peru - policies to stop hyperinflation - vol 2

8/18/2019 Peru - Policies to Stop Hyperinflation - Vol 2

1/149

Report o.7460-PE

Peru

Policieso StopHyperinflation

and

nitiateEconomic ecovery

(InTwo Volumes) Volume l:AnnexesandStatisticalAppendix

December5,1988

CountryDepartmentV

LatinAmerica nd he Caribbean egional ffice

USE ONLY

U.,~~~~~~~~

Document f heWorldBank

hasa restricted istribution ndmaybeused y recipients

n the performancef theirofficial uties.tscontentsmaynot otherwise

disclosed ithoutWorldBank uthorization.


2/149

CURRENCY

EQUIVALENTS

Currency

Unit

= Inti

(I/.)

Official

Exchange

Rate

(Effective

ecember

1,

1988)

I/.

1.00

=

US$0.002

US$

1.00

=

I/.

500

FISCAL

YEAR

January 1 to December 31


3/149

FOR OFFICIAL

USEONLY

PREFACE

This report was prepared and drafted prior to the announcement f

two packages of economic

measures by the Peruvian Government,

first in

September

1988 and then in November 1988. A description

f these measures

as well as an update on the current state of the economy is contained in

the Addendum provided in the last section of Volume I.

This report is based on findings and analysis of Bank

economic

missions which visited Lima in October 1987, November/December 987, and

March/April 1988. Support for the Bank work with the Government was

provided by the United Nations DevelopmentProgramme (UNDP). Participation

in the missions, which varied in size and composition, as as follows:

William Tyler (Mission hief); Ricardo Lago (Deputy h.tCsion hief ani

principal

author); Ulrich Lachler

(trade and exchange rate policies);

Daniel Oks (consultant, acroeconomics); eno Malatinszky (public

enterprises); icardo Martin (projections); ernando Rezende (consultant,

taxation); Javier Escobal

(consultant, griculture); ruce Herrick

(consultant, abor

markets); Cesar Burga (projections, tatistical nnex,

and research assistance). Pedro Mercader (UNDP Lima Representative)

accompanied he work of the missions in Lima and provided valuable guidance

and overall support. Valuable comments on an earlier draft were provided

by Rudiger Dornbusch. Michel del Buono provided

a short note on the

state

of the energy sector. Brian Wesol provided research assistance in one of

the missions. Dorothy

Jenkins provided secretarial

ork throughout the

cycle

of the report. Milagros Aquino-Divino rovided secretarial

assistance in the final stage of

the report.

This report was discussed in great detail with the Government's

economic team in Lima during October/November

988 by Messrs. Tyler

and

Lago.

While there was general

agreement etween the Bank

and the

Government's

economic team

as to the diagnosisand analysis of the

situation,the Government's conomic team stressed political and social

constraints

o taking strong

policy action to forestall yperinflation nd

indicated the need for

a more gradual policy

approach.

This

document has a restricteddistribution

and may be used by recipients

only in the performance

of their officialduties. Its contents may not otherwise be disclosedwithout WorldBank authorization.


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PERU- POLICIES TO

STOP HYPERINFLATION

ND

INITIATE ECONOMIC

ECOVERY

TABLEOF CONTENTS

VOLUME

:

THEMAIN

REPORT

Page

No.

COUNTRY ATA

EXECUTIVE UMMARY i

RESUMEN

JECUTIVO

xvi

CHAPTER I. THE EVOLUTION

OF THE PERUVIAN CONOMY

.............

1

A. Background

............,

1

B. Recent History ................................

1

C.

The Diagnosis of

the Economy in 1985

and

Strategy

of the Incoming PRA Government .....

3

D. The Implementation

f the Policies,

July

1985 to December 1986

.................. 4

E. The Results in 1986: Reactivation

nd

Disinflation

................................

9

F.

Economic Policy

in 1987 ....................... 12

G. Economic Perfor.mance

n 1987: Stagnatio

i of

Production and

Intensification f

Inflationary

ressures ...................... 19

H. Economic Policy during January-August

988 ....

21

CHAPTER

II. THE ECONOMIC PROSPECTS

IN THE ABSENCE OF

MAJOR

POLICY

EFORMS . ....... .. ...........

23

A. The Diagnosis

of the Current

Crisis ...........

23

B.

The Likely Evolution of

the Economy

without

Major Corrective

easures ........... 28

CHAPTER

III. THE MAIN

ECONOMIC ISSUES

AND POLICY RECOMMENDATIONS

38

A.

Public Finance

..... ......

.............9

1.

The Tax System:

Evolution, Structure,

and Recommendations

.....................

41

2. Prices

and Tariffsof State Enterprises:

Evolutions, tructure, nd

Recommendations

.........................

47

3. Public Investment:

ecent Trends and

Recommendations

.........................

54

4. The

Central Bank's

Quasi-Fiscal eficit:

Definition, easurement, nd

Recommendations

.........................

56

B. Externial ector Policies

..

60

1. Exchange

Rate Policy:Evolution,

Structure,

and Recommendations..........

60

2. Import Restrictions:

tructure,

Assessment, and

Recommendations.........

68

3. Export Incentives: tructure,

Assessment,

and Recommendations.........

76


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-

ii

-

C. Other Resource Allocation Issues . .............0

1. Financial

olicy: Main

Issues and

Recommendations .

.

80

2. Price Controls: Structure nd

Recommendations.........................

85

3. Agricultural Pricing

and Subsidies:

?olicies, ssessment, nd

Recommendations......................... 87

4. Labor Market Issues and Recommendations ...

92

5. The State Enterprise

Sector ...............

96

CHAPTER IV. ECONOMIC POLICY TO STABILIZE NFLATION ND

SET THE CONDITIONS FOR MEDIUM-RUN

GROWTH .......... 99

A. The Preconditions or Stabilization............ 99

B. Resumption of Growth and the Foreign Debt

Problem .....................................

100

C. Overall Macroeconomic trategy ................ 103

D. Illustrative volution of the Economy under

Stabilization nd Structural djustment ..... 112

ADDENDUM

- AN UPDATE

ON

RECENT DEVELOPMENTS

..

.. . 120

VOLUME

II:

ANNEXES

AND STATISTICAL PPENDIX

A;NNEXES* ....

...........................................................

1

Annex 1.

Inflation nd Inflationary inance

...... 1

Annex 2. The Inflation Tax: Theoretical

Derivation and Calculation for

1980-87. .. . 4

Annex 3. The Central Bank's Quasi-Fiscal efieit..

17

Annex 4. Main Characteristics f the Peruvian

Tax System

.... .................

28

Annex 5. Misalignment

of Prices and Tariffs of

State Enterprises:

A Preliminary

Calculation

...........................

38

Annex 6. The Working of the "Mesa de

Negociacion"

f Foreign

Exchange

Certificates.......................... 41

Annex 7. The Financial System: Institutional

Characteristics.......................

42

Annex 8. Population,

ncome Distribution, nd

Labor

Market Segmentation.............

47

Annex 9. The State Enterprise Sector ............. 58

Annex 10. The Interaction

f Fiscal and

Monetary

Policy ................................

79

Annex 11 Reserve Requirements

nd their

Remuneration

..........................

92

Annex

12 Brief Background n the Agricultural

Sector ................................ 93


6/149

- iii -

STATISTICAL APPENDIX

......

...............................

...... 95

I.

POPULATION

AND EMPLOYMENT

... ...... ......................

, 5

1.1 Total Population

istribution

. . 95

1.2

Demographic

Indicators

.

.

96

1.3 Enploymentand Labor Productivity ........... 97

1.4 Un- and

Under-Employment

...................

98

II. NATIONAL ACCOUNTS

......................

.

.

99

2.1 GDP by Sectoral

Origin (Constant ntis)

..... 99

2.1(A)

Real GDP Average

Growth Rates (Percentages)..

100

2.2 Nominal GDP by

Sectoral Origin

(Current ntis) ...........................

101

2.2(A) GDP:

Percentage Distribution

................ 102

2.2(B) GDP

Deflators

.................

103

2.2(C) GDP Deflators:

Yearly

Percentage Changes .... 104

2.3 GDP

by Expenditures

Constant ntis)

........ 105

2.4 GDP by Expenditures(Current ntis) ......... 106

2.5 Domestic

Irncome.............................

107

2.5(A) (PerceLatageistribution) .............

108

2.6 Gross Capital Formation

y

Goods and Origin-..

109

2.7 Real GDP Per Capita .........................

110

2.8 Per

Capita GDP by

Departments . .11....... i

III.

BALANCEOF PAYMENTS

.............................

.... 112

3.1 Summary

Balance of

Payments .

......... 112

3.1(A) (As

a Percent of GDP)

.............

113

3.2 Merchandise

Exports

by Commodities

(Current

Dollars) .................................. 114

3.3 Merchandise

xports by Commodities

(Constant

Dollars) 115

3.4 Merchandise

i.tportsCurrent

ollars)

116

3.5

Merchandise Imports

(Constant ollars)

117

3.6 Export,

Import ar.A erms of

Trade Indexes... 118

IV. EXTERNALDEBT .................

-..**e...

.......... 119

4.1

Total External

Debt Outstanding

and

Disbursed

................................

119

4.2 ServicePayments, isbursements

nd

Outstanding

mounts of External Public.

