1. The Peruvian economy has proved to be quite resilient to exogenous shocks. In 2002, despite the reduced global growth and the financial turmoil that affected several countries in Latin America, GDP is estimated to grow at a rate above 4 percent, the unemployment rate has fallen by more than 2 percentage points during the year, and annual inflation is projected to close the year below 2 percent. At the same time, the level of net international reserves has increased to almost $10 billion, covering close to 190 percent of short-term debt on a residual maturity basis.

2. These positive results have been achieved despite several years of successive adverse events such as the EI Nino phenomenon and its negative impact on infrastructure and exports; the fall in terms of trade in the wake of the Asian crisis; the reduction and outflow of short-term capitals during the Russian financial crisis in 1998; the volatility caused by devaluations in Brazil and Argentina; and the domestic political crisis at the end of the 1990s. Sound fundamentals have enabled Peru to weather all these shocks and start a period of economic recovery, thus creating the conditions to reduce the poverty level.

I. Economic Activity

3. Pern’s GDP growth is one of the highest in the Latin American region this year, as the recovery in economic activity continues. The latest figures show that GDP increased by 5.2 percent in the third quarter relative to the same quarter last year, thus confirming the accelerating trend initiated since the second half of 2001. It should be underscored that the stagnation in private investment was reversed by a substantial 4.5 percent pickup in the third quarter. Exports show increased dynamism, and manufacture and construction have started to lead growth, with 5.6 and 11.4 percent increases in the same period, respectively.

4. The recent extension of the Andean Trade Promotion and Drug Eradication Act, which enables Peruvian textile and agricultural goods to enter the U.S. market free of tariffs, is envisaged to have a high positive effect on exports. In particular, the arrangement increases significantly the growth potential of Peruvian textiles and apparel—currently the fourth most important export item. Additionally, the Camisea gas project, which will start operations in 2004, will imply an important reduction in energy costs and substitution of oil imports.

II. Monetary and Exchange Rate Policy

5. In January 2002, the Central Bank announced the adoption of an inflation targeting strategy with a target of plus or minus one percentage point around the midpoint of 2.5 percent. The launching of the new monetary framework included the dissemination of the calendar of Central Bank board meetings—in which monetary policy actions are taken—as well as the announcement of the publication of an inflation report every fourth months. Under this monetary arrangement, the Central Bank successfully neutralized deflation risks, with inflation passing from -0.1 percent in 2001 to an expected 1.8 percent in 2002.

6. Peru has been able to maintain an expansionary bias in monetary policy this year, reflected in an average interbank interest rate of 3.9 percent by end-November, vis-à-vis 8.4 percent right after the presidential election in 2001. At the same time, credit to the private sector, after falling by 4.6 percent in 2001, grew by 2.5 percent over the twelve months to October—with a 7.8 percent growth in credit denominated in domestic currency—while the banking system has shown improvements in all its indicators.

7. The freely floating exchange rate has served the economy well, acting as a cushion against external shocks and remaining quite stable, given the international financial conditions. As of November, the domestic currency showed one of the lowest accumulated depreciation rates in the region (4.3 percent).

8. In response to risks arising from the partial dollarization of deposits and credits in the financial system, since the beginning of the 1990s Peru has adopted prudential measures against the possibility of an abrupt withdrawal of dollar deposits and the potential effects of a significant currency depreciation on loan portfolios. The banking system maintains demand deposits at the Central Bank amounting to $3.6 billion, representing 33 percent of dollar liabilities. As for the risk of pressures on the exchange rate, it is important to note that the Central Bank’s net international reserves amount to 5.8 times the monetary base and 2.1 times liquidity in domestic currency.

9. At the same time, the mismatch stemming from foreign currency loans to domestic firms and households with revenue sources in domestic currency is being addressed by the development of the foreign exchange forward market, in which they can cover open foreign exchange positions, In addition, provisioning requirements on commercial banks are helping to cover unhedged risks, and the development of a fixed income market in domestic currency is favoring a process of financial de-dollarization. In this regard, the authorities aim to introduce in 2003 a system of primary dealers for auctioning government paper in domestic currency, thus helping the development of a secondary market in these instruments that should prompt the development of bank liabilities denominated in domestic currency. In any case, the process is supported by the application of consistent macroeconomic policies and the consolidation of monetary stability through the inflation targeting framework.

III. Fiscal Sector

10. During the last year, the fiscal position was somewhat affected by unforeseen developments, including lower than projected grants and unanticipated judicial liabilities. In this context, the Peruvian authorities, in consultation with the Fund, have revised slightly the fiscal deficit target to 2.3 percent of GDP for 2002.

11. The authorities have succeeded in bringing revenues back on track through tax measures and administrative enhancements. General Government current revenues are estimated to remain at 17.2 percent of GDP and would increase to 17.6 percent in 2003. In the second half of 2002, several policies can explain the recovery in tax collections, mainly: (i) the introduction of new VAT withholding systems; (ii) the increase in excise taxes on fuels; and (iii) the tax audit program of corporations and independent professionals, which is ahead of schedule.

