December 3, 2019

Recent Developments, Outlook, and Risks

1. Peru continues to be one of the best-performing economies in the region, but economic activity has lost momentum in recent years. With annual real GDP growth averaging 5.4 percent over the past fifteen years, Peru has been one of the fastest economies in the region, which enabled it to make significant progress in reducing poverty. Since 2014, however, a less benign external environment and adverse domestic factors have weakened considerably the pace of economic activity. Trade tensions have reduced global growth and increased uncertainty, international financial markets have become more volatile, and commodity prices have only partially recovered from the 2011-15 decline. Domestically, the adverse 2017 El Niño weather event caused significant economic disruption and the findings of the Lava Jato investigation hampered large investment projects.

2. Growth is expected to remain modest in the short term before strengthening gradually. GDP grew by 2.2 percent in the first nine months of 2019, but the measures taken by the government to speed up execution at all levels of government should help public investment recover. Lower extraction and social unrest in mining and weather-related transitory factors in fishing should also recede. As a result, GDP growth for 2019 is projected to be 2½ percent. With the negative output gap expected to persist, inflationary pressures should remain subdued. A gradual strengthening of demand from Peru’s main trading partners and resilient private consumption and investment would raise GDP growth to 3¼ percent in 2020 and 3¾ in the following years.

3. Risks are tilted to the downside, but policy buffers are strong enough to mitigate the impact of adverse shocks. Prolonged uncertainty and continued trade tensions could undermine growth prospects in Peru’s main trading partners, reducing exports and the prices of mining and agricultural commodities. Likewise, external risk-off events could determine a sudden tightening of financial conditions and trigger contagion effects. The associated exchange rate movements could be magnified by balance sheet effects owing to the partial degree of dollarization still present in Peru’s financial system. Domestically, prolonged political uncertainty and ongoing corruption investigations could stifle business investment and growth. However, a favorable public debt position buttressed by considerable financial assets, a large stock of international reserves, and a solid financial system should help cushion the impact of adverse shocks.

Policy Recommendations

To re-kindle growth amid increasing uncertainty, a broad set of policies is needed to continue strengthening Peru’s resilience to shocks, enhance productivity, and improve social protection. The current slowdown in activity and heightened uncertainty would justify fiscal and monetary stimulus. A stronger financial infrastructure would buttress the system’s capacity to absorb a wider range of domestic and external shocks. Structural reforms would enhance competitiveness and productivity and make growth more inclusive.

Fiscal Policy

4. To provide a fillip to the economy, the authorities should make full use of the space available under the fiscal rule. While policy is focused on bringing the fiscal deficit below the 1 percent of GDP ceiling by 2021, budget under-execution has led to a tighter policy stance than required by the fiscal rule. This has contributed to slowing growth amid rising uncertainty. In this context, the measures taken by the government to remove financing and capacity constraints of local and regional governments should help speed up the execution of capital spending, but close monitoring and other supporting measures may be necessary to ensure success. In the medium term, significant efforts are also needed to enhance the quality of public investment management, including formulation, assessment, and selection of projects.

5. If fully executed, desirable plans aimed at boosting public investment could require additional measures to comply with the deficit ceiling. Enhancing the quality of infrastructure is a key component of the government’s strategy to increase the economy’s competitiveness. The National Plan of Infrastructure for Competitiveness identifies significant infrastructure gaps, which would be partially bridged by priority projects—amounting to 13 percent of GDP—to be executed in the next decade. To be consistent with the fiscal rule, this effort will require enhancements in revenue administration, improved performance of public enterprises, and reduced current spending, but projections of these items seem subject to significant risks.

