Peru Unscathed

In mid October, at the Annual Meetings of the World Bank and IMF, the Minister of Finance of Peru, Luis Valdivieso, announced his intention to float a US$600 million, 30 -year bond   . Will currently dysfunctional capital markets welcome a new bond   from a developing country issuer? The short answer is no , but Peru may be one of the  exceptions .The paradox is that Peru could succeed to tap  capital markets  precisely because it does not   need the money .It has been running  budget surpluses for many years and its  public debt is small .In fact , Peru  is one of the few countries where  central bank’s  international reserves ( at US$35 billion or 26% of GDP ) exceed the total domestic and external public debt ( at US$ 30 billion ) . In other words , Peru’s public sector is a net creditor .Since the proceeds of the bond are not needed to pay for expenditures , the authorities intend to use the money  to buy back Peru’s  short-end  maturity  bonds from  investors  .The operation will extend   the average  maturity of the external  debt ,  now at eleven years .

The international meltdown of the last two months has underscored the strength of Peru’s finances. Unlike in some other Latin American economies, the exchange rate of the sol – Peru’s home currency – has stayed stable with moderate central bank intervention and the inter-bank rate has not blinked much. Further, the authorities have not had to jump to the rescue of any big financial institution or corporate.  It was most unfortunate that these achievements were clouded by a corruption scandal that prompted a partial renewal of the ministerial cabinet.

Beyond sound fiscal and monetary fundamentals,   Peru have a relatively small but strong banking system –with total assets at just  over one third of GDP .Banks are properly capitalized, well supervised, and extremely liquid. About half of total deposits are invested in either reserve requirements or official debt. The Central Bank is well positioned to pump sufficient sol and dollar liquidity by loosening requirements or buying back official paper. The structure of the banking sector also helps.  Four large banks account for three quarters of total intermediation; and two of them belong to international banks, BBVA of Spain and Scotiabank of Canada, so far survivors of the recent purge. Peruvian banks operate with low leverage ratios   (lower than ten to one) and practice traditional banking:  loans for collateral.

A run on bank deposits is unthinkable for it would be  unsuccessful .The reason is that the total deposit base of the system (about US$29 billion) is lower than  central bank’s international reserves. Likewise the authorities have the latitude to nip in the bud any speculative attack against the sol.

It is clear that in the wake of the coming international recession, Peru’s GDP growth will slow down from 10% expected for 2008 and 7% average over the last six years .Declining export revenues and capital inflows will no doubt take a toll on incomes, tax revenues, and the balance of payments. However, analysts project Peru’s growth for both 2009 and 2010 at over 5 % .There are three key drivers underpinning this projection. The first is the strong pipeline of committed FDI projects under execution which total US$ 8 billion per year .The second is the scope the authorities have for contercyclical fiscal policy stemming from the strong budget and debt   fundamentals. And the third is the feasibility of continued lending for local investment and housing in view of the sound condition of the banking system.

Peru is a real success story of free markets and fiscal discipline. Free trade has delivered a nine- fold increase in exports in les than two decades   . Following progressive unilateral tariff reduction under the WTO, Peru recently signed a free trade agreement with the US and is now negotiating agreements with the European Union and China.  Also, Peru is a textbook case of successful turnaround. Only eighteen years ago it was a basket case in default with all its creditors   -including the IMF and the World Bank – and enduring hyperinflation .Today, Peru is a fast growing economy and its public sector in a net creditor. In recognition, in early 2008 the rating agencies S&P and Fitch lifted Peru to the selective club of investment grade economies.

Peru‘s central bank deserves a lot of credit in the country’s success. It is an independent institution, staffed with competent economists who view central banking as a lifelong job. The build up of international reserves to a level equivalent to one  quarter of GDP is  nowhere easy but it is all the more difficult in a developing  country loaded with a backlog of social demands  .This  reserve buffer is paying off in these rainy days. In essence, Peru has underwritten its own insurance policy.

And what about poverty? The end result of Peru’s free market policies has been a steady reduction in poverty. From 2003 to 2007, the poverty rate –as defined by the World Bank – declined from 52% to 39% and extreme poverty eased from 21% to 14%. In the first two years of his second tenure, President Alan Garcia has shown   strong commitment to poverty reduction under sustainable macroeconomic policies .This is in sharp  contrast with his first term, from 1985 to 1990, when he tried to fight poverty under the wrong macroeconomic policies .The leadership and charisma of President Garcia is now at the root of Peru’s so far successful journey amid the unprecedented financial storm.

