monetary and exchange rate policy in peru

Monetary and exchange rate policy

in Peru

Adrián Armas (BCR)

“XXI Meeting of the Latin American Network of Central Banks and Finance Ministries“

May, 2005

2

Motivation

Which are the optimal monetary and exchange rate regimes in a dollarised economy?

How can dollarisation risks, in terms of both the central bank’s reaction function and regulatory issues, be dealt with?

How can confidence in the domestic currency be restored?

The Peruvian experience: inflation targeting in a partially dollarised economy (IT + dollarisation risks control)

3

Agenda

Financial dollarisation and its effects on monetary policy design

Financial dollarisation and its effects on monetary policy implementation

The BCR’s strategy for controlling financial dollarisation risks

4

Financial dollarisation and MP design

Monetary policy framework in Peru

Inflation targeting +Financial dollarisation

risks control

Financial dollarisation considerations

5

Financial dollarisation and MP design

a. The inflation target

Inflation targets in some IT countries

Country Inflation target Target's horizon

Australia 2% to 3% (since 1993) Medium termBrazil 5,1% (for 2005) 1 year

Canada 1% to 3% (since 1998) Medium termChile 2% to 4% (since 2001) Medium term

Colombia 4,5% to 5,5% (for 2005) 1 yearCzech Republic 2% to 4% (since 2005) Medium term

Mexico 2% to 4% (since 2004) Medium termNorway 1,5% to 3,5% (2001) Medium term

Peru 1,5% to 3,5% (since 2002) Medium termPhilippines 4% to 5% (for 2004-2005) 2 years

Poland 1,5% to 3,5% (since 2004) Medium termSweden 1% to 3% (1995) Medium termEngland 2% Medium term

6

Financial dollarisation and MP design

b. The operational target

Interbank interest rate(in percentage points)

Year Average Standard deviation

1998 18,7 6,451999 15,0 4,722000 12,6 2,672001 9,0 0,912002 3,2 0,482003 3,4 0,092004 2,7 0,07

Interbank interest rate volatility has reduced

7

Peru: Interbank interest rate in domestic currency

Apr.04-Apr.05

Interest rates in domestic currency(April 2004 - April 2005)

1%

2%

3%

4%

5%

6%

Overnight in S/.

Interbank

Rediscount in S/.

3,25

1,75

Max

Min

3,5

2,0

3,75

2,25

OctJul AugJun SepApr2004

Nov Apr20

May Jan2005

MarDec Feb

8

Agenda

Financial dollarisation and its effects on monetary policy design

Financial dollarisation and its effects on monetary policy implementation

The BCR’s strategy for controlling financial dollarisation risks

9

Financial dollarisation and MP implementation

Monetary policy framework in Peru

Financial dollarisation considerations:

Phillips curve: relative low pass-through

Inflation targetingAggregate demand:

- foreign currency interest rate

- balance sheet effect

Exchange rate: - UIP- exchange rate inertial term

+

Financial dollarisation risks control

10

Financial dollarisation and MP implementation

The inflation forecasting system

Combines judgement and model-based projections

Main inflation forecasting model: QPM. Semi-structural, calibrated model. Captures main monetary policy transmission mechanisms

Assumes that financial markets are not under stress

11

Agenda

Financial dollarisation and its effects on monetary policy design

Financial dollarisation and its effects on monetary policy implementation

The BCR’s strategy for controlling financial dollarisation risks

12

Peru: Dollarisation Ratio

0

20

40

60

80

79 85 90 95 2000 2005

2000: 70%

2005: 54%

13

Financial dollarisation risks control

Financial dollarisation is decreasing, but still remains high

With high financial dollarisation, the economy is vulnerable to large domestic currency depreciations

The BCR implements policies to mitigate the risks posed by financial dollarisation

IT plus financial dollarisation risks control

14

Financial dollarisation risks control

Monetary policy framework in Peru

Inflation targeting

+- IT- Short term interest rate as operational target- Yield curve in domestic currency

Financial dollarisation risks control

Dedollarisation policies

15

Financial dollarisation risks control

0

5

10

15

20

25

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Inflation target Inflation expectation two years in advance