Debt ..................................... 120

V. PUBLIC FINANCE

.........................

121

5.1 Non-Financial

ublic Sector

Operations ...... 121

5.1(A) (As a Percent

of GDP) .......................

122

5.2 Central Government

Operations ............... 123

5.2(Al (As a percent of GDP) .......................

124

5.3 Non-Financial ublic

Enterprise Operations

.. 125

5.3(A)

Non-Financial ublic Enterprise perations

.. 126

5.3(B) Non-Financial ublic

Enterprise perations

by Company ................................

127


7/149

- iv -

5.4 Current Revenue of the Central Government

by Source

.

.

128

5.4(A)

(As a Percent

of GDP)

.. 129

5.5

Current Expenditures f the Central

Government .......

130

5.5(A) (As a Percent of GDP) .............. 131

5.6 Fiscal Cost of Exemptions on

Import

Tariffs by Sectors . . 132

VI. MONETARY STATISTICS

................................

.....

133

6.1 Summary Accounts of the Consolidated

Financial ystem ..............,......

133

6.2

Summary Accounts

of the Consolidated anking..

System ...................................

134

6.3

Summary Accounts

of the Central Reserve Bank..

135

VII. PRODUCTION STATISTICS

........ ..........

136

7.1 Agricultural

Production ...................... 136

7.2 Volume Index of

Manufacturing roduction

.....

137

'VIII.RICES AND EXCHANGE RATE .................................... 138

8.1 Consumer Price Indexes for Metropolitan ima.. 138

8.2

Exchange Rates ............................... 139

8.3 Real Exchange Rate Index ..................... 140

COUNTRYMAP


8/149


9/149

ANNEX 1

INFLATION AND INFLATIONARY INANCE

1. The purpose

of this annex is to

study the relationship

etween the

inflation

rate and the

real resources

rom inflationary inance

(seigniorage). In particular, he focus

is placed on identifying

he shape

of the trade-off

etween the inflation

ate (as a tax rate) and the amount

of real resources hat can be transferred o the government from a given

demand for

money (as a tax base).

This trade-off an

be termed as a Laffer

curve,

in analogy with the theory of taxation.

From analyzing this

trade-

off it

can be calculated he inflation rate that

maximizes revenues

from

inflationary

inance. It

is found that in the case

of Peruvian economy,

that inflation

rate is between 500

percent and 600 percent

per annum, and

the maximum revenue

from inflation

is just over 10 percent

of GDP.

2.

The demand for

money utilized here

is the simple Cagan

formulation:

M/p

= A exp (-anl)

(1)

Where M/p

= real broad money;

= inflation rate:

y = real GDP

Since in Peru

interest rates on Bank deposits are

very low compared

to

inflation and the share of deposits

in broad money is declining

rapidly, it

is assumed

for simplicity

hat the nominal return of all broad money

is

zero.

3. The government's

ea'l evenuefrom irnflation

R) is:

R

= (M/kp) 1 =

[A exp (-%l)Y

]/k (2)

Where k =

money supply multiplier.

To maximize inflationary evenues:

d

R/dfl = A [exp

(-&ll) -anl

exp (-al) ]/k

0

This can be

written as:

(A exp (-dl)y/k)

1-5U)

0

The maximum revenues re reached

at n (max)

I/a (3)

Also when n = o or f

= w ==) R (Min)

= 0

4. To infer the

value of the

parameter "a'.

the following

onvenient

expression of (1) can be used:

(M/p)/y = A exp

(-acl) or y/(M/p)= exp (fIa)/A

Since V = py/M =

income velocity of money; therefore:

V = exp (Ia)/A

(4)

Taking

logs and

then derivatives:

d log V ldH =

a

or (dV/V)/dll

a

(5)


10/149

5. The variables

of expression (5) can be proxied by the growth rate

of velocity and the increase in inflation rom the second semester of 1987

to the first semester of 1988. Thus:

d V/V

t Av/v =

1163/bO9

=

0.44

Since: M/P (at Dec. 1987)

=

1163; Real GDP (average uly-Dec. 1987)

=

121;

and M/p (at June 1988) = 809; Real GDP (average

Jan.-May 1988) = 121

In addition:AH

=

3.62 1.38 2.24

Since: n (July to Dec. 1987) = 138 (annual rate)

I

(Jan. to June 1988) = 362 (annual rate)

Therefore the estimate of "a" is: (AV/v) /An 0.44/2.24 0.196 and,

as a result, the inflation ate that maximizes inflationary inance is:

n

(max) I/a

=

1 / 0.196

=

5.1 or 510 percent per annum

Chart 1-1

I

' I- , i l,,_

hS.d. Pr.j

irfe.8 I e'1Ir'i;. ":'r.'@ )

P

.

-1

Lil

~ fl

t..:1~~~~~~~~~~~~~~~~~y

.0

;I l;

I' 'ij}

l

gill [f { kv [ 0

(' t f l t 2 at

r.

.i V-, 1 1. i 1,,>,-I I

X.

,-

X

l ,r IT."3 jr LI. ' r1 I tX 1 ; - V- '.27 O -), i

^

' r l eDi)coP 1: °C O

*1~~~~~~~inlt3 n-1LItltl[Fl9i

~I i1ol3n rsfi1

6. To find out the numerical expression of equation (2), it is also

necessary to calculate . This can be done using expression (4) and


11/149

-3-

substituting he values of V and

11

observe' in 1987 1/

V - 10.9 = (1/A) exp (0.196 1.15)

-=)

A = 0.11

Therefore, the expression for revenue

from inflation (equation (2)) is:21

R/y

=

0.065 x exp

(-0.19611) x

II (6)

This equation calculates the government's revenue from inflation as a

percentage of GDP. The Laffer curve implied by equation (6) is plotted in

Chart 1-1.

7. It can be seen in the figure that the maximum revenue from

inflation s about 12 percent of GDP and that this is reached at a steady

state inflation f between 5002 and 6002. For inflation rates beyond 600Y

percent the model becomes unstable and the revenue from inflation rops

exponentially owards zero. (Note that for each (revenue/GDP) oint in the

vertical axis there are two solutions (two inflation ates) in the

horizontal axis; one solution is at low inflation--along he efficient and

stable portion of the Laffer curve, and the other solution is at high

inflation--that s in the inefficient r unstable portion of the curve.

The second solution is, therefore, in the hyperinflationary ath).

1/ The value used for V, 10.9, is equal to nominal GDP (1987) divided broad

money supply (as of end of 1986); that is GDP/M_. Because this measure

of velocity is more suitable for inflationary evenue calculations than

the alternative DP/M. The inflation rate in 1987 was 115 percent.

2/ The money supply multiplier

in 1987/88 was k = 1.7.


12/149

-4-

ANNEX

2

THE INFLATION

TAXs THEORETICALDERIVATIONAND CALCULATION

FOR 1980-87

A. Introduction

1. The purpose

of this annex is

to propose a broad measure

of the

inflation

ax and a method

to estimate it for Peru in

the 3980-87 period.

2. The textbookconventional

easurement f

the inflation tax

is

restricted to

the inflation-erosion

f non-interest earing

public debt

(e.g.,currency). However, currency is not

the only public liability

hich

can

be amortized through

inflation. The

real value of other forms of

public debt, such

as bonds, fixed int0rest loans, or

interest bearing

reserve requirement

f the commercial

anks in the Central Bank, is also

eroded by increases in

the price level. Thus,

a broader measure

of the

inflation

ax ought to focus on the inflation-amortization

f the principal

of all public

debt instruments

(monetary nd financial) ot compensated

y

interest payments.

The difference

between monetary and

financial debt

instruments, hough, is that the latter

bear an interest hich

tends to

compensate

(partially r

totally) the debt-holderfor the amortization

f

debt in

real terms induced

by inflation. Accordingly,

the inflationtax

proposed here

refers only

to that portion

of the inflation-amortization

f

debt

which is not compensated

y interest

payments. To illustrate

this,

consider the case of currency.

Since currency

is a zero-interest

liability, there is no interestcompensation or the inflation-induced eal

amortization f it and, hence,

all that real amortization

s inflation

ax.

In the case

of financial ebt, since

it bears a nominal interest rate which

compensates (partially

t least) debt-holders

or inflation-induced

apital

losses, the

inflation tax will

be smaller than the total inflation-

amortization

f

debt.

3. Estimating

the inflation tax

according to this definition requires

knowledge

of the component

f nominal interest

rates which is

a

compensation(to debt-holders)

or inflation-induced

apital

losses. That

component

is, of

course, equal

to the nominal

interest rate minus the

"benchmark" eal interest rate.l/ To simplifythe calculation rocess,it

is first

assumed that the

full amount of nominal

interest rates is

compensation

for the inflation-erosion f

debt. This obviously

implies

that the benchmark real interest

rate is zero.

In a second

calculation,

though,

it is assumed

that the benchmark

real interest rate is

5 percent.

This,

in turn, implies

that the compensation

or inflation-amortization

f

debt is

approximately

qual to the percentage ominal

interest

rate minus 5

percent (see Footnote

1).

4. In principle,

in order to

estimate accuratelythe inflation tax,

all assets

and liabilities

f the consolidated

ublic sector,and their

corresponding

nterests nd returns,

ould be

required. However, in Cae

1/

More rigorously, ((l + i)/(l + R)] - 1, where

'i" is the nominal

rate of

interest and

"R" is the

real rate of interest.