6. Addressing priority needs while preserving fiscal sustainability makes it imperative to bolster revenue mobilization. Despite significant efforts by the authorities to mobilize revenues, Peru’s tax revenue ratio remains comparatively low, with modest progress being made in the last twenty years. But without higher revenues, Peru will be unable to address priorities in several areas, including infrastructure and the social safety net. In this context, continued improvements in revenue administration are paramount and require maintaining SUNAT’s ability to focus on its core activity and attract top quality staff. Measures taken in recent years to reduce non-compliance, such as the introduction of electronic invoicing and the adoption of best practices on international taxation, should start bearing fruit. The authorities’ intention to simplify tax regimes for small businesses should also help reduce loopholes and increase compliance.

7. To avoid a procyclical fiscal stance and to create space for infrastructure spending, the authorities could also consider introducing more flexibility in the fiscal framework. Although frequent revisions may weaken the integrity of the rules-based system, low debt and the strong fiscal framework would limit the risks associated with a modest increase in the deficit ceiling. The erosion in fiscal buffers would be minor and the existing expenditure rules would continue to limit current spending even under a higher deficit ceiling, thereby reducing reputational risks.

Monetary and Exchange Rate Policies

8. The recent easing of the monetary policy stance is appropriate, given weakening growth, increased uncertainty, and muted inflationary pressures. Inflation expectations are well anchored, the output gap is expected to remain negative for some time, and fiscal policy is contractionary. The recent forward guidance from the central bank—indicating that the last policy rate cut did not necessarily imply that further cuts would follow—is helpful in clarifying that policy remains data-driven. In this regard, further policy easing might be needed if downside risks to the inflation outlook materialized. Nonetheless, with the real interest rate now close to zero, the monetary stance is clearly expansionary, and the authorities should remain vigilant against the emergence of financial sector vulnerabilities.

9. As dollarization declines, the central bank could allow greater exchange rate flexibility to absorb external shocks and promote financial development. In fact, the use of foreign exchange intervention (FXI), which largely reflects the authorities’ concerns for liability dollarization and its impact on financial stability, has declined over time. With loan dollarization now at 39 percent for firms and 10 percent for households, greater exchange rate flexibility would carry lower risks. Limiting central bank intervention to cases of disorderly market conditions could help reduce dollarization further, encourage the use of hedging instruments, and strengthen the interest channel of monetary policy.

Financial Sector Policy

10. The authorities have taken important steps to strengthen financial sector oversight, but additional efforts are needed to complete the legislative and regulatory reform agenda. The coming-into-effect of the new law on credit cooperatives is an important milestone. In addition, in response to last year’s recommendations of the Financial Sector Assessment Program, the SBS has implemented measures to: limit systemic risks; enhance its governance and control frameworks; broaden the supervision of bank and insurance sectors; and strengthen financial integrity. Further steps are, however, needed to reinforce the legal protection of supervisors; mandate the SBS to exercise consolidated supervision; and enhance the effectiveness of the AML/CFT framework. It will also be important to bring some regulations in line with Basel III, including those regarding risk weights for foreign currency loans, which would help reduce dollarization further.

Structural Reforms

11. A stronger focus on key priorities would help more rapid progress on the authorities’ broad structural reform agenda. The National Competitiveness Plan released in June covers a large spectrum of reforms which might require a focused approach with clear timelines. Legal and product market reforms would ensure the best growth payoff while commanding enough popular support. The authorities have already made significant progress in improving public sector transparency and governance. These efforts should be complemented with additional anti-corruption reforms, such as: making the government procurement system simpler, more transparent, and competitive; reforming the National Control System to better manage risks and increase accountability; and introducing independent internal auditors in some entities while strengthening external audits. In addition, it will be important to foster economic diversification, for which an extension of the agriculture promotion law appears crucial.

12. Improving social protection is necessary to make growth more inclusive and sustainable. Peru has made significant progress in reducing poverty since the turn of the century. Nonetheless, action is needed to address critical needs, including by reforming the pension system to ensure its sustainability and enhance its coverage, providing a more equitable distribution of natural resource revenues across regions, and deepening financial development and inclusion, which the authorities have identified as a priority in the National Competitiveness Plan. These actions should be accompanied by reforms that reduce labor market rigidities and other costs that prevent workers and firms shifting from the informal to the formal sector.