If the do not need the money, why then are the authorities determined to float a bond in today’s dysfunctional   markets? One reason may be to signal to the capital markets its own macroeconomic strengths at a time when everyone’s vulnerabilities have been brought to an extreme stress  test. Also, the success in placing the bond with investors will prove the point that sound economies are able to tap private capital -even in dislocated markets – as opposed to relying exclusively on “emergency room” financing from the IMF and World Bank.

Meanwhile, as few skeptic, beaten- down bankers shrug at the chances of Peru’s bond, investment bankers rush to Lima to present their bids.

4 Responses to "Peru Unscathed"

  1. Anonymous   October 29, 2008 at 10:41 am

    I was under the impression that fiscal spending in Peru has actually been very loose, increasing at a multiple of GDP growth in recent years, and these high fixed expenses would be near-impossible to bring down in a slowdown. Is that incorrect?

  2. Félix Jiménez   October 29, 2008 at 5:54 pm

    Ricardo Lago doesn’t say the entire true. In effect, «Peru’s central bank deserves a lot of credit in the country’s success. It is an independent institution, staffed with competent economists who view central banking as a lifelong job». This is only part of the true story. It is also the result of fundamental changes introduced by previous board of the central bank in the institutional framework of monetary policy (for example, a monetary policy rule and inflation targeting).Ricardo Lago says «Peru is a real success story of free markets and fiscal discipline. Free trade has delivered a nine- fold increase in exports in les than two decades». He also pretends to link this success with free trade agreement signed with the US. However, it is important to mention that the new framework of monetary policy designed by the previous central bank board included the rule of sterilized intervention in the exchange rate market, and an active policy aimed at restraining the domestic private credit in foreign currency. This was the lesson that all of us learned from 1998 financial crisis. These policies paved the way to build up international reserves, to increase the real exchange rate and lower interest rate. For this reason economic growth was accompanied by a trade balance surplus. But, in the last two years of the Alan Garcia government the real exchange rate has decreased; so this year the current account will end with deficit.Notice that the present central bank board has promoted the currency appreciation, has favored the increase in the external debt of the commercial banks, and, hence, domestic credit in foreign currency has grown substantially. Today the external debt of commercial banks is equivalent to 42% of total domestic credit in foreign currency. This is approximately 6 thousand million dollars.On the other hand, contrary to the IMF and World Bank orientation, the economic team of Toledo’s government introduced a «program of market makers» to expand the public debt in domestic currency. This program, together with the international reserve accumulation and the restriction to borrowing in the external markets by de commercial banks, was the third column to absorb the effect on the adverse external shocks. The economic team of the Garcia’s government didn’t pay attention to the development of this market. Without this market it would have been impossible to substitute domestic debt for external debt and to extend the average maturity of public debt.If the minister of finance of Peru floats a US$600 million 30 –year bond, the market risk (exchange rate risk) of the public debt will increase. A better choice would be to float 1800 millions of soles in the foreign capital market, but this is another story.Summing up, international reserve accumulation, restrictions to international financing for commercial banks (which restrains the private credit in foreign currency), and «market makers program» for public debt in domestic currency, were the mains columns for preventing the effects on our economy of the external financial crisis. Of all the above, only the first was maintained by the present central bank board appointed by the president Alan García.

  3. Anonymous   October 30, 2008 at 6:18 am

    Peru is enjoying the fruits of more than 15 years of uninterrupted responsible macroeconomic policies. This started with Fujimori, right after Alan Garcia’s first term, continued with Toledo and now a reformed Alan Garcia. Continuity is critical and the reduction of poverty levels has a direct impact on this. Fujimori, Toledo and Garcia were all elected because they made extremely populist offers to the poor population. Three very lucky choices not three wise selections. As poverty comes down the desperate vote for the populist promise is reduced. This will be put to the test in 2011 which will be a turning point for the country. If our luck with elections runs out we can easily end up with the next Hugo Chavez or Evo Morales. We need one more lucky round or the start of thoughtful choices. Or maybe after all there is a wisdom of crowds in a country with an emerging middle class. Watchout 2011. Peru is likely the next Chile not the next Venezuela. Reducing poverty is the keystone.

  4. Ariel   November 1, 2008 at 11:01 pm

    Felixjimenez brings some important points particularly asregards to innovations by previous boards of the Central Bank and also the Team of President Toledo , but Felix’s analysis does not appear to contradict the central argumentation of Lago .OS does it ?