13/149

- 5 -

calculation resented here, only a small number of interest rates of

financial ssets and liabilities re considered. This implies, on

occasion, imputing the same interest rates to different types of assets and

liabilities. However, the approximations re good enough to provide

reliable estimate of inflation ax proceeds.

5. Estimating

the broadly defined inflation ax requires assessing

the inflation tax base first. This task is best done by consolidating he

balance sheets of the non-financial

ublic sector and the financial

public

sector. The Consolidated Public Sector (CPS) balance sheets arrived at

provides the sought tax base for the inflation ax calculations erformed

below. It also provides the base for the inflation subsidy calculations,

the inflation subsidy being defined below as the inflation-erosion f net

financial ssets of CPS in hands

of the private sector which is not

compensated y interest payments.

6. The plan of this Annex is as follows. The first step taken to

calculate the inflation ax (IT) is to derive the CPS balance sheet; this

is done in Section B. The IT calculations re performed in

Section C.

Finally, comments on the evolution f the IT and its relationship ith the

macroeconomic nvironment re left to *Section .

B. The Consolidated Public Sector Balance Sheet

7. The balance sheets of the non-financial nd financial ublic

sectors are presented in the first sub-section. Then the CPS balance sheet

is analyzed. The last subsection shows a table with the different interest

rates imputed to different groups of assets and liabilities.

The Balance Sheets

8. The sectors (and subsectors) ere chosen considering the

presentation

f the monetary accounts of the financial ystem utilized by

the Central Reserve Bank and reported in "Nota Semanal". The sectors and

the notation employed are:

- The Non-Financial ublic Sector (NFPS), of which the Central

Government is part (the other main subsectors eing public sector

enterprises, rovincial governments nd decentralized gencies.)

- The System of Public Sector Banks (PB), (excluding

ommercial

banks and COFIDE)2/ hich is formed by the Central Reserve Bank

(CRB), the Banco Nacion (BN) and the Banca de Fomento

(BF).

2/ The Banca Asociada and the recently nationalized commercial anks were

not considered public financial institutions ecause, despite their

state property, their lending to private sector is financed through

private sector deposits and cancels out. The remainder (requirements n

the Central Bank) are already considered as a liability f the Central

Bank and, hence, form part of the base of the inflation ax in any case.


14/149

- 6 -

-

The Consolidated ublic Sector (CPS), hich comprises

both PB

and NFPS.

-

The Foreign Sector (F), composed

of foreign creditors nd

debtors.

-

The Non-Financial omestic Private Sector

(SPR)

- The Financial

System

(FS), which includes

(apart from PB) the

group of Non-Public

Financial Institutions (NPB). NPB includes, in turn,

CommercialBanks (BC) (see

Footnote 2) and the Non-Banking

Financial

System

(NB)

(of which COFIDE, the Development inance

Corporation, and

"Financieras" re the most important institutions).

-

A miscellaneous tem is the specified

n the monetary accounts

as "Otros" (0).

The assets and liabilities onsidered are:

- Deposits (D)

- Foreign Currency Deposits (FCD)

-

Loans (L)

-

Net Loans (NL)

- Real Capital (K)

- Bonds

(B)

-

Reserves (R)

- Currency in Circulation (C)

9. An asset, (e.g., D) held by sector i (e.g., BC) and originating n

a

transaction ith sector (e.g., CRB) is

written as D[i,j]. In our

example this would

be D[BC,CRB] hich refers to deposits of

BC on the CRB

(these are

principally legal

and excess reserves

of BC held in CRB). Note

that in this

case D[BC,CRB]

appears as a liability

n the balance

sheet of

the CRB and as

an asset of BC. When

an asset is held

by more than one

sector

(or when it is

originated in transactions

ith more than one sector)

this is indicated

y a dash; e.g.,

DrSPR-BC,BN] efers

to deposits of SPR

and

BC at BN.

10. The other items reported in the balance sheets are:

- Net Worth (NW)

- Other Accounts

Net (OCN). A description

f OCN is provided

in

ANNEX III.

11. The simplified

alance sheets of the NFPS, the CRB, BN and BF are

reported in the following table:


15/149

Table 2-1: THE BASIC BALANCE

SHEETS

(A

-

Assets/L

-

Liabilities)

i. A Non-Financial Public Sector L

K[NFPS,SPR-F]

L(CRB,NFPS]

D[NFPS,CRB] L*[BN,NFPS] /a

D[NFPS.BN] I L[BN,NFPS]

D[NFPS,BF] L[BC,NFPS]

D[NFPS,BC]

I L[BF,NFPS]

L[NB,NFPS]

B[BC-SPR,NFPS]

/b

NL[F,NFPS]

NW[NFPS]

il.

A Central Reserve Bark L

R[CRB,F] | NL[F,CRB]

L[CRB,BF]

I C[SPR,CRB]

L[CRB,BC]

I

D[BN,CRB] /c

L[CRB,NB]

I

D BF,CRB /c

L[CRB,BN] I D[BC,CRB]

L[CRB,GC] D[SPR,CRBJ

OCN[CRB] | FCD[FS,CRB] /d

L[CRB,O] I D[O,CRB]

| D[NFPS,CRB]

i NW[CRB]

iii. A Banco Nacion L

R[BN,F] I NL[F,BNJ

OCN[BN] D(SPR,BN]

L[BN,NFPS]

I FCD[SPR,BN]

L[BN,SPR] | D[NFPS,BN]

D[BN,CRB] /c | L[CRB,BN]

L[BN,BC] | D[BC,BN]

L[BN,BF] | L[BF,BN]

L*[BN,NFPS] /a

I

NW[BN]

iv. A Banca de Fomento L

R[BF,F]

I

NL[F,BF]

L[BF,NFPS] D[SPR,BF]

LfBF,SPR] I

FCD[SPR,BF]

D[BF,CRB]

/e I L[CRB,BF]

L[BF,BN] L[BN,BF]

LIBF,BC] D[BC,BF]

OCN[BF] D[NFPS,BF]

NW[BF]

/a With CRB resources.

/b Includes "Bono Tipo C" issued by COFIDE.

/c Includes legal reserves on FCD.

/d Excludes legal reserves on FCD of BF and BN.

/e Includes legal reserves on FCD.

The Consolidated Public Sector Balance Sheet

12. The balance

sheet of the CPS reported in Table 2-2 was obtained

consolidating

the balance sheets of NFPS, CRB, BN

and BF. Assets and

liabilities

of the CPS were grouped into different

categories, each of

which was imputed a different interest rate (see Table

2-3).


16/149

-8 -

Table

2-2z

THE CONSOLIDATEC

UBLIC SECTOR

BALANCE

SHEET

A

Consolidated

ublic

Sector

L

K[NFPS,SPR]

LF

=

NL[F,NFPS]

NL[F,CRB]

+

OCN[CRB-BF-BN]

+ NL[F,BN]

+

NL[F,BF]

R[CRB-BN-BF,F]

| NW

L[PB,BC-SPR]

L[BF,BC]

+ | C

+

L[BN,BC]

+ B[SPR-BC,NFPS]

+ L[CRB,BC]

| L[NPB,NFPS]

L[BC,NFPS]

+

L(BF,SPR]

i

+ L[NB,NFPS]

+

L[BN,SPR]

| EME

=

FCD[FS,CRB]

+

L[CRB,NB]

i EMN = D[BC,CRB]

+ D[SPR,CRB]

D[NFPS,BCJ

j

+ D(O.CRB]

FCD[SPP.,BN-BF]

D(SPR-BC,BN-BF]

Notation:

EFL are

reserve requirements

(including

xcess

reserves)

n FCD

of FS in CRB.

EMN are reserve

requirements

(including

xcess

reserves)on

deposits

of NPB and

SPR in

CRB.

LF are

net foreign

loans

to CPS.

NW stands

for total

public

sector

net worth.

C

is currency in circulation.

Imputed

Interest

Rates

13.

The data

source

for each

type of asset

was the

Central

Reserve

Bank's

publication

"Nota

Semanal"

(NS),

various numbers.

The

interest

rates

imputed

to the groups of

assets

of the

CPS balance

sheet

are

described

in

Table

2-3 (all interest

rates are

effective

rates

and are

averages

for

the period).

Most

of the

interest

rate data

was

provided

by

the

"Subgerencia

el

SectorMonetario"

of the

CRB (SGSM).

The LIBOR

intere.t

rate was

obtained

from

the IMF FinancialStatistics (IMF-FS).


