force.
3. Strong fundamentals, consistent policies, and reduced external vulnerability have been recognized by international markets through a declining trend in sovereign spreads, reaching 343 basis points in end-January, from 613 one year earlier. Peru’s access to international capital is secured on increasingly favorable terms. The latest bond issuance, in November 2003, was completed at a lower spread and a longer maturity than previous placements—30 years—and included collective action clauses (CACs). The authorities hope that these financial conditions will contribute to establishing a benchmark for future private sector bond operations in the international capital market. Moreover, a sound international reserve level—$10.2 billion as of end-December, equivalent to 2.1 times short-term external obligations and 15 months of imports—places Peru in a good position to weather liquidity shocks.
Monetary and Exchange Rate Policy
4. The stance of monetary policy continues to be defined within the inflation targeting regime. Inflation in 2003 closed at 2.5 percent, at the center of the target range. Since July 2003, the Board of the Central Bank has reduced its policy interest rate four times, and these actions were closely followed by market-determined rates. As a consequence, both the level and volatility of the interbank interest rate have continued their falling trend. Also, the achievement of price stability and the improvement in global economic conditions, together with a more stable regional outlook, have helped to improve the external position and to attract additional capital inflows, thus contributing to the strengthening of the local currency. The authorities underscore that their interventions in the foreign exchange market are to be considered as a tool for monetary policy, in particular to prevent deflationary pressures arising from currency appreciation, and do not reflect a commitment to any predetermined exchange rate. Furthermore, reserve accumulation through these purchases has enabled the Central Bank to underpin the country’s external liquidity position.
5. The promotion of financial de-dollarization through the development of a fixed-income market in domestic currency has been enhanced through a primary dealer system for domestic public debt. Under the system, management of domestic debt has been improved, and a benchmark for the interest rates of assets denominated in domestic currency has been defined. Maturities have become longer and yields have decreased significantly, reflecting greater confidence in the domestic currency and providing a reference for longer-term financial instruments. Also, private bond issues, as well as loans in domestic currency, are gaining a larger share of financial operations. Particularly, dollarization in the banking system has diminished from 67 percent of deposits in 2001 to 65 percent in 2002 and to 62 percent as of end-2003. hi addition, as of December 2003, bank profitability increased due to the greater quality of the loan portfolio, reflected in the significant drop in the ratio of nonperforming loans.
6. The public sector deficit target of 1.9 percent of GDP for 2003 was achieved, to a large extent through good revenue performance. The tax measures adopted in 2002 and 2003, together with a continuing dynamism in economic activity, led to higher tax revenues, equivalent tol2.9 percent of GDP in 2003, from 12.1 percent in 2002, and to a central government primary surplus of 0.1 percent of GDP, from a 0.3 percent primary deficit. The authorities will continue to modernize processes, and enforcement operations will emphasize the VAT and the income tax.
7. Moreover, with the aim of creating room for priority spending, and to increase public investment in infrastructure to enhance the overall productive capacity, the authorities completed the comprehensive tax reform launched in October. The reform was enacted through special powers granted by Congress to legislate on tax matters, and includes a number of administrative measures intended to enhance the efficiency and collection potential of the tax system, mainly by clarifying rules to prevent evasion, enhancing control mechanisms and expanding the supervisory powers of the tax authority. Also, the corporate income tax rate was increased and deductions were narrowed, and the personal income tax base was widened. The financial transactions tax (FTT) will be complemented with the obligation to perform financial operations above a threshold through the banking system. The authorities argue that such obligation will increase financial intermediation and provide additional information that will be instrumental in improving tax control. At the same time, they are aware of the staffs advice in this regard, and have lately expressed their intention to revise it in order to minimize its distortive effects.
8. The authorities’ pledge to reinforce fiscal sustainability is further underpinned by the objective of refining expenditure control within the framework of the reform of the state. Thus, they expect the deficit to decline to 1.5 percent of GDP in 2004—with the primary surplus increasing to 0.6 percent of GDP. Furthermore, they remain committed to reducing the fiscal deficit as announced in the medium-term macroeconomic framework, to 0.5 of GDP by 2006, with the aim of bringing the debt-to-GDP ratio towards 40 percent of GDP over the medium-term from its current level of 47 percent.
