Peru: Monetary Policy Dilemmas

In the first two weeks of this year, the Banco Central de Reserva del Peru (BCRP) has bought US$2.3 billion in the foreign exchange market, almost a quarter of its full intervention in 2007. This has led to questions about the sustainability and rationale of this policy, as the central bank’s stock of Certificates of Deposit (CDBCRP) ballooned during 2007.

In the long run, this policy is not sustainable. Fully sterilized intervention keeps domestic interest rates high, inviting more portfolio inflows; partial sterilization risks unwarranted boosts in domestic liquidity and inflationary pressures down the road. On top of that, the central bank’s frequent intervention in the currency market dampens exchange rate risk, again inviting further speculation. These are the main dilemmas faced by Peru’s monetary authorities.

In fact, the central bank hiked its reserves requirements on nuevos soles and dollar deposits last week, in view of continued pressure on its balance sheet. This is a policy response designed to increase the central bank’s liabilities at a low cost.

Intervention in the currency market is taking place in a context of rising inflation. Food prices have been a major driver of inflation in Peru, as they make for almost half of the consumer price index. If food is excluded, CPI has only risen by 2%Y, right at the center of the inflation target. We believe that the authorities have overstressed this fact, and run the risk of falling behind the curve.

Headline and core inflation are now above the upper bound of the central bank’s inflation target. In particular, core inflation (which excludes not only volatile foodstuffs but also fuel, transportation and utilities) breached the 3%Y limit last December, a level unseen in the recent inflation-targeting history of Peru. As headline inflation is the target of Peru’s monetary regime, monetary authorities should be vigilant that food price inflation does not contaminate the price formation process in the rest of the economy.

Tools of monetary policy in Peru

As in the case of other countries pursuing an inflation-targeting monetary regime, the central bank’s main operational target is the reference interest rate, which it hiked last January 10 from 5% to 5.25%. Authorities conduct open-market operations so as to keep the interbank interest rate close to its policy rate.

However, in the case of Peru, a high degree of financial dollarization complicates the executionand effectiveness of monetary policy. Although it has decreased steadily during this decade, the proportion of the banking system’s liquidity and credit in dollars remains one of the highest in the region. Authorities are preoccupied with possible balance sheet effects of currency volatility within this context.

The central bank intervenes, at times heavily, in the foreign exchange market in order to accumulate international reserves and to smooth exchange rate fluctuations. Over the last few years, it has mostly purchased dollars; the associated soles liquidity is then sterilized via issuance of CDBCRPs. The central bank handles day-to-day liquidity fluctuations via its overnight window and the use of repos.

We have to question the sustainability of the central bank’s practice of issuing costly liabilities as the main tool of its sterilization strategy going forward. Much of the sterilization of international reserves accumulation last year was achieved issuing CDBCRPs. As evidence of a responsible fiscal stance, fiscal policy – via accumulation of government and Banco de la Nacion deposits at the central bank – has facilitated its sterilization efforts. Accumulation of bank deposits at the central bank, due to reserve requirements on dollar deposits, also helped to sterilize the accumulation of reserves.

Unlike recent years, the central bank now has to incur quasi-fiscal costs for sterilization. Until September 2007, it was profitable for the BCRP to buy dollars and issue CDBCRPs in return. This is not the case any longer, as the central bank has had to hike its reference interest rate for inflation-fighting purposes and the US Federal Reserve is lowering its rate in order to fight off recessionary pressures.

In addition, as explained above, the stock of CDBCRPs has increased materially lately. Doing some back-of-the-envelope calculations, we estimate that if the central bank sterilizes as much this year as in 2007, it will incur a cost of 0.20% of GDP, which seems a manageable amount at the moment. This is the ‘cost of the insurance’ to be paid for reserve accumulation.

Dilemmas of monetary policy in Peru

Peru’s current monetary policy strategy poses several dilemmas:

There is little exchange rate risk. As Peru has become an attractive place to invest, foreign direct and portfolio investment is entering the country, bringing about appreciation pressures on the nuevo sol. The central bank then intervenes in the currency market in order to slow it down. However, as inflation has been on the rise, the central bank has been forced to hike its reference interest rate. Therefore, expectations of higher domestic interest rates are attracting portfolio inflows in an environment where appreciation of the currency is a one-way bet, which encourages further portfolio inflows.

We suspect that precisely more volatility in the currency would increase exchange rate risk and thus discourage speculative, short-term portfolio inflows. In a recent working paper (“El Mecanismo de Transmision de la Politica Monetaria en un Entorno de Dolarizacion Financiera: El Caso del Peru entre 1996 y 2006” by Rossini, R. and M. Vega, Working Papers Series: DT No. 2007-017, November, 2007), the BCRP staff rationalizes its “slow as it goes” approach to currency appreciation. In a nutshell, it is willing to slow down movements in the exchange rate so as to allow a more lasting and powerful pass-through to domestic prices and to avoid “bubble-like” behavior of the currency.

Another dilemma is that heavy intervention in the FX market is bringing about strong increases in domestic liquidity; in 2007, money base grew by 28%Y, well above growth of nominal GDP and despite the swelling CDBCRP stock. We should not assume that the fiscal authorities will make an increased contribution to the sterilization effort, as we expect fiscal accounts to deteriorate marginally this year. Therefore, the authorities would have to rely more on further issuance of CDBCRPs, in an environment of rising local rates.

Good central banking practice suggests that the central bank intervenes at the short end of the yield curve. However, the central bank is making a concerted effort to extend the duration of its CDBCRP stock. This strategy runs the risk of cannibalizing the T-bill and T-bond curves, which is the location of the government’s debt management operations. Therefore, it would be appropriate to suggest that the central bank sticks to the very short end of the yield curve (i.e., its reference policy rate), and uses it as a pivot for the rest of the yield curve in order to solidify the transmission mechanism of its policy actions.

But don’t expect market-unfriendly policy responses, such as capital controls. The authorities understand clearly that, in a context of financial dollarization, it is key that the domestic banking system has ready access to financing abroad and that capital flows freely, subject to reasonable prudential controls.

By Boris Segura New York
Morgan Stanley
January 23, 2008