17/149

Table 2-3: IMPUTED INTEREST ATES

Asset Group

Interest Rate (Description nd Notation) Source

C institutionally ixed at zero

B[SPR,NFPS] i(b): average

return on "Bonos Tipo

C"

of COFIDE for

1984-87; does

not

account for fiscal

benefit (these

bonds are tax-deductible)

NS

L[NPB,NFPS]

i(nDb): is the interest

rate of BC for

90 days "Descuento" oans (for 1980-85)

and for 360 days loans (for 1986-87) SGSM

EMN

i(emn): until

1983 is the

passive

interest rate for saving deposits;(data n

remuneration f reserves was not available),

since 1984 it is the remuneration f

reserves

("encaje xigible") f BC SGSM

EME i(el2e): s

1

plus the LIBOR 90 days

interest

rate times 1

plus

the rate

of

devaluation f the official exchange rate IMF-FS

minus one

and NS

D[SPR,BC-BF]

i(ci): interest rate of "Cedulas

Hipotecarias"

SGMS

FCD[SPR,BN-BF] i(fcd): idem i(eme)

L(PB,BC-SPR]

i(red): rediscounting

nterest rate of

Banco Agrario until 1984

and a simple

average

of "Selectivo

grario" and

"Fomento gropecuario" oans thereafter

SGSM

D[NFPS,BC] i(dep): fixed term deposits for 90-180

days at BC

SGSM


18/149

- 10 -

C. Calculation f the Inflation ax (IT)

14. The broad inflation tax is defined here as the inflation-

amortization

of the principal of monetary and financial

liabilities f the

CPS held by the domestic private

sector which is not compensated y

interest

payments. To illustrate this assume

that the only two public debt

instruments

re currency and fixed int rest short-term onds. In the case

of currency,

since it bears an institutionally ixed zero rate of interest

(i.e., there is no compensation or the inflation-amortization f the

stock), the inflation ax is equal to the whole inflation-amortization f

the stock (that is, the loss in real value of the stock of currency). On

the other hand, bond holders are compensated for the inflation-induced rop

in value of the real stock of bonds by interest payments. If the interest

rate does not suffice to compensate for the inflation-amortization f debt,

the difference between the inflation-induced mortization f principal and

the interest payments (i.e., the uncompensated nflation-amortization f

debt)

is

deemed the inflation ax

on bonds.

15.

Accordingly, mploying ominal interest rates to measure the

compensation

or the inflation-amortization f debt

(that is, assum'ng a

zero "benchmark"

eal interest rate), the IT on a given debt instrument,

measured in units of "goods" at the beginning of the period, is equal to

the product of the stock of debt and the difference between the rate of

inflation nd the nominal interest rate of that stock, all divided by one

plus the

rate of inflation. The total IT is then equal to the sum of the

ITs

on all public debt instruments.

16. Therefore, employing he notation of the CPS balance sheet derived

in paragraph 12, the total IT is:

(1) IT = (1/1+inf)*(C*inf

B[SPR,NFPS]j(inf i(b)) +

+ L[NPB,NFPS]*(inf i(npb))+ EMN*(inf i(emn))+

+

EME*(inf i(eme))+ D[SPR,BC-BF1*(inf i(ci)

+ FCD[SPR,BF-BN]*(inf

i(fcd))}

where:

inf is the rate of inflation.

17. A similarapproach can be employed to define and calculate the

inflation subsidy (IS)

which the CPS gives to the domesticprivate sector.

The IS arises

when the private sector

borrows from the CPS at interest

rates

which are below

the rate of inflation. In this case the inflation-

erosionof private

financial liabilities xceeds

the cost of holding them,

and there is an implicit subsidy

to financial debtors. More

precisely, the

IS is defined as the

inflation-amortization

f financial ssets of the CPS

in hands of the private sector which is not compensated

y interest

payments.

Following the notation of

the CPS balance sheet of Section

B the

IS can be calculated as follows:

(2) IS = (l/l+inf)*{L[PB,BC-SPR]*(inf

i(red))

+ D[NFPS,BC)*(inf i(dep))}


19/149

-

11

-

18. The net inflation-induced inancial ealth transfer from the

private and the public sector is termed net inflation ax (MIT), and can be

expressed s the difference between the IT and the I:

(3) NIT = IT - IS.

19. From the conceptual point of view inflationary

axation can arise

both from: (a) inflationary isperceptions, hich make inflation igher

than originally anticipated, hereby rendering x-post real interest rates

lower than ex-ante interest rates; or (b) institutional igidities in the

determination f interest rates, which impede agents from adjusting ominal

rates to anticipated inflation. In general, assessing the relative signi-

ficance of both sources of inflationary axation (inflation isperceptions

and institutional igidities) nvolves considerable ifficulty. The main

difficulty stems from the fact that inflation xpectations re non-

observable. However, the system of fixed and artificially ow interest

rates, which have been prevailing in Peru since 1976 (and in particular

since 1985), suggests that institutional igidities ave been the principal

explanatory actor of the IT on financial ssets/liabilities.

20. From equation (1) it is clear that only public financial and

monetary liabilities eld by the domestic private sector are considered a

source of IT. Real assets (such as K[NFPS,SPR]) re excluued because,

unless their relative price changes, their nominal value moves along with

inflation. Foreign liabilities (such as LF) or assets (such as R(CRB-BN-

BF,F]) are neglected since their rate of return in domestic currency is

equal to the external real interest rate plus domestic inflation nder

purchasing power parity and, therefore, hey are perfectly indexed assets.3/

21. The account OCN[CRB-BN-BF], hich approximates umulative

operational osses of public banks (mainly the CRB, see ANNEX III), can be

viewed as a non-performing sset (that is an asset with zero nominal

return). Or else, the CPS balance sheet could have been presented

substracting his item from the right-hand side of the balance sheet in

which case the CPS net worth would have been smaller by a similar amount.

3/ Under purchasing power parity:

dev. = inf - inf*

where: dev is the rate of devaluation

inf is the domestic rate of inflation

inf* is the foreign rate of inflation.

The domestic currency nominal return on the foreign asset is equal to

the sum of the foreign interest rate and the devaluation rate:

i* + dev = i* - inf* + inf=

= r* + inf

where: i* is the foreign nominal interest rate and

r* is the foreign real interest rate.

Assuming that the external real interest rate is zero, the nominal

return on the foreign asset is equal to inflation nder purchasing

parity, i.e. the inflation-erosion f the foreign asset (prior to

devaluation).


20/149

- 12 -

22. The data

employed stocks

f assets rd liabilities nd interest

rates) re reported n Table 2-4. and the estimates f the IT, IS and NIT

are in Table 2-5.

Tabt. 2-4s l130c IOF AU ALIAIRZ3

MD

DIwa 95155

ItO lost i 168 1is4 19W

1956 19t?

Stt ke (average,

ill.1.tl8)

C

219 U

582 71 :,6f 1,817 12,1W 23,1W

st(W,Sp1 1

418 1,030

2,02

8,218

LO4P

,PJ

*/

21

as 61 1" m 7" 1,804 2,68

E1 148 213 247 404

725

1,018 14,52t 20,58

eM el

180

238

68 1 06 4.o13 6,"6 5.04 6,444

o(IPl,-6P 141 25 421 I4 1,244 2,6*0 5,828 11,124

FGC6P3,I-IW

41

6a

112

2n

ON 2,512 1,171 4,274

LLft,K-5P11j me

6t# 1.21t 2,608 6,064 120,9

24,85S

47,797

D(WPNS,K S 14

21

a8

110

*U 1. 2,042

nteret

notes

and In"flatio

I(b) 33.1 6. 57. a 63.6 62.0 6.0 48.2 10.4

i(np) 68.0 71.4

6*.6 7.4

*7.8

119.6 40.0 6.5

l(_,)

8

t2.6

6.

67.4

66.6 60.0 76,4 38.8

U8.

I() 58.1

72.6 116.0 114 1U8.3 160.6 6.6 158.6

I(ci) *87.

62.2

61.6 66.0 78.5 72.1

21.7 14.8

i(fcd)

55.1

72.6 116.0 156.4 116.2 160.6

6.6 158.6

I(red)

25.3 87.5

870. 47.6 71.2 50.7 25.1

24.4

I (dep) 54.

023. 70.6

74.0

60.2 1.5

28.6 21.0

l,,letlfi /60.6

72.7 72.0 121.1 I.

118.$

61.0 114.5

1906-IV 1997-1 1927-11 1917-411 167.11

Stock.

(averarm. gill. KatIe)

C 14,100 16,216 16,216 24,637

81,616

(plR,WISl @/

1,714

1,62 1,714

1,680 2,245

LD6,WFPS) k/ 1,56

1,5U 1,988 2,?72

8,672

EO 10,764 20,60 24,062 26,246 51,76

EI IE

8,7 24 8,670 8,581

8,27 5,"7

OESPRIM6-17] 6,920

*,172

9,l11 11,250 13,482

PCOISPOIN48p 2,748

2,604 2.751 2,747 4,275

L(' ,C-1,J 28,064

88,061

$8,155 45*,68

156.87

DWPMS,K]

1,721 2,206 2,264

2,064 1,9S4

Interest ate and Jntlet_et 9/

I(b) S.t

10.7 10.6 10.7 10.9

I(npb) 6.0

U.S 6.6

6.0

7.2

I(am)

6.8 6.8 O.& 7.7 7.0

i(aea) 1.5 7.4

9.0 2.2 114.9

I(el) 6.0 5.0 5.4

5.6 5.3

l(fed) 1.S 7.4

*.0

2.2 114.9

I(red)

5.6

5.6 5.6 5.6

6.6

I (dep)

6.7 6.7 6.7 6.1

6.0

inflation

l

12.7

1U.5 16.2

22.7

24.0

I1 r

1064 elY 'ksa. Tilpe C of COPIOII for 106-Ge alee Central

GOver,mt

banda In

found for 1960.-U

Apprite.td by

L[C , IIF).

e/ EMEOVre ti.atet net

lgal rearvae on FC of SRI

and tC bacause It

slte

co eritae

legal rautrvte

on fCD of

ON

and

IF.

ndilrect *atletes of the

letter (aNlch

are

net

reported In Nate S_rnal)

suggest

that EMS

my

_av bea overettilted 1S percent In

196, 26

perent Ia

1966

and 1i percent In 1ii7.

d/ Anual

Interet rates .ape In efectIve prcentao tare.