9. Concerning the decentralization process, the government will continue to coordinate with the regional authorities the phasing out of exemptions in exchange for investment in infrastructure and social programs. To ensure that the process is implemented in an orderly, gradual, and fiscally neutral manner, the authorities completed the legal framework for decentralization. The Fiscal Decentralization Law, recently enacted, is geared to protect public finances over the medium term. Among other features, it (i) establishes criteria to define the revenue base for subnational governments; (ii) indicates fiscal rules, mainly limits on the increase in expenditure in real terms and on the debt stock and debt service; and (iii) requires the elaboration of multi-year frameworks and quarterly reports as accountability mechanisms.
10. The authorities are pursuing trade agreements both within the framework of regional trading blocs and bilaterally, hi August, Peru became an associate member of the Common Market of the South (MERCOSUR), and the authorities have also made initial progress in negotiating free-trade agreements with the U.S. and the European Union. Likewise, in October Peru started discussions towards a free-trade agreement with Thailand. At the same time, the authorities remain committed to participating in the FTAA initiative.
11. The authorities emphasize their determination to relaunch the Private Investment Promotion Program (PIPP), in an effort to encourage private sector investment. They are confident to be able to muster support for the program, including by involving sub-national governments in the process. A long-term management contract was recently completed for a hydroelectric plant, and near-future operations will include the sale of the remaining government’s stake in electricity transmission companies and in an oil company, the exploitation of a phosphates deposit and a copper mining project, and road system concessions.
12. The reform of the state is also prominent in the authorities’ agenda. A single regime for government workers—to become effective in 2005—has been enacted in an effort to further rationalize and improve expenditures control. The authorities will also persist in the modernization and transparency of procurement procedures. In addition, they have stated their intention to continue controlling and evaluating current beneficiaries of the national pension system to eliminate irregularities, and to centralize the system.
Relations with the Fund
13. The Fund has provided sound policy advice and has maintained a direct and open dialogue with the authorities in the context of a series of precautionary SBA programs, and financial exposure has been maintained at a minimum (less than 15 percent of quota). This combination of close policy collaboration, creditable performance under Fund support, and almost no financial exposure, represents a deal that members do not usually offer to the institution. Furthermore, since resource implications are one of the main criteria for constructing the list of members with longer-term program engagement, the authorities continue to be of the view that consecutive precautionary arrangements, like in the case of Peru, should be excluded from such list.
14. Our authorities recognize that, despite the progress achieved, substantial work remains to be done to fulfill their reform plans aimed at further improving investor sentiment and creating the conditions for sustained growth and sizeable poverty reduction. Therefore, they have confirmed their interest to continue a close cooperation with the Fund by negotiating a successor SBA, which they also intend to treat as precautionary. The Ex-Post Assessment of Longer-Term Program Engagement (LTPE) broadly recognizes that continued support of the government’s economic program through a precautionary SBA could be beneficial. At the same time, for clarification, we would like to provide the following comments:
- Engagement with the Fund has strengthened program implementation, and the compliance problems at the end of the 1990s were isolated events, owing to an institutional disruption already overcome. Under the most recent programs, the authorities have been able to deliver, thanks to their commitment to disciplined macroeconomic management and structural reform. There has been no complacency on the part of the authorities and, even thought a certain degree of flexibility has been required, the program has been conducted in the clear understanding that completion of reviews was subject to attainment of the performance criteria and structural benchmarks agreed in the letters of intent.
- The authorities concur that the credibility of a successor program would hinge on addressing fiscal consolidation, de-dollarization, and remaining institutional weaknesses. The significant improvement in market perception in response to a good record of compliance under the recent program suggests that, far from wearing out, the effectiveness of Fund support has increased. Also, the use of structural performance criteria in a continuation program could be politically sensitive and prove counterproductive. Therefore, the authorities continue to be favorable to using structural benchmarks. At the same time, the authorities’ approach of garnering political support for their reform agenda has been challenging, but nonetheless they have been able to deliver in crucial areas such as decentralization and the tax reform.