Peru: Concluding Statement of the IMF 2016 Article IV Consultation Mission
After decelerating sharply in 2014, economic activity recovered last year despite a volatile external environment. Weak external demand, production bottlenecks, and low public investment at sub-national levels constrained economic activity in 2015. However, the recovery accelerated in the fourth quarter of 2015, largely reflecting additional mining production capacity coming on stream.
Services and commercial activity also picked up while gross fixed investment remained a drag on overall activity. As a result, GDP grew 3.3 percent in 2015. The sol depreciated significantly with respect to the U.S. dollar but strengthened against key trade partners in the region, which added to large declines in metal prices to produce a wider external current account deficit (4.4 percent in 2015). This current account deficit was financed mostly by long-term capital inflows.
Inflation rose to nearly 4.5 percent (year-on-year) at end 2015, beyond the central bank’s target band of 1.0 to 3.0 percent, reflecting supply shocks and the pass-through from currency depreciation vis-à-vis the U.S. dollar, especially to rents and electricity prices. A fiscal deficit of around 2.0 percent was recorded in 2015, but Peru’s gross public debt remained low at 24.0 percent of GDP. The financial sector remained resilient in 2015, with banks reporting strong results.
Macroeconomic policies responded promptly to the weaker activity and higher inflation of 2015. The central bank raised the policy rate by 100 basis points between September 2015 and February 2016 to address inflation concerns, while allowing more currency volatility. Credit dollarization receded in 2015 in large part due to central bank measures to limit dollar lending, although deposit dollarization increased reflecting expectations of a weaker currency. The central bank’s policy to close banks’ open balance-sheet position by providing sol liquidity through dollar repos helped support robust private credit growth. The stimulus plans announced by the government in late 2014, which included reducing tax rates, simplifying tax administration, and boosting public investment, supported activity.
However, implementation problems at the sub-national government level hampered full execution of the budgeted capital spending, thus limiting the effect of the support.
Activity is expected to accelerate in 2016 and 2017, and inflation to decline. An expected increase in mining capacity and exports, and a continuation of large public investment projects should impart a strong positive impetus to growth and help lift business confidence, with positive spillovers to non-commodity sectors. Growth is expected to reach 3.7 percent in 2016, and slightly more than 4.0 percent in 2017, assuming expanded mining production remains as competitive as currently, and large infrastructure projects advance. Inflation has been slowing since end-2015 and is expected to decline further, as El Niño effects disappear and currency depreciation slows down; inflation should return to the central bank’s targeted range by early 2017. The external current account deficit is projected to shrink gradually as mining exports pick up.
Risks to the outlook are balanced. External pressures have carried over from last year and comprise possibly weaker-than-projected growth in China, sharp asset price adjustments in advanced and emerging economies, and an even stronger dollar. Response to shocks should be through further exchange rate flexibility and easing liquidity conditions to support credit activity. Upside domestic risks include stronger-than-expected improvements in business confidence (especially if the incoming government announces decisive productivity-enhancing reforms) and a more effective execution of the existing pipeline of infrastructure projects, which could lift growth further in 2016-17 and beyond.
Following a monetary tightening, the central bank should maintain its wait-and-see stance. The real policy rate remains low at around 1.0 percent, but many factors support the maintenance of the policy interest rate at 4.25 percent for now: inflation and medium-term inflation expectations have been coming down since end-2015, the effect of past monetary tightening will be fully felt only with a lag, and uncertainties surrounding output gap estimates are high. This said, a possibly steeper interest rate path in the United States than currently priced in by financial markets could engender the need for further monetary tightening in Peru.
Greater exchange rate flexibility is a welcome development. Despite continued foreign exchange intervention, the central bank has been increasingly letting the sol absorb the decline in commodity prices, without a noticeable impact on firms’ and banks’ balance sheets. Peru’s external current account deficit is expected to narrow over the medium term and close the gap with its estimated equilibrium level. While temporary intervention to reduce excess volatility could be appropriate, further exchange rate flexibility should support the development of hedging instruments to reduce currency risk. In turn, this would help accelerate the de-dollarization process. Other measures to help de-dollarization could also be considered, including creating incentives for diversifying savings and investment instruments. Recent measures to deepen Peru’s equity market are very welcome.
A gradual fiscal consolidation in the next few years is advisable to ensure continuing healthy debt dynamics and to protect fiscal buffers. These buffers shield the Peruvian economy against natural disasters, commodity price shocks, and the realization of contingent liabilities. While in 2016 a slightly larger deficit is expected, current spending growth is already being contained in the budget.
With the output gap estimated to be closing by end 2017, a withdrawal of stimulus in line with the current fiscal framework is appropriate. Going forward, it would be important to deliver the budgeted capital spending in an efficient manner to support medium-term growth and social objectives, and to ensure the sustainability of pensions.
New infrastructure projects should be ready to start as soon as the current mega projects are completed in order to shrink Peru’s large gap in this area. Such investments should help boost potential growth beyond the baseline projection of 3.5 percent (in the absence of further reforms and investment). To accommodate higher public capital spending consistently with protecting Peru’s stable public debt dynamics, it will be critical to create adequate fiscal space (rather than exceeding deficit targets consistent with Peru’s current fiscal framework, which has served the economy well). This should be accomplished through containing current spending that is not complementary to capital expansion and structural reforms, and raising the low tax revenue collection by streamlining administration, reducing informality and exemptions, and further tightening the protection of Peru’s tax base from possible international profit shifting by multinational firms.
Reducing bottlenecks to public investment would go a long way toward enabling full execution of budgeted spending and supporting private investment. Bureaucratic impediments at the national level, such as an excessive number of authorizations and permits, should be streamlined and Peru’s current decentralization framework (a constraint to fully executing planned capital expansion and to a better allocation of resources where they are mostly needed) could be improved. In particular, revisiting revenue sharing across regions and municipalities with the goal of ensuring fair development, strengthening the efficiency of sub-national investment and effective capacity to manage it, and addressing the fragmentation of jurisdictions are important. Implementing multiyear budgeting, and enhancements to project selection and quality assurance should build on the existing framework of public investment management.
The agenda for growth-spurring structural reforms is multi-pronged and should not be postponed, so that poverty is reduced further. Long-standing challenges include reducing informality, which should be in part addressed through labor market reforms, and spurring investment in non-extractive industries, including through improving competitiveness and infrastructure. While Peru has achieved one of the highest rates of education coverage in Latin America, low quality of education remains a challenge, and the ongoing reforms in this area are very welcome. Similarly, despite remarkable reductions in poverty and income inequality in the past 15 years because of both fast growth and government policies, more can be achieved. In particular, rural versus urban, and regional economic and social disparities remain sizable.
Efforts to raise financial inclusion, including through the recently launched e-money mobile platform, are very welcome. New free trade agreements provide an opportunity for boosting and diversifying long-term growth, especially through direct access to new markets, higher exports to current trading partners, and innovation and job creation. In a virtuous circle, a more flexible economy with higher human and physical capital would magnify the benefits from these agreements.
We would like to take this opportunity to thank the Peruvian authorities for their hospitality and open dialogue. We look forward to a constructive dialogue with the incoming administration and stand ready to continue providing policy expertise and technical assistance to Peru.
IMF COMMUNICATIONS DEPARTMENT