The annual rate of Inflation (bta

the Ieant ontU of the year end the leet month of

the Previoet year) according to te coneumr Price Index of Lie.

Qu"terIy Interea raOte 1 quarterly eff* ctiV Percentage.

The quarterly rte of infltiotn (betae the leat eattf tib quarter a"d the eat

otentb f the previous quarter) accordin, to the ceatamr pIet Index of Liet.

Sourctt AlI

a*eet

eteche eare aepla avere" obtalned ftre "t Smaati

(various numbrs). ibt Intereat rate serles were provided by the

aS3|wt5g"io

del Sector .ntaterlo' of the

M

and llf' P'nanaclal

Statletite.


21/149

- 13 -

Table 2-5: INFLATION

AX ESTIMATES a/

Inflation Inflation Net Inflation

Tax (IT) Subsidy (IS) Tax (NIT IT-IS)

(Intis) Z GDP) (Intis) (Z GDP) (Intis) (Z GDP)

Annual

1980 135 2.3 69 1.2 66 1.1

1981 185 1.7 122 1.1 63 0.6

1982 74 0.4 250 1.4 -175 -1.0

1983 536 1.6 893 2.7 -357 -1.1

1984 23r 0.3 1,162 1.6 -923 -1.3

1985 5,037 2.5 5,532 2.8 -495 -0.3

1986 11,783 3.2 5,868 1.6 5,914 1.6

1987

30,843 4.2 20,622

2.8 10,221

1.4

Quarterly b/

1986-IV 3,587 0.8 1,867 0.4 1,720 0.4

1987-I 6,141 1.2 3,849 0.8 2,292 0.5

1987-II 6,613 1.0 4,415 0.6 2,198 0.3

1987-III 10,925 1.4 4,974 0.6 5,951 0.7

1987-IV 7,164 0.8 9,001 1.0 -1,837 -0.2

a/ The above calculations re based on equations: (1) for the IT, (2) for

the IS and (3) for the NIT. These assume that

the benchimark eal

interest rate is zero (See Footnote 1).

b/ Since INE does not provide quarterly figures of GDP, the

annualized

quarterly

figures of GDP employed were

obtained by multiplying the

annualized quarterly level of GDP reported by the CRB (base 1970) by

the ratio between

the annual GDP figures of CRB and INE.

23.

The inflation tax and inflation subsidy calculations ere repeated

assuming a 5 percent

benchmark real interest rate (instead

of the zero

percent assumed before). This implies that the interest compensatior.or

inflationis smaller than the nominal

interest rate by approximately

5 percentage points.4/ The results are reported in

Table 2.6.

4/ More rigorously and following

he notation of Footnote 1, the

compensation for inflation is, [(1

+

i/1.05)1 1 where

i is the nominal

interest rate.


22/149

- 14 -

'rable-6: INFLATION AX ESTIMATES

a/

Inflation Inflation Net Inflation

Period Tax (IT) Subsidy (IS) Tax

(NIT)

(intis) (%GDP) (intis) (ZGDP) (intis) (ZGDP)

1980 160.0 2.6 80.6 1.4 79.4 1.2

1981 222.3 2.1 145.5 1.4 76.8 0.7

1982 155.5 0.9 298.4

1.7 -142.9 -0.8

1983 679.9 2.1 983.0 3.0 -303.1 -0.9

1984 652.2 0.9 1,401.0 1.9 -748.8 -1.0

1985 6,395.6 3.2 5,781.9 2.9 613.7 0.3

1986 13,139.0 3.6 6,827.0 1.8 6,312.0 1.8

1987 31,564.0 4.3 22,095.0 3.0 9,469.0 1.3

a/ The above estimates re based on equations (1) for the IT, (2) for the

IS and (3) for the NIT, assuming that the benchmark, real interest rate

is 5 percent; i.e. in equations (1) and (2) i () should be replaced by

(1 + i ())/1.05 1 (see Footnote 4.)

D. The Inflation ax: Evolutionand Its Relationsh

with the Macroeconomic

nvironment

24. Coinciding ith the program of economic

liberalization mplemented

in 1981-84, the inflation tax and the net inflation tax followed a downward

trend (only temporarily nterrupted

n the case of the inflation ax in

1983, see Tables 2-5

and 2-6). This was mainly due to higher interest

rates on public financial liabilities inflation

ctually rose) and the

dollarization f the economy

(in 1982-85 the average return on foreign

currency

deposits was on average 37 percent higher than the rate of

inflation, see paragraph 26). Since 1985, the inflation ax rose steadily

from 0.3/0.9 percent of GDP in 1984 to 4.2/4.3 percent of GDP in 1987

(according o whether the benchmark real interest rate is 0 or 5 percent

respectively). Inflation, ogether with low nominal interest rates and a

dedollarized conomy (as measured by the share of foreign currency deposits

in total liabilities f the financial ystem), were the factors to blame

for the inflation tax increase.

25. In 1983, as the drop in the conventional ax

revenue led to a

record fiscal deficit, inflationary axation grew from 0.4/0.9 percent of

GDP

to 1.6/2.1 percent. A similar pattern was

reproduced in 1986-87. In

those circumstances nflation ressures ere the result of

high public

deficits and expansionary

financial olicies. The exchange rate was frozen

in 1985 and lagged behind

inflation ntil the fourth quarLer

of 1987, and

no major adjustments

n public sector prices and tariffs

were implemented

until

early 1988. Inflation nd the policy

of lowering ominal interest

rates, i.e., lowering the compensation or the inflation-induced rosion of

the principal of debt, propelled jump in the 1987 inflation ax level to

three times its average 1984-85 level (measured s a percent of GDP).

Between the same periods the tax revenue of the central government dropped

from 11.7 percent of GDP to 8.5 percent.


23/149

- 15

-

26.

The

dollarization

f

the economy

in

1983-85

was

the

result

of

the

attempt

by

private

agents

to

escape

the inflation

ax

as well

as the

liberal

measures

which

allowed

foreign

currency

deposits

in the

financial

system.

On

the

other

hand,

although

since 1985

dedollarization

ollowed

mainly

from

the

suspension

f

convertibility

f

foreign

currency

deposits

into foreign currency, he policy of fixing the exchange rate (and the

subsequent

real

appreciation)

lso

played

a role.

This

became

particularly

obvious

after

the

official

exchange

rate

devaluations

f

the last

quarter

of

1987

have

raised

significantly

he

return

on foreign

currency

deposits.

However,

by

then,

the

low share

of

foreign

currency

deposits

in

total

financial

liabilities

ad

left

depositors

eakly

hedged

against

inflationary

axation.

27.

Inflation

as

also

induced

financial

ealth

transfers

(implicit

subsidies)

from

the

public

to the

private

sector.

A

measure

of these

is

given

by

the

inflation

ubsidy

estimated

in

Section

C. The

inflation

subsidy

rose

from 1.2/1.4

percent of GDP in 1980 to 2.7/3 percent in 1983

(according

o

whether

the benchmark

real

interest

rate

is zero

or

5

percent).

Thereafter,

it

exhibited

an oscillatory

ehavior

reaching

a

level

equivalent

to

2.8/2.9

percent

of GDP

in 1985

and

2.8/3

percent

in

1987.

28.

However,

the

on average

higher

level

of

the

inflation

ubsidy

did

not suffice

to

neutralize

the

upward

trend

in

the

inflation

ax.

As

a

consequence,

the

average

net

inflation

ax

(the

difference

etween

the

inflation

tax and

subsidy)

has risen

from

-0.41-0.8

ercent

of GDP

in

1984-85

to

1.5/1.6

percent

in

1986-87.

Between

the

same

periods

the

central

government

tax

revenue

dropped

from

11.8

percent

of

GDP to

8.8

percent. This suggests that there

has

been

strong

substitution

etween

conventional

and

inflationary

ources

of

taxation.

Since

the

inflation

ax

is a

more

regressive

ind

of tax

(from

the

income

distribution

oint

of

view),

this

substitution

s bound

to

have

had adverse

social

effects.

29.

Moreover,

to

the

extent

that the

beneficiaries

f

the

inflation

subsidy

tend to

differ

from

those

who

bear

the inflation

tax

burden,

inflation

ay

have

distributional

ffects

even

if the

net

inflation

ax

was

zero.

Since

the

recipients

of subsidized

redit

are

producers

(themost

important

eing

agricultural

roducers),

inflation

s

bound

to induce

transfers

f financial

ealth

from

cash holders

and

bank

depositors

to

poor

"campesinos" nd other beneficiaries f subsidized RB credit. Although

this could

be

justified

n

income

distribution

rounds

if the holders

of

liquid

assets

were

sufficiently

icher

than

the

beneficiaries

f subsidized

credit,

it

could

not

be justified

on

efficiency

grounds

since it

implies

taxing

savings

and

the

use

of money

(a

commodity

ith

high

productivity

that

society

can

produce

at negligible

cost).

Since,

in

addition,

there

is

evidence

that

poorer

consumers

are the

main

holders

of cash,

it

is

not

warranted

to

tax

them

in

order

to finance

the poor,

but

perhaps

not

necessarily

oorer

"campesinos".

