Jan. 13, 2015

Julio Velarde


Julio Velarde

Governor, the Central Bank of Peru

"Inflation has been high, which is the main reason behind our reluctance to cut rates."


Julio Velarde studied economics at the Universidad del Pacífico in 1974, and went on to complete an MA and a PhD in the same subject at Brown University. He served as dean of the economics faculty at the Universidad del Pacífico from 1986 to 2003, and as director of the Central Bank of Peru from 1990 to 1992 and from 2001 to 2003. Other senior positions have included the executive presidency of the Fondo Latinoamericano de Reservas from 2004 to 2006, as well as the directorships of various companies. He received the Latin American Governor of the Year award in 2010 from Emerging Markets Euromoney Institutional Investor, and a Bravo award from Latin Trade.

Peru is one of South America's top economic performers, but before this decade, it had experienced monitory woes. However, during your tenure the sol has seen stability and growth against the dollar. What role have the Central Bank's policies had in this transformation?

We have a highly turbulent monetary history. Back in the 1980s macro policies, both monetary and fiscal, were very poor in Peru. Since 2001, when we adopted an inflation target regime to conduct monetary policy, we became the first country to adopt this regime with negative inflation rates. The credibility in the new regime allowed the Central Bank to adopt a more expansionary monetary policy, without affecting inflationary expectations. The second country to apply inflation targeting under negative inflation was Japan, in 2014. Since introducing inflation targeting, core inflation in Peru has been at 2%, and headline inflation at 2.6%, on average. That is the lowest in Latin America, which is consistent with the fact that we have the lowest inflation target in the region.

How is the Bank acting to stimulate growth in the context of lower mineral prices, and what has led you to keep the rate constant over the past two months?

Inflation has been high, which is the main reason behind our reluctance to cut rates. Instead, we reduced reserve requirements to enable financial institutions to increase their lending at a faster pace. The Central Bank has adopted an expansionary policy stance since May 2013 when it started cutting reserve requirements. Since that time, we have also cut the policy rate three times up to 3.5%, which implies a real interest rate of less than 1%.

“Inflation has been high, which is the main reason behind our reluctance to cut rates."

For many emerging economies the rise in the dollar, coupled with a fall in commodities, may come as a shock. How do you plan to insulate Peru from that trend?

After 2008, the emerging markets recovered quickly, because China was growing rapidly, particularly in 2009, which pushed commodity prices up. In addition, the Fed extended sub-lines to certain important emerging market economies like Brazil, Mexico, Korea, and Singapore. This allowed them to limit exchange rate pressures, whereby credit resumed flowing to emerging markets. Those conditions are not going to exist this time around, as commodity prices are falling, and the US is set to tighten its monetary policy. Expansionary policies will remain in place in Japan and Europe, which will partially compensate for the impact of the Fed's tightening in emerging market economies. Last year Peru was the only country in the region with a fiscal surplus. Peru saved during good times and now we can use those savings to pursue a more aggressive counter-cyclical fiscal policy. We have a large level of international reserves, so if there is pressure on the currency, we can use a good chunk of those reserves to limit the risks of an abrupt depreciation of the sol, which gives us some leeway. The third important factor is that many important projects, particularly in the mining sector, will enter production in 2015/17, which will nearly double copper production over the next three years.

Do you have any thoughts about Peruvian debt markets and on the effects of quantitative easing?

We are the emerging economy with the largest participation of non-residents in the domestic-currency government bond market. This participation reached 58% in the past, and nowadays is less than 40%. Besides this reduction, the yields of government bonds have not increased, reflecting the high demand for these bonds of domestic agents. Private Peruvian pension funds that had increased its investments abroad are moving it back to Peru. In the case of corporate bonds, the issuance in emerging markets have increased substantially recently, particularly in the last three years. Last year for example, we accounted for almost a fifth of total bonds issued in South America, Brazil and Chile each one for 31%, and Colombia for the 14% of the total issuance during 2013. Those bonds have typically been issued in dollars at historically low interest rates. They are bullet bonds, typically issued with a maturity of between seven and 10 years, therefore the rollover risk is relatively low. As part of policy to smooth the credit cycle in Peru, during the period of QE, we increased the reserve requirement in dollars, in the case of deposits up to 50%. This policy increases dollar lending rates, particularly for SMEs and households, as corporates have access to international capital markets, and such reserve requirements impact them less.

Over 2014 the Peruvian government focused on infrastructure. What can be done to help infrastructural investment or aid this momentum?

Our policy rate is currently higher than Mexico's for example, but our long-term interest rates are lower. This is largely because investors forecast inflation remaining lower in Peru than in Mexico. Consequently, Peru has the lowest yields of government bonds in the Americas for long-term domestic currency bonds. The main reason is that investors forecast lower inflation in Peru. Having such competitive rates is one way of helping to finance infrastructure.

You mentioned cutting the reserve requirements this year. Is that cut responding to current global pressures and inflation, or will it become part of longer-term policy?

In April 2013, more than 20% of deposits in domestic currency were at the Central Bank as reserve requirements, while today the corresponding reserve requirement is down to 9%. As lower reserve requirements increase the amount of loanable funds for banks, the sequence of cuts implemented by the Central Bank is helping the banks to expand loans in domestic currency. In addition, lower reserve requirements contribute to reducing the cost of credit. As a trend, credit to GDP has continued growing in Peru and, in consequence, there has been a dramatic rise in financing access for consumers and small businesses. According to the Economist, Peru has the most developed micro finance system in the world. And if growth accelerates, we may have to adopt a more restrictive monetary policy in order to guarantee low inflation.

There should be improved mineral production in 2015, and even though prices are not likely to rise, export volumes will. Coupled with infrastructure investments and a stronger growth rate, what else can you say about conditions for 2015?

In terms of infrastructure projects, there exists a large pipeline, such as the second line of the Lima subway, and our biggest gas pipeline yet scheduled for 2015. Additionally, because of political unrest in local and regional government, public investment in the first three quarters has not grown at all. Yet we expect public investment to grow by close to 7% in 2015. In short, all of these factors will help to regain the economic momentum. As far as monetary policy is concerned, in principle, we still have an expansionary bias. However, we are monitoring the economy closely, and if circumstances permit we might change that bias, to avoid inflationary pressures, in case the economic rebound exceeds our expectations.

© The Business Year - January 2015