Summary: KEY ISSUES Context: The overall state of the economy remains strong despite lower metal prices and market turbulence in mid-2013. The economy is still operating somewhat near potential and continues to be one of the most dynamic in the region. However, the pace of growth slowed in 2013 as a result of external shocks and lower domestic confidence. Headline inflation increased due to a combination of supply shocks and exchange rate “pass-through” effects. The current account deficit has widened recently due to a fall in exports. Against this background, fiscal policy provided a positive impulse, while the Central Reserve Bank of Peru (BCRP) eased monetary policy to support activity and allowed greater exchange rate flexibility to protect the economy from external shocks. Perspective: The outlook is positive with balanced risks. On the upside, a faster implementation of structural reforms and elimination of investment bottlenecks can greatly increase growth potential. On the downside, unexpected effects of the withdrawal of monetary stimulus in the U.S. could affect Peru through higher cost of investment. Near-term policy mix: The current policy mix is broadly adequate. With the economy close to full-employment and inflationary expectations in check, a relatively neutral policy stance should be maintained. Monetary policy should remain flexible as long-term interest rates in the U.S. start to gradually rise. Fiscal stance should remain broadly neutral, while the exchange rate should continue to show flexibility, strengthening its role as a shock absorber. If the external environment deteriorates further, the authorities have significant buffers that can be used to support demand to limit the negative effect of an external shock on domestic demand. Additional macro-prudential measures could also be employed, including those contributing to the de-dollarization of the economy. Medium-term challenges: Over the medium term, the economy will need to adjust to a lower growth rate in China (one of Peru’s principal trading partners) by fostering productivity improvements and sustaining investment growth. It will be key to persevere with the structural reform agenda to enhance potential growth prospects. Deepening of the reforms is needed to bolster competitiveness through increases in labor market flexibility, upgrades in human capital, the elimination of infrastructure gaps, and fostering financial deepening.

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