Taxing

the rich

through

direct

conventional

taxes is

a more

desirable

venue.

A similar

reasoning

ould

be

applied

for

wealth

transfers

etween

private

agents

through

the

banking

system: low and middle income bank depositorssubsidizefirmswho are large

enough

to

be

able

to borrow

from

banks.


24/149

- 16 -

30. Under the present circumstances, s further relative price

realignments

eem inevitable nd,

given that the nearly depleted level of

foreign exchange reserves cannot cushion further demand pressures, the

policy of maintaining low nominal interest rates can only enhance the risk

of inflationary

axation. Moreover, since the process

of financial

disintermediation s quite advanced and accelerating, .e., the inflation

tax base is shrinking ast, collecting a similar level of inflation revenue

would require ever increasing inflation rates.

31. Unless serious fiscal measures are undertaken the monetary effects

of the fiscal and financial imbalance ill fuel the inflationary rocess to

even more worrying levels. The socially regressive ffects of inflationary

taxation are bound to show quickly into a further deterioration f the

government's olitical strength and into greater social disintegration.

This, though, may be

the cost that society and the government s

part of it

has to bear in order to be ready to accept the fiscal and financial remedy.


25/149

-17-

ANNEX3

THE CENTRAL BANK'S QUASI-FISCAL

EFICIT

A.

Introduction

1.

The Central Reserve

Bank's (CRB) intervention

n Peru's financial

and foreign

exchange markets has

created subsidies

to the private sector

with budgetary implications. Those

subsidies, onventionally

eferred to

as the quasi-fiscal

eficit of the CRB,

have recently become an important

source

of primary money

creation. The sources

of the quasi-fiscal

deficit

(QFD) examined here are

interest rate and

foreign exchange losses.

Interest

rate losses occur when the interest

the CRB pays on its

liabilities

(mainly reservesof the financial

ystem, since currency

in

hands of the public

pays zero interest)

s higher than

the interest it

receives on

its assets (mainly

credit to the government,

redit to the

Banca de Fomento, rediscountfacilitiesand international eserves).

Foreign

exchange losses arise

when the average

buying price of foreign

exchange

by the CRB exceeds

the average selling

price. During the 1985-87

period

foreign exchange losses

were due to the

fact that the average

exchange rate

paid to exportersand other sellers

of foreign exchange

(including hose

offering foreign exchange

to the governmentin the open

market) exceeded,

on average, the exchange

rate charged to

importers nd

financial ebtors.

2.

Interest rate losses

were

estimated

y two

methods: i) directly,

from analyzing

the movements in

the sub-account ermed

"Costo por

Regulacionde Exceso de Liquidez"of the CRB account "Otras Cuentas Netas"

(which, reportedly, easures

precisely interest

rate losses); and ii)

indirectly,

hrough measurement

of the average

return on CRB assets

and

liabilities. ikewise, foreign

exchange losses were

also estimated:

i)

directly,

through inspection

f the movements in the sub-account

ermed

"Diferencial

ambiario" of

the CRB account "Otras

Cuentas Netas";

and ii)

indirectly, omparing

average buying and

selling exchange rates.

For

reasons given below

(paragraph 8) the direct measurement

f QFD is deemed

more

reliable that' he

indirect one. The

adequacy of the direct measurement

of the QFD hinges on the

specific accounting

ethodology

employed by the

CRB of Peru.

Thus, it cannot be assured that

the same approach

will be

valid for similar

studies of other

countries. The indirect easurement

f

QFD, apart from

serving as a check

for the direct

measurement, ermits

assessing the

composition f

foreign exchange

and interest rate losses

(which

the direct measurement

does not convey). The

direct estimate

of QFD

is

performed in Section B and the indirect

estimate

in Section C. The

evolution

of QFD is analyzed

in Section D.

B. Direct Estimate to The

Quasi-Fiscal

Deficit (QFD)

Foreign

Exchange Subsidies

3.

The sub-account

Diferencial ambiario" of the

CRB account "Otras

Cuentas Netas" measures: i) foreign exchange losses due to the difference

between buying

and selling exchange

rates; and ii) accounti-g capital

losses/profits rising

from changes in

the Inti valuation of the CRB's

assets

(including old)

and liabilities enominated n foreign

currencies

due to

either changes in the inti/US$ exchange

rate or to changes

in the


26/149

-18-

rates f other

relevant urrencies and old) gainst

he US$. However,

here the focusis only on tte former

osses ince hey

entail subsidy nd

its financing eads

o monetary xpansion.For

his reason his item should

be added

to the

public

ector eficit.

y contrast

he

latter

losses/profitsre capital

ains/lossesn the

CRB net position

n foreign

exchange nd therefore o not entail er se monetary xpansion. herefore,

the exercise hatfollows s

concer.ed ith

estimating hich

part of the

movement n the account

Diferencialambiario" eflects

osses ue to

exchange ate subsidies.

e refer enceforth o this item as "foreign

exchange ubsidies" FES)

o distinguish t

from the more general

erm

'foreign

exchange

losses".

4.

More precisely, hanges

n the sub-accountDiferencialambiario"

(CDC) easure,

part from FES, the change n value f the net foreign

exchange osition FEP) f the CRB (termed Posicion

e Cambio III" in CRB

publications)t the beginning

f the period. hus, if FEP,(t-l,t)s the

FEP of time (t-l) alued

t exchange ates f time t:

(1) CDC = FES

- [FEP(t-l,t)

FEP(t-1,t-l)]

The FEP measures

ross foreign xchange eserves including old) inus

short nd

long run foreign iabilities

f the CRB (principallyith

the

IMF, i.e.

SDR's) nd minus foreign urrency bligations

ith domestic

residents. he

main components f FEP

which are not denominatedn US$ are

gold reserves nd SDR's liabilitieso the IMF. It is assumed

or

simplicity nd in the

absence f proper nformationhat the rest of the

assets/liabilities

re stipulated

n US$. ThusFEP can be written:l/

(2) FEP'(t,t)

=

e(t)x[G*(t) g(t)

-

S*(t) x s(t) + R*(t)]

where:

e (t) is the inti/US$ xchange ate at time t.

G* (t) is

the stock f gold at time t (in

physical nits).

g (t) is the

CRB accounting rice

of gold at time t in

USs.

S*

(t) is the stock f SDR' liabilities

ith the IMF at

time t.

s

(t) is the exchange ate

of SDR's at time t in

US$.

R* (t) are othernet assets/liabilities

f the CRB (after

deducting oreign

urrency bligationsith

residents)t time t in US$.

1/ Note that stocks n Intis ear a

" '

n and

stocks n other currencies

bear a " * n


27/149

-19-

It thus follows that the change in value between time (t-l) and time (t) of

the FEP existing at the beginning f period (t) is:

(3) FEP'(t-l,t)-FEP'(t-l,t-l) G*(t-l) x [g(t) x e(t)

-g(t-1) x e(t-1)] - S(t-1)

x

[o(t) x e(t) -

s(t-l) x e(t-l)]

+ R*(t-l) x [e(t) - ^(t-l']

=

e(t) x G*(t-l) x lg(t) - g(t-l)]

-

e(t)

x S*(t-l)x[s(t)

- s(t-l)]

+ [e(t) - e(t-l)] x [G*(t-l)

x g(t-l) - S*(t-l) x s(t-l)

+ R*(t-l)]

=

e(t) x G*(t-l) x [g(t) - g(t-l)]

-e(t)

x S*(t-1) x [s(t - s(t-l)]

+ [e(t) - e(t-l)] x FEP'(t-l,t-l)

The first term measures the revaluation f gold due to the appreciation f

gold with respect to the US dollar; the second term

measures the

revaluation f SDR's due to the appreciation f SDR's with respect to the

US dollar; and the third term

captures the revaluation f the FEP of (t-l)

due to the inti devaluation

ith respect

to the US dollar. Substituting

"changes in the FEP"

of equation (3) in equation

(1) we arrive at the

expression for FES employed for its direct estimate:

(4) FES' = CDC + e(t) x G*(t-l) x [g(t)

-

g(t-l)]

-

e(t) x

S*(t-1) x [s(t) - s(t-1)] + [e(t) - e(t-1)] x

FEP'(t-l,t-l)

5. The official benchmark exchange rate (MUC) is the accounting rate

used by

the CRB for the inti valuation

of foreign exchange

assets/liabilities. However, actual transactions ake place at a set of

premia and discounts on it. Other transactions ake place at the rate of

the Mesa de Negociacion (MN). These rates constitute he basic system of

multiple exchange ra'.es t which trade and capital transactions ake place.

In order to estimate directly FES arising from multiple exchange rates the

other items of equation (4), that is, changes in the dollar valuation of

gold and SDR's, and the revaluation f the net foreign exchange position

due to domestic devaluations, ust be estimated. Annex Table 3.1 reports

estimates for each of these items and the resulting irect estimate of FES

based on equation (4):


28/149

-20-

Tabl- $-Is DIRECTESTIMATEF FOREIGN XCHANGEUBSIDIES

(in illon lntl.)