Source: Consensus forecast

Inflation target and inflation expectations: 1995-2005

Dedollarisation policies: building credibility in the target

16

Financial dollarisation risks control

Dedollarisation policies: long term financial instruments in soles

4,6%

6,6%

5,7%5,5%

3,9%

5,9% 6,0%

4,7%

6,4%

3,6%4,1%

3,1%2,7%

2,5%

8,3%

9,6%9,6%

5,1%

7,3%

6,7%

4,5%

3,9%3,0%

2,0%

6,0%

10,0%

Interbank 6 months 1 year 1,5 years 2 years 3 years 4 years 5 years 6 years 7 years

Yield (%)

April 2003 December 2003 December 2004

Interest rates for domestic currency Treasury bonds

|

17

Financial dollarisation risks control

Monetary policy framework in Peru

Financial dollarisation considerations:

Phillips curve: relative low pass-through

Inflation targetingAggregate demand:

- foreign currency interest rate

- balance sheet effect

Exchange rate: - UIP- exchange rate inertial term

+- IT- Short term interest rate as operational target- Yield curve in domestic currency

Financial dollarisation risks control

- Availability of foreign currency liquid funds:

- High NIR level- Moderation of excessive fx volatility

- High reserve requirements for foreign currency liabilities

Dedollarisation policies

Internalisation of risks and policy responses to negative shocks

18

Financial dollarisation risks control

Net International Reserves

9.28.4 8.2 8.6

9.610.2

12.613.6

0

2

4

6

8

10

12

14

1998 1999 2000 2001 2002 2003 2004 2005 April

(bill

ion

of

US

do

llars

)

Exchange intervention to reduce exchange rate variability has let a process of NIR accumulation.

19

Financial dollarisation risks control

Central Bank Certificates of Deposit (CDBCRP)

0.41.4

1.8 1.6

4.1

8.3

10.0

0

2

4

6

8

10

12

1999 2000 2001 2002 2003 2004 2005 April

(bill

ion

of

sole

s)

NIR accumulation has implied an increase of the CDBCRP’s stock.

20

Peru: Nominal Exchange Rate Jan.99-Apr.05

3.2003.2503.3003.3503.4003.4503.5003.5503.6003.650

21

Financial dollarisation risks control

Interest rate variability

Period Interbank overnight interest rate

Average mean (%)Average standard

deviation (pp)

1999-2001 12,3 2,82002-2004 3,1 0,2

The average standard deviation is an average for monthly standard deviations in each of the two periods considered in the table.

Exchange rate variability

Period Exchange rate

Average mean (S/.)

Average standard deviation (S/. cents)

1999-2001 3,460 1,32002-2004 3,470 1,2

The average standard deviation is an average for monthly standard deviations in each of the two periods considered in the table.

While interest rate variability has been reduced in recent years (2002-2004), exchange rate variability maintains a similar level.

22

Peru: Interbank Interest Rate Jan.02-Apr.05

5.4

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Jan.

200

2Feb

.M

ar.

Apr.M

ay.

Jun. Ju

l.Aug

.Sep

.Oct

.Nov

.

Dec. 2

002

Jan.

200

3Feb

.M

ar.

Apr.M

ay.

Jun. Ju

l.Aug

.Sep

.Oct

.Nov

.

Dec. 2

003

Jan.

200

4Feb

.M

ar.

Apr.M

ay.

Jun. Ju

l.Aug

.Sep

.Oct

.Nov

.

Dec. 2

004

Jan.

200

5Feb

.M

ar.

Abr.

Interbank Standing facilities benchmark Overnight deposits

Interbank, benchmark (ceiling), and overnight deposits (floor) interest rates 1/

(in percentage points)

Escape Clause

23

Concluding remarks

Peru is a financially dollarised ITer

IT + financial dollarisation risks control:Inflation targetInterbank interest rate as operational targetFinancial dollarisation considerations in the QPMDollarisation risks control

Financial dollarisation does not preclude independent monetary policy oriented at maintaining low and stable inflation

24

Concluding remarks

Inflation target fulfilment: 2002 to 2004

Consumer price index(yoy% change)

-1,5

-0,5

0,5

1,5

2,5

3,5

4,5

Jan. 2002

Apr.Jul.

Oct.Jan. 2003

Apr.Jul.

Oct.Jan. 2004

Apr.Jul.

Oct.Jan. 2005

%

Inflationary supply shocks (food and oil)

Gradual financial dedollarisation process