Taming Capital Flows

Capital Account Management in an Era of Globalization

J. Stiglitz, R. Gurkaynak, J. Stiglitz, R. Gurkaynak

• Publisher: Palgrave Pivot
• Year: 2015
• ISBN:
  9781137427687
• Topic: Volkswirtschaftslehre
• Subtopic: Entwicklungsökonomie

This volume contains country experiences explained by policy makers and studies by leading experts on causes and consequences of capital flows as well as policies to control these flows. It addresses portfolio flow issues central to open economies, especially emerging markets.

Part 1

Country Experiences

1.1

Peru’s Recent Experience in Managing Capital Flows

Paul Castillo B.

Abstract: This paper highlights the role played by the buildup of international liquidity buffers and the introduction of preventive measures aimed at reducing financial vulnerabilities during capital surges as key elements of Peru’s recent experience in managing capital flows. It shows how the emphasis of monetary policy on minimizing risks associated with financial dollarization and the improvement in fiscal policy has further contributed to the effectiveness of the policy response against capital reversal episodes, such as in the wake of the collapse of Lehman Brothers.

Keywords: capital flows; monetary policy; Peru

Stiglitz, Joseph E. and Refet S. Gürkaynak (eds). Taming Capital Flows: Capital Account Management in an Era of Globalization. Basingstoke: Palgrave Macmillan, 2015. DOI: 10.1057/9781137427687.0006.

1Introduction

Capital flows are an important source of funding for investment in Peru. In the last two decades, they have accounted for 6 percent of GDP on average, mostly foreign direct investment (FDI) and long-term loans. However, they also have created important challenges to macroeconomic management, particularly in periods when portfolio and short-term capital flows have become more important, such us during the Asian and Russian crises and, more recently, during the global financial crisis.

In 1998, the Russian crisis triggered a 50 percent decline in short-term external credit lines in only 12 months, coupled with a real currency depreciation of 13 percent, in a context of high financial dollarization (79 percent of credit was denominated in foreign currency). The end result was a deep contraction in banking credit that doubled the ratio of non-performing loans in foreign currency and halved the number of banks operating in the economy. The outcome was different during the most recent financial crisis, when the Peruvian economy showed more resilience to a similar type of shock. The economy not only recovered faster after the sudden stop of capital flows that the economy experienced in 2009, but also the financial system was almost unaffected, banking credit continued to grow, lending interest rates fell, and non-performing loan ratios remained at historical minimums. The considerable reduction in the vulnerabilities affecting the Peruvian economy and the policy framework that the authorities put in place after the Russian and Asian crises shaped these outcomes.

A key feature of Peru’s strategy to manage capital flows in the last decade has been the application of a coherent macroeconomic framework that emphasizes the buildup of international liquidity buffers and the introduction of preventive measures aimed at reducing financial vulnerabilities during capital surges. On the monetary side, in 2002, the Central Reserve Bank of Peru (BCRP) adopted an inflation targeting (IT) regime with a target of 2.5 percent ± 1 percent. In contrast with other IT economies, Peru’s IT regime also takes into account the risks associated with financial dollarization by using, in addition to the short-term interest rate, other less conventional instruments, such us high reserve requirements for bank liabilities in foreign currency and exchange rate intervention amid decreasing exchange rate volatility to prevent negative balance sheet effects. On the fiscal side, there has been an improvement in the fiscal position, which has contributed to a significant decline in public debt, from 46 percent in 2001 to 20 percent in 2012, and has fostered a deepening of the market for government bonds in domestic currency. These in turn have reduced the government’s exposure to exchange rate movements and enhanced its ability to enlarge the average maturity of the debt stock.

This policy framework has contributed to maintaining low inflation levels during this period – 2.5 percent on average in 2001–2010 – and average growth rates close to 6.5 percent. It has also fostered financial resilience against sudden stops of capital flows, as was evident after the recent global financial crisis.

An important lesson from Peru’s experience is that a credible monetary policy and a strong fiscal position, together with prudential policies aiming at reducing financial vulnerabilities, such us building a high stock of international reserves and introducing high reserve requirements in foreign currency, can significantly increase the resilience of an economy during episodes of capital surges, even in dollarized economies such as Peru’s.

The rest of the chapter is organized as follows: the second section describes the taxonomy of capital flows in Peru, the third analyzes the policy strategy put in place by the Peruvian authorities and their policy responses before and after episodes of capital surges, and the final section presents some concluding remarks.

2Taxonomy of capital flows to Peru

Peru regained access to international capital markets in the mid-1990s, after the government signed a Brady plan in 1997, and the economy’s macroeconomic fundamentals showed a significant improvement. Previously, capital flows to Peru were mainly FDI, linked to the privatization of state-owned companies, and official funds associated with the IMF programs that were in place during those years.

After a period of considerable macroeconomic instability during the 1980s, which ended in a hyperinflation process, the government successfully implemented a stabilization program that brought inflation rates down from an average of 7,300 percent in 1990 to less than 7 percent in 1997. During this period, the government also put in place an aggressive program of structural reforms that included the liberalization of both the current and capital accounts and the privatization of state-owned companies across a wide range of economic sectors, which contributed to increasing the productivity and competiveness of the real sector of the economy.

FDI has remained Peru’s main source of capital inflows, mostly associated with large investment projects in the tradable sector linked to the production of minerals, oil, and gas. Between 1993 and 2011, capital flows to Peru represented 6 percent of GDP on average, and 92 percent of these flows were FDI and long-term loans.

Short-term capital flows account for only 0.1 percent of total capital flows on average, whereas capital flows to the public sector account for 0.4 percent on average. Nevertheless, there have been departures from those averages are observed, particularly during Peru’s two episodes of surges in capital flows: first in 1996–1997, just before the Asian and Russian crises, and more recently before the global financial crisis.

During the first episode (1996–1997), Peruvian banks increased their short-term external liabilities from less than 0.5 percent of GDP in 1996 to 4.5 percent of GDP at end-1997, in a context of low international interest rates and improving access to international financial markets. As result, bank credit expanded rapidly (particularly dollar-denominated loans), fuelling an accelerated increase in aggregate demand and widening the current account deficit to 7.3 percent of GDP at end-1997, thereby increasing the vulnerability of the financial system and the economy to sudden stops of capital flows.

The second episode of surge in capital flows occurred just before the global financial crisis, during the first quarter of 2008. During the latter, capital flows increased to 23 percent of GDP, more than twice the level of capital flows in the fourth quarter of 2007; portfolio flows accounted for 9.3 percent of GDP, more the four times the end-...

Table of contents

• Cover
• Title
• Introduction
• Part 1  Country Experiences
• Part 2  Recent Trends in Currency Flows
• Part 3  Effects and Multilateral Aspects of Currency Flows
• Index