Fiscal Policy

The government balance is a budgetary item used to determine the balance between the government spending and the revenue generated from taxes. Although the government spending increased by 19.1 % in the 2012 budget, the government balance showed a strong surplus with a tax burden of 14.5 % of the total domestic tax (The Heritage Foundation, 2013). Figure 1 shows that the government has been operating with a surplus budget from 2010-2012. The government of Peru has maintained an expansionary since 2007 to protect its economy from the adverse effects of global financial crisis. The government has been pursuing the expansionary policy by targeting the key budgetary items that can help in increasing the aggregate expenditure and aggregate demand by increasing the government spending and reducing taxes. Specifically, the government of Peru reduced the size of public debt and increased the size of fiscal stabilization funds. This has helped the government in reducing the output gap that resulted from the pro-cyclical fiscal policy.

Figure 1: Peru government budget

 

Source: Trading Economics (2013)

The debt-to-GDP ratio is an economic indicator that is widely used to evaluate the health of the economy of a given country. The ratio is computed by determining the amount of national debt as a parentage of the gross domestic product. The government of Peru has reduced the amount of accumulated debt from 2008 to 2012. The data given by Global Finance (2013) indicated that the public debt as a parentage of GDP from 28.4 % in 2009, to 24.6 % in 2010, 21.6 % in 2011 and 20.7 % in 2012. The government’s efforts to reduce the debt ratio resulted in the ranking of Peru as the third country outside Europe with the lowest debt to GDP ratio. The approach to reduce the ratio is reasonable and safeguards the government from the effects of fiscal irresponsibility. The Euro convergence requires countries to maintain their debt-to-GDP ratio below 60 %. This is because the low debt-to-GDP ratio is an indication of the capacity of the country to produce a large number of goods and services, which help in the generation of profits that are high enough to pay the debts. Peru’s fiscal policy is among the best in the Latin America and has helped the country in establishing fiscal stability and strengthening the budget process after the global financial crisis.

Figure 2: Government debt

 

Source: Trading Economics (2013)

Monetary Policy

The government of Peru has emphasized on the use of the reference interest rate to regulate the money market in the country. The reference rate is the interest rate benchmark on which the floating rate and interest rate are based. The Central Reserve Bank of Peru retained the interest rate at 4.25 %, a rate that has been in force since 2011 (Whelan, 2013). The interest rate reduced from 6.5 % to 1.25 % in 2009 but was raised by 175 bps in 2010 and 125 pbs in 2011. The low interest rate of 1.25 % was set as a stimulus measure to facilitate the process of economic recovery. However, this rate has been increased slightly following the rapid rate of disinflation and expected decline in the rate of inflation amidst a weaker economy. The decision to maintain a stable reference rate (at 4.25 %) resulted from the projection that the inflation rate, which had reduced to 2.65 % by the year 2011, would continue to fall to about 2 %. This would help the government achieve the midpoint of the target range of 1-3 % by the end of the year. In addition, the Central Bank of Peru suggested that the national economy has shown reasonable stability in the long-term rate, thus resulting in a projected rise in interest rate to 4.33 % by 2014. The central bank intends to maintain a stable interest rate until the global economy indicates reasonable improvements.

Figure 3: Trend in interest rate

 

Source: Focus Economic (2013)

Money supply in Peru has been increasing exponentially in almost the last one decade. The trend in the money supply as shown in Figure 4 indicates that Peru has been using an expansionary monetary policy to regulate its economic growth. The value of the money supply was below 2 billion in 1992 and approximately 14 billion in 2012. This suggests the existence of some relationship between the interest rate and money supply. Money supply increases with a decrease in the interest rate, but the money supply continues to increase even when the interest rate is held constant for some period. The expansionary monetary policy contributed towards the economic recovery in Peru, thus making its performance better than economies in the region. The monetary policy is appropriate, and an effective tool that has assisted Peru in the recovery process, but there is a need to loosen the monetary policy given that the global economy has established positive trend in the recovery after the financial crisis.

Figure 4: Peru monetary policy

 

Trading Economics (2013)

Review of comments on fiscal policies and monetary policies

The expansionary fiscal policy adopted by the government of Peru was effective and made significant contributions in the establishment of a sustainable economic growth rate. Both the government expenditure and tax revenue increased but at different rates, which resulted in an exponential decline, in public debt. The two approaches used to manage public debt include an increase in the share of domestic debt relative to the total public debt and extension of average debt maturity from 7 years to 13 years in by the year 2012. According to Rossin & Loyola (2012) revenues from exports and tax collection increased exponentially from 14 % to in 2001 to 18 % in 2011 as shown in Figure 5, which is an indication of effective fiscal policies. The efforts to reduce the rate of inflation have contributed to financial stability in Peru despite the weakness in dollarization. This was accomplished through the reserve requirements that prevented the occurrence of significant credit swings.

Figure 5: Government revenue and export price index

 

Source: Rossin & Loyola (2012)

The long-term strategy of the Peruvian government is to increase economic stability to withstand the adverse effects of global financial crisis. To this end, the government has several incentives that give the local firms competitive advantage in the local market and at the international level. These incentives are designed to enhance the performance of individual industries. The incentives are entailed in the legal frameworks, which include the laws for the promotion of the agricultural sector, benefits for reinvestment in the private sector educational institutions, benefits for the non-distributed income in mining, and exemptions and benefits for tourism and hotel sector. In addition, the stability agreements and double taxation agreements enhance the competitiveness of the local business by reducing the cost of operation.

The labor laws in Peru ensure that there is a balance in work-life among the both private and public workers. The law limits the maximum working time to 8 hours a day and 48 hours per week, and work beyond this is paid as overtime at specified rates. However, the income tax rates for personal income and corporations create no comparative advantage between Peru and other countries. For example, the corporation tax rate is 30 % while the graduated tax rate for personal income is 15 % for up to 27 UIT, 21 % for 27-54 UIT and 30 % for over 54 UIT (Tax Rates, 2013). The government of Peru should reduce the rate to increase the competitiveness and productivity of citizens and local corporations. Additionally, the major obstacles to competitiveness (including infrastructure, weak institutions, and deficiencies in innovation) should be rectified.

 

 

 

 

 

 

 

 

 

 

 

References

Focus Economic (2013, June 13). The central Bank keeps monetary policy stance. Barcelona: Focus Economics.

Global Finance (2013). Peru country report: Data on GDP and economics information. Retrieved July 28, 2013, from http://www.gfmag.com/gdp-data-country-reports/199-peru-gdp-country-report.html#axzz2aLE4gWBE

Rossin, R. & Loyola, J. (2012). Fiscal policy considerations in the design of monetary policy, in Peru. Lima: Central Reserve Bank of Peru.

Tax Rates (2013). Peru tax rates. Retrieved July 28, 2013, from http://www.taxrates.cc/html/peru-tax-rates.html

The Heritage Foundation (2013). 2013 Index of economic freedom. He Heritage Foundation. Retrieved July 28, 2013, from http://www.heritage.org/index/country/peru

Trading Economics (2013). Peru Government debt to GDP. Trading Economic. Retrieved July 28, 2013, from http://www.tradingeconomics.com/peru/government-debt-to-gdp

Whelan, J. (2013). Unchanged Peruvian monetary policy. Currency Thoughts. Retrieved July 28, 2013, from http://currencythoughts.com/2013/02/08/unchanged-peruvian-monetary-policy/

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