12. In addition, a set of new measures geared to reinforce collections in 2003 is being approved by Congress, among them the increase in the highest personal income tax rate from 27 percent to 30 percent; the introduction of a new collection system for the corporate income tax based on the value of companies’ assets; and the extension for one year of the special 2 percent payroll tax.

13. The recently approved budget law for 2003 considers a rate of growth of one percent in real terms for non-financial expenditures, consistent with a public sector deficit of 1.9 percent of GDP. Tax expenditures have been explicitly incorporated in the 2003 budget to underscore their fiscal cost. Also, the new Law on Fiscal Responsibility and Transparency introduces a more realistic period of three years for convergence to the limit, as well as fiscal rules for and control mechanisms on the new sub-national governments.

14. In addition, the authorities will begin to phase out certain regional and sectoral tax exemptions. Full implementation of this process, which is expected to occur by end-2004, will involve reaching agreements with the incoming regional administrations on exchanging the elimination of these exemptions for investment in infrastructure in the regions concerned, as well as approval by Congress.

15. Building on the successful reentrance into the international private capital market in February, confidence in fiscal sustainability, and isolation from regional disturbances, on November 25 the government of Peru placed S500 million of 5-year sovereign bonds with a coupon of 9.125 percent, at a spread of 612 basis points over comparable U.S. Treasuries. Peru thus turned into one of the few Latin American economies that have been able to tap international capital markets. The placement had a demand three times higher than the amount offered, and the yield was lower than that obtained by countries with higher ratings. Peru’s external public debt—which has an average maturity of 8 years—comes mainly from concessional sources, and sustainability analyses—including the one presented by staff—shows the significant soundness of Peru’s debt position.

IV. Progress in Structural Reform

16. At the beginning of 2002, a constitutional amendment launched the decentralization process—one of the central points in the authorities’ agenda—aiming at deepening the democratization process and promoting economic growth. Our authorities have taken great care in designing a legal and institutional framework intended to effectively facilitate an orderly transfer of government functions to the regions—notably the provision of government services—while preserving fiscal discipline. The process will count with technical and financial assistance from the World Bank and the IDB.

17. The principles that would guide the process—which enjoy political consensus—were approved by Congress in July: (i) responsibilities at the three levels of government—national, regional and municipal—should be clearly defined to ensure accountability; (ii) the process should be gradual, and its impact on the consolidated public finances should be neutral; (iii) any external borrowing carried out by the new regional administrations require approval from the Ministry of Economy and Finance (MEF) and should be consistent with the overall public sector’s indebtedness limit; and (iv) fiscal rules should be established at the sub-national level to guarantee the financial sustainability of the decentralization process.

18. The law also establishes that the formulation, approval, and control of the annual budget at the three levels will be governed by the norms established by the MEF. Accordingly, sub-national governments will require to submit to the central government information on the implementation of their budgets. Additionally, according to the Regional Governments Law, approved in November, sub-national governments will be subject to the fiscal sustainability mechanisms established in the Law on Fiscal Responsibility and Transparency.

19. Despite domestic developments that affected the process of transferring the operations of the electric generation companies EGASA and EGESUR to the private sector, the authorities remain committed to encouraging greater private sector participation in the economy, In order to strengthen domestic support and preserve foreign investors’ interest, the Private Investment Promotion Program (PIPP) is being refined, with an increased emphasis on concession contracts and strategic partnerships. In light of this revised outlook, the government is requesting a modification to the adjustor on the end-December 2002 performance criterion on the net international reserves of the Central Bank for shortfalls in PIPP receipts. In 2003, proceeds from the PIPP are expected to yield $400 million.

20. Measures have been put in place during 2002 to reform the public pension system: (i) differences between survivor benefits under the National Pension System’s two main retirement plans were reduced; (ii) in the public pension plan encompassing most employees, the minimum pension—which was well below the standard consumption basket—was raised; (iii) a minimum pension was ensured for a group of workers older that 55 years who moved into the private system and did not have enough time to accumulate an adequate pension; and (iv) the calculation method for both the replacement rate and the pension base were modified to improve the actuarial equilibrium of the National Pension System. In the near future, the authorities will set out to further equalize the National Pension System’s main plans, as well as to reduce the operating costs and expand the investment options of private pension funds.

21. The authorities will continue to carry out social programs with multilateral support. Also, they have expressed their decision to move forward in the integration and liberalization processes, and a complete action plan aimed at fostering competitiveness is being developed in cooperation with the World Bank and the Inter-American Development Bank. Furthermore, with the aim of building consensus on key governance issues, such as the rule of law, social equity, competitiveness, and efficiency in public management, the authorities promoted a National Agreement, which was signed in March with political parties and civil organizations.

22. In sum, Peru remains in a solid position to sustain high economic growth, and the policy framework has enough flexibility to resist and adequately respond to negative shocks. A fruitful combination of consistent policy implementation, active domestic debate, and international cooperation has been effective in confronting perceived risks.