1986-I 1986-II 1958-I 1986-Il 1987-I 1987-II

A. Changesn the

'Diferencial

CamblarioO/ 6,012 4,878 2,870 -366 -2,045 23,011

8. Gold pprociationia

a vie theUSS b/ -618 0 0 0 3806 1040

Ce t)

x O*(t-1) (g(t) -

g(t-1))J

C. Revaluationf SDR's

liabilitiesiea via

thaUSs c/ 185 88a 687 180 722 2,498

tE(t) S*(t-1) (s(t) -(t-l))]

D. Revaluationf foreign

exchangeosition FEP)

due to devaluationsf

the official xchange

rate /

-8,a89 -1,479

0 0

211 -7,528

[(e(t) *(t-1)) FEP'(t-1,t-I)]

E. Foreign xchange

Subsidy FES) W88 2,611 2,183 -646 749 14,626

[E = A

+

8 C e D]

from

equation

4)

a/ Obtained rom the CRB account Otras uentas etss8I

Change n the CR8 accountingrice f gold, n USS, ultpliledy the

beginnlng of period tock f

gold oserves nd theend f period UC

exchange ate.

Change n the US$ value ,f SDR's nd

the end of period UC exchange

rate.

The not foreign xchangeposition

termed Posicione Cambi) ll1

In

-

CRB publications)

n US dollars ultipliedy the Increase

n he

exchange ate Intis er dollar very onth quarters in 1986-I) hen

there

as a devalustion.

he

total EP reported s equal o

the

sum of

all monthly

(quarterly) revaluation.

Source: Note omenal variousumbers) nd *Subgerenciael

Sector oneterlo'f Cha.

Financial Losses

6.

The QFD is also composed of financial,

r interest rate, losses.

As it was mentioned before these losses derive from the fact that the CRB

has an average return on its assets smaller than the average cost of its

funds. Financial losses are

measured with precision by the sub-account

"Costo por Regulacion de Exceso de Liquidez" of the CRB account "Otras

Cuentas Netas". Table 3.2 reports both estimates of financial losses (the

change in value of the sub-account Costo por Regulacion de Exceso de

Liquidez") and foreign exchange subsidies (derived in Table 3.1). Their

sum, QFD, is also reported in Annex Table 3.2 (in nominal terms, in real

terms and as a proportion of GDP).


29/149

-21-

TABLE

.2: DIRECT STIMATES

F CFD */

(in illion ntla)

86-I 86-II 1986

86-I 86-II 1988 87-I 87-II 1987

A. Financial

Losses l/

-mlt. I7.

0 899

899 1,641

8,783

5,874

1,7683 4,337 6,100

B.

Foreign

Exchange

Subsidy /

-mil. /. 869

2,611 2,879 2,188

-646 1,688 749

14,626 16,874

C.Quai-

Fiscal

D etict

A + B

-mil. I/. 868 3,410

8,778

3,824

8,188

7,012 2,612 18,962 21,474

-U

ODP 0.2

1.7 1.9 1.0

0.8 1.8 0.3 2.6 2.8

Memorandumtem:

Nominal CDP

-nil.

1/. 199,846

881,022

760,168

Notes. a/

TheCRB sub-accountCosto orRegulacion

Exceso e Liquldozw.

Si Foreign

exchange ubsidy (FES)

obtained In Table 3.1.

Source:

Nota Seminal (various

numbers), INE, Table 3.1 nd

Subgerencla del Sector

MonetarloCR8).

C.

Indirect Estimate of

the Quasi-Fiscal Deficit

7.

In order to provide

a double check

of the previous estimates, an

additional exercise

was carried out.

In this exercise: a)

foreign exchange

subsidies were calculated

through comparing

buying and selling

exchange

rates

of the foreign exchange

transactions of the CRB; and b) financial

losses,

through comparison

of interest rates applicable

to CRB's financial

assets

and liabilities.

Foreign Exchange Subsidies

(FES)

8. Ideally,

if the volume of

purchases of foreign

exchange by the CRB

equalled the

volume of sales, FES could be calculated

by subtracting the

weighted

average exchange rate of all purchases

from the weighted

average

exchange rate of all sales, and

multiplying that difference

by the volume

of purchases

(or sales). In general,

though, the

volume of purchases

differs from the volume of sales, i.e.

the CRB either accumulates

or draws

down foreign

exchange reserves. In this

case, a convenient procedure to

calculate

FES is to select a :^eference r accounting exchange

rate. The

measurement of FES

will of course vary with the choice

made of the

reference

exchange rate.

The reference rate may

be, for example, the

average historic cost of foreign

reserves, some

sort of market average

exchange

rate or, as in the

case of the CRB, the official MUC exchange

rate.


30/149

-22-

9. More formally,

FES can

be measured

as follows:21

(5) FES = (ep - e) x P - (es -e) x S

where: P is the volume of

purchases

S is the volume of sales

e is the reference exchange rate

ep is the purchase price of foreign exchange

es is the selling price of foreign exchange

i.e. FES arise whenever the CRB buys foreign exchange at a price

above the

reference exchange rate, or sells foreign exchange at a price belnw the

reference exchange rate. If the first

term is positive (the second term is

negative) the CRB is purchasing

(selling) foreign exchange above the

reference price, and is therefore making a loss (gain). Thus, if both the

purchase and selling

price are above the reference exchange rate there will

be FES if the first term is larger than the second one. Note that if the

volume of sales equals the volume of purchases, the previous formula

becomes the product of the volume of transactions and the difference

between the purchase and sale exchange rates.

10. The indirect estimate of FES performed here is based on equation

(5). To facilitate comparisons with the direct estimate of FES obtained in

the previous section, the accounting exchange rate used by the CRB (that

is, the KUC rate) was chosen as the reference exchange rate.

11. The indirect estimate of FES provided here measures only FES

originated: in import and export transactions and in CRB direct purchases

of foreign exchange from residents in the open market. Due to

the lack of

data any other balance of payment transaction are excluded. Hence, the

calculation here is only partial and it is conducted to identify the main

items that explain FES, but in no way

are meant to challenge the direct

estimates of the previous section. Based on equation 5, total FES were

calculated as

the difference between the sum of items a) to c) below:

a) The flow of CRB purchases of foreign exchange from exporters

was multiplied by the average spread between the purchase

price and the MUC exchange rate

(that is, the CRB accounting

exchange rate). This captures FES originated in purchases to

exporters.

b) The flow of CRB purchases of foreign exchange from residents

in the free market was multiplied

by the average spread

between the average buying price and the MUC exchange rate.

This measures FES originated in purchases to residents.

C) The flow of CRB sales of foreign exchange to importers was

multiplied by the average spread between the sale price and

the MUC exchange rate. This measures FES originated in sales

to importers. Note that the difference between a) and c;

measures FES originated in foreign trade alone.

2/ Following the presentation of the Paraguay Country Economic Memorandum

(Report No. 7031-PA, Annex III).


31/149

-23-

12.

The indirect

estimate

of FES,

and

the corresponding

ata

employed,

are reported

in Annex

Table

3-3.

It

can be

seen that

FES in

this

calculation

iffer

considerably

rom

the

direct

estimates

f FES

performed

in the

previous

section.

This may

be due,

apart

from

the omissions

mentioned

above,

to the

lack

of proper

weighted

average

exchange

rates for

items a) to c) as well as to the lack of a reliable figureof CRB purchases

of foreign

exchange

to residents.

Table 8.8:

NDIRECT

CTIMATE

FFOREIGN

XCHANGE

UBSIDIES

86-I 8S-II

1986

86-I

86-II

1986 87-I 87-II

1987

A.

Flows f

Purchases

ndSales

million

Sf)

$.

Exports

1,493

1,527

3,020

1,210 1,299

2,609

1,254

1,306

2,659

2. Imports

782

788 1,570

1,051

1,474

2,626

1,821

1,682 2,903

3.

Purchaseo o

Residents

/

-

861

361

395 82

477

88

202

238

B. Average

xchange

ate

Premium ver

he MUC

(intis

er US$)

4. Exports

-0.03

0.13 0.06

0.32

0.96

0.64

2.77 6.73

4.76

5. Imports

0.00

0.04 0.02

0.17

1.08

0.62

2.60 4.28

3.39

8. Purchases

Residents

0.00

8.46

1.72 .46

3.8

86.8

6.40 22.80

13.80

C. Foreign

xchange

ubsidies

FES) /

7. Exports

(1x4)

-46

198

163 398

1,261

1,644

8,471

8,782 12,263

8. Imports

(2x6)

0 -33

-33

-181 -1,669

1,740

3,298

-6,771

10,089

9. Foreign

rade

(7 8) -46

186

120

212

-808

-96

173 2,011

2,184

10.Purchases

o

Residents

3 x 6)

0

1,211

1,211

1,383

300 1,863

194

4,601

4,696

11.Total ES

(9 + 10)

-46

1,376

1,331

1,676

-8 1,667

387

86,12

8,879

-as

X GDP

(0) (0.7) (0.7)

(0.4)

(0) (0.4)

(*06)

(0. 6)

(0.9)

Memorandum

tem:

Nominal DP

(million

f Intis)

199,845

381,022

760,166

a'

Corresponds

o the

CR8 accounts:

aptacion

e Excedentes

e laBancao

ntil uly

1987;

nd

*Compras

Residentes'

hereafter.

b/ FES

originated

xclusively

n trade

ransactions,

urchases

o residents

nd

redemption

f reserve

equirements

n foreign

urrency

eposits.

