Peru—Concluding Statement of the IMF 2015 Article IV Consultation MissionApril 1, 2015
Economic growth slowed markedly in 2014. Lower metal prices and weaker demand from trading partners were a major drag on private investment and exports. On the domestic front, an unexpected drop in public investment and temporary supply disruptions in mining, fishing, and agriculture compounded external shocks. The drop in public investment was due to implementation problems at the subnational level, which accounts for over 60 percent of total investment, and despite an increase of 17 percent in national public investment. Against this background, real GDP growth slowed to 2.4 percent in 2014, from 5.8 percent a year earlier. Still, growth in Peru was double the regional average of around 1.2 percent. The current account deficit remained high at 4.1 percent of GDP and international reserves fell as net capital inflows were not sufficient to finance the current account deficit.
Strong policy frameworks and fundamentals allowed the authorities to loosen the macroeconomic policy stance. The authorities embarked on a series of fiscal and structural packages, including tax cuts, increases in fiscal spending, and structural measures to support investment, consumption, and growth. Monetary conditions were also eased against a widening negative output gap and stable inflation expectations, helping to lower corporate lending rates and supporting robust growth of credit to the private sector.
Within the constraints of a still weak external environment, the policy mix is broadly appropriate to support the recovery and maintain macroeconomic stability. In the mission’s baseline scenario, real GDP growth in 2015 is projected to be close to 4 percent, anchored by the reversal of last year’s supply shocks and policy stimulus.
Growth is expected to rise in 2016-17, assuming new mines come on stream, large infrastructure projects are implemented, and terms of trade shocks fade, with the output gap closing by 2018. Inflation is projected to converge towards the mid-point of the target range by end-2015, and the current account deficit will narrow gradually as mining exports gain ground.
Important risks loom on the horizon, but ample buffers place Peru in a comfortable position to respond to future shocks. The external environment is expected to continue to pose downside risks, including from lower terms of trade, slower growth in China, or unexpected turbulence in global financial markets. There are also domestic downside risks from weaker investment and uncertainty in light of the upcoming election cycle. At the same time, a faster pick-up in metal production entails upside risks. Efforts to allow a more complete pass-through of lower global oil and food prices to domestic prices would also help support the economy. If shocks materialize, exchange rate flexibility should be the main line of defense, liquidity should be provided to avoid an undue contraction in credit, and monetary conditions could be eased if downside risks to inflation projections become evident.
The sharp slowdown in growth warranted a fiscal stimulus that should be gradually withdrawn from 2016 onwards. Fiscal policy is expected to remain appropriately expansionary in 2015, with the overall fiscal deficit rising to 2 percent of GDP. Approval of the draft law explaining the reasons for deviating from the original structural deficit target of 1 percent of GDP and outlining the gradual fiscal consolidation plan starting in 2016 is important, as a signal of commitment to fiscal sustainability and to maintain the credibility of the new fiscal framework. For the medium term, it would be advisable to target a small structural fiscal surplus of ½ percent of GDP to preserve buffers in the face of commodity shocks, contingent liabilities, and natural disaster risks.
An immediate priority is to step up public investment execution, given its higher effectiveness in stimulating growth in both the short and the long run. The government has initiated several actions to strengthen investment execution capacity and to capitalize on private sector expertise through public-private partnerships. It will be important to embed public-private partnerships in medium- and long-term budget planning and debt sustainability analysis to ensure that commitments remain manageable, with transparent reporting of contingent liabilities and risks. With respect to public works-in-lieu of taxes initiatives, they may offer a pragmatic solution in current circumstances to deliver on infrastructure needs at the subnational level, but should be monitored closely and adhere to high transparency standards. Hikes in non-priority current spending should be avoided, given the need to finance structural reforms, carry through the civil service reform, increase allocations for physical and human capital investment, and protect targeted social programs.
To regain fiscal space and support investment and inclusion along a fiscal consolidation path, the erosion of tax revenues would need to be offset over the medium term. The cut in corporate income taxes has contributed to align rates in Peru with the rest of the region. However, they have amplified the existing tax collection gap, both with respect to peers and to the tax effort expected for Peru’s level of development, at a time when commodity fiscal revenues have declined. Compensatory measures should aim to enhance the equity and efficiency of the tax system, by widening the tax base, streamlining exemptions, promoting formalization, boosting collection of local property taxes, and reviewing excise taxes to address negative externalities. Ongoing efforts to transition towards a client- and service-based revenue administration will be instrumental to deliver on these goals.
Monetary policy continued to respond effectively to changing conditions. In 2014, headline inflation hovered slightly above the 3 percent upper limit of the target band due to supply shocks and some pass-through from exchange rate depreciation, but core inflation and expectations remained within the band. Looking ahead, monetary policy should continue to pay close attention to inflation expectations and external developments. Declining inflation expectations in early 2015, driven by the sharp drop in global oil prices yet to be fully reflected in domestic prices and a widening negative output gap, could provide some monetary policy space in the near term. At the same time, the room for further easing may eventually be constrained by the expected rise in US interest rates.
The exchange rate is assessed to be broadly in line with fundamentals. Foreign exchange intervention should continue to be limited to smoothing excessive volatility that could lead to disorderly market conditions and undermine financial and macroeconomic stability. Exchange rate flexibility will be key to cushion any additional pressures from further declines in commodity prices and the expected normalization of US monetary policy. It would also support de-dollarization by appropriately encouraging the private sector to hedge their foreign currency exposures. The authorities may also want to assess the case for regulations on foreign currency exposure of pension funds.
The new de-dollarization measures will help address a key structural vulnerability of the financial system. However, financial market developments will need to be followed closely and the de-dollarization measures implemented flexibly. On the asset side, strengthening prudential requirements on dollar lending to un-hedged borrowers by the bank supervisor could prove effective in addressing foreign currency credit risk without undue pressure on dollar deposits and covered dollar loans. At the same time, improving data and analysis of private sector balance sheets would allow a better assessment of systemic risks from currency mismatches and the need for targeted macro-prudential tools. Deepening financial and capital markets should also be an important component of the de-dollarization agenda.
Despite weaker economic conditions, the financial system remains stable. The banking system is profitable, liquid, and well capitalized, with strong operational efficiency. Bank supervision is of high quality, though there is scope to strengthen regulatory standards in line with Basel III principles. Deposits continue to provide the lion’s share of funding and direct exposure to the commodity sector appears limited. Nonetheless, the recent deterioration in the quality of the loan portfolio of non-bank financial institutions warrants close monitoring and supervision. While these institutions are non-systemic, they serve a large number of relatively vulnerable and small clients. More effective use of existing programs to support small and medium-size enterprises could help mitigate the impact of the slowdown in growth and softening labor markets conditions.
With the end of the super commodity cycle, accelerating structural reforms is needed to boost growth potential and advance social inclusion. The continued slide in metal prices, the moderation of growth in China, and the decline in investment suggest that potential growth may have fallen from the heights of the last decade. Boosting potential growth requires steadfast implementation of structural reforms to enhance productivity, investment, human capital, and formal employment, including persevering with labor market reform. The ambitious education reform and integral inclusion polices are already showing noteworthy results and should stay their course within the framework of fiscal discipline. Ongoing efforts to reform the civil service, streamline permitting procedures, accelerate infrastructure projects, enhance innovation, and diversify exports are also clear steps in the right direction. Finally, the OECD Country Program with Peru could provide a useful new platform for designing reforms and strengthening policies.
We would like to take this opportunity to thank the Peruvian authorities and private sector representatives for their hospitality and open and constructive dialogue.
IMF COMMUNICATIONS DEPARTMENT