Source:

oteSemanal

various

umbers)

nd

"Subgerenciael

Sector

xterno'

CRB).


32/149

-24-

Financial

Losses

13. The indirect estimate of financial osses of the CRB was obtained

subtracting otal interest paynments eceived on its assets from total

interests aid on its liabilities:

(6)

FIL = i(l) x L - i(a) x A

wheres FIL

are CRB's financial losses.

i(l) is the weighted ave'age interest rate on CRB'

liabilities.

i(a) is the weighted average interest

rate on CRB's

assets.

L is

the total stock of CRB's interest earing

liabilities.

A is the total stock of CRB's interest earing assets.

14. The CRB receives interest

on its credit to the financial nd

public sectors and on its net international eserves, nd it pays interest

on deposits

of the financial nstitutions n the CRB (primarily eserve

requirements f commercial anks). To measure interests received and paid

by the CRB the followinginterest rates were imputed.

Returns on CRB's Assets

a) On credit to the public sector (including anco Nacion): a

weighted average of the interest rate charged

to Banco

Nacion and

0.01% (which is the interest

rate on the

consolidated

entral government ebt at the

CRB).

b) On credit to the

financial system:a weighted average

of

the interest rate of credit to Banca de Fomento ("Fomento

Agropecuario"),

ith a two-thirds eight, and rediscounts

to

commercial banks and the

Banca de Fomer.to commercial

rediscounting or 1985-I) with a one-third eight.3/

3/ A proper weighted average interest rate for credit to the financial

system requires considering large number of interest rates and credit

stocks. Since these were not available, the weights were chosen (somehow

arbitrarily) aking into account that: a) in 1986-87 more than half of

the credit to the financial ystem went to the "Banco Agrario" and

approximately ne-third ent to commercial banks; b) the interest rate

on the "Fomento gropecuario" line lied somewhere in between the zero

interest rate charged to "campesinos" f the "Trapecio ndino" region

and the interest rate on other promotional redit lines of the Banco

Agrario.


33/149

-25-

c) On net international eserves: he LIBOR 3 months interest

rate multipliedby one times the rate

of devaluation.

Interest costs on CRB's liabilities

a) On currency in circulation: ero.

b) On reserve requirements n domestic currency depositst the

remuneration f domestic currency reserves of commercial

banks (see Annex 11).

c) On reserve requirements n foreign currency deposits: the

LIBOR 3 months interest rate (minus one p.p. for 1986 and

minus 3.5 p.p. for 1987) multiplied by one times the rate of

devaluation.

15. The data employed and the indirect estimate of CRB financial

losses (FIL) are reported in Annex Table 3.4. The indirect estimate of FIL,

based on equation (6), is equal to the sum of the product of average

stocks

of liabilities nd their corresponding nterest rates (according o para.

14) minus the sum of the product of average stocks of assets and their

corresponding nterest rates.


34/149

-26-

Table

: I DIRECT STIMATE

F FINANCIAL OSSES

Stocks of: 1986-I 1985-I 1966-I 1986-II 1987-I 1967-11

A. Average tocks f CR8

assets nd

Liabilitiesmillton ntis)

a) Assets

1.

Not Credit o Public ector 471 -862 -1,231 978 6,007 18,148

2. Credit o the Fin. ystem 3,910 6,803 7,608 10,723 16,376 28,109

3. Net Internet.eserves 9,842 16,844 19,318 16,686 12,962 6,987

b) Liabilities

4. Legal eserves f

Fin.

System n Domestic

Currency 1,426 7,898 17,811 21,366 24,363 a3,374

S. Legal eserves f Fin.

System n Foreign

Currency 8,463 8,926 5,998 4,192 3,842 4,998

B. Interest

ates

n

CR8 Assets

nd

Liabilities

effectivennual

-) Assets

6.

Loan

o Public ector 21.4% 22.6% 13.3%

9.2% 13.3%

6.3%

7. Loans o the Fin. System 95.6% 32.3% 18.2%

14.9% 14.9% 10.4%

S. Net International

Reserves 19.3% 9.3%

7.6% f.2% 8.4% 16.0%

b) Liabilities

9. Legal eserves n

Dom. Currency 101.2% 8.3% 37.8% 37.8% 37.8% 31.2%

10.Legal eserves n

Foreign urrency

19.3% 9.3% .65% 6.2%

4.1% 8.1%

C. Financialosse measured

s:

(1/2)x[(4)x(9)+(6)x(10)-(1)x(6)-(2)x(7)-(3)x(8)]/

1985-I 1986-II 1986 1986-I 986-II 1986 1987-I 987-II 1987

11. Financial

Losses

451 3,620 4,071 3,761 3,786 7,547

3,669 4,003 7,672

-mill.

I/.

-as % GDP

0.4 1.6 1.9 1.2

0.9 2.1

0.6

0.5 1.0

Note: ominal DP

-mil. /. 199,845 381,022 760,168

/ Since ll Interestates reexpressed n annual erms hesemestral evel f

financial osses

as obtained ividing et

Interestayments

y two.

Sources: ote

emanal various

umbers) or

section ; and

"SubgerencIael

Sector

onstarlolnd *Superintendencia

e Banco Seguros"

CRB)

for section .


35/149

-27-

D. Evolution

of the Quasi-Fiscal eficit

16. The

discussion below

is based on the direct

estimate of the QFD.

This is bound to be more accurate because data on neither of the following

(required

or the indirectestimate) as available:

i) a proper

weighted

average interest rate of CRB assets and liabilities; nd ii) a weighted

average exchange rate for CRB's services and napital transactions. owever,

the indirect estimate of QFD remains useful for assessing the evolution f

several components of foreign exchange subsidies nd financial losses.

17. The size of the QFD has varied considerably long the period. It

roie from 0.2 percent of GDP in 1985-I to 1.7 percent in

1985-II, mainly as

a consequence f foreign exchange subsidies nduced by CRB purchases of

foreign exchange in the open market (at a premium over the official

exchange rate). The QFD dropped

slightly to approximately .9 percent of

GDP during

the two semesters f 1986. Foreign exchange subsidies from this

source remained important

uring 1986-I and, financial losses were more

important in 1986-II.

The downward trend of QFD was drastically

reversed in

the second half of 1987 whien, trongly impulsed y foreign exchange

subsidies, FD represented .5 percent of GDP (5.0 percent

in annualized

terms). The latter were caused by a growing spread of the average export

exchange rate over the average import exchange rate and, to a lesser

degree, by

CRB purchases of

foreign exchange

in the open market.

18. Throughout the peri3d, financial losses (the other component f

the QFD) stemmed from CRB financing f the central government and the

financial system at an interest rate which, on average, was below the cost

of its funds (that is, a weighted

average between zero, which is the cost

of currency,and the remuneration f reserves of the financial system).

Interest rate losses were particularly mportant in 1986-II and 1987-II

when they represented percent

and 0.6 percent of GDP respectively.


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ANNEX4

MAIN CHARACTERISTICSOF THE PERUVIAN

AX SYSTEM

1.

The modifications ntroduced in the past

three years reduced

the

number of taxes that composes the

Central Government revenues. Minor taxes

were either derogated or transferred o the responsibility f the local

governments.

A major reform was

introduced in income tax following

recommendations

o broaden its base and reduce exemptions. In addition,

special taxes on assets revaluation nd the

capitalization f profits

were

derogated. In turn, taxes on the holding or transfer of property

(including

ehicles and on

gambling) ere

transferred o the

municipal

sphere). A description f the main components of the present system

follows.

A. Income Taxes

Net Income Tax

2. Net income of private and public enterprises s subject to this

tax, which applies to distinct forms of corporations s defined by law

(sociedades nonimas, empresas publicas, sociedades de respornsabilidad

limitada, ooperativas). Unipersonal

omestic firms are exempt. Foreign

enterprises are subject to the tax on the part of their income generated in

Peru. Capital gains receive the same treatment pplied to other sources of

income. The usual deductions, .g., expenditures incurred on production,

interest, depreciation, arry over of previous year losses, are used to

obtain the taxable income.

3. Taxpayers ay choose among three options to estimate their monthly

obligations:

(a) fixed percentages f the tax due in previous year,

whose values are set annually by Government decree.

The percentages pplied in 1987 were 10 percent of

1985 liabilities January, nd February) and 15, 16

and 25 percent of 1986 debts for the periods March-

June, July-September nd October-December,

respectively. These percentages ave been rising

in the recent years to allow for a greater

inflation. For 1988, the two first payments were

set at 25 percent of 1986 profits, and the

Government intends to readjust this value at

shorter intervals;


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(b) duodecimos

of the estimated tax liabilities or the

same year,

based on projections

ade

at the

moment

of the first payment.

Employers are requiredto withhold duodecimos

of the expected

taxes due by

their respective employees.

8. Rates. The progressive chedule is the

following:

Income

Level (in l'IT)

Rates

(Percent)

Up to 15

8

15 to 20

10

20

to 25

12

25

to 33

16

33 to 41 20

41

to 50

25

50 to 60

31

60

to 72

38

Over

72

45

*

UIT

stands for Unidad Impositiva

ributaria.

One UIT is equal to

27,300

Intis (March1988).

9. Deductionsfrom gross income

are made in the

form of credits

against

the tax. The most important eductions--the

imits

are shown

peru - policies to stop hyperinflation - vol 2

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