Background Debt Trends

Peru’s debt levels have been on a declining trend. The total gross stock of Peru’s pub-lic debt¹declined from over 63 percent of GDP in 1993 to about 40 percent in 1997. The debt ratio increased to about 50 percent in 1999 and declined again in 2005 to 37.8 percent of GDP (Figure 1 and see also Table A.I.1 in Annex I, which includes general government historical debt ratios for a set of countries).²These trends were mainly as a result of improvements in fiscal balances at different levels of government during the economic expansions of 1995–97 and 2003–05 (Figure 2), privatizations, and revaluation of the local currency during 2001–05. These out-comes are in line with a study on emerging market debt dynamics that finds that pri-mary fiscal surpluses and real GDP growth were the main contributors to reductions in the debt-to-GDP ratio in a set of 21 countries from the period 1991–2002.³The same variables appear to explain the reduction of external debt-to-GNP ratio in the case of debt default/restructuring countries, whereas for nondebt default/restructur-ing countries the explanatory variables are net repayments and output growth.⁴

The general government and the nonfinancial public sector (NFPS) have posted a series of improving balances, strengthening from –2.8 percent of GDP and –3.3 percent of GDP, respectively, in 2001 to about –0.5 and –0.3 percent in 2005 (Fig-ure 2). These balances reflect increases in revenues and, to a lesser extent, declining expenditures. On revenues, tax collection has improved since 2002 due to transitory factors such as the increase in Peru’s export prices, economic growth, and the tax reform enacted in 2002.⁵In 2005, total revenues reached an estimated 18.3 percent of GDP, up from 17.4 percent in 2001. On the expenditure side, total general gov-ernment expenditures decreased to 16.6 percent of GDP in 2005 from an average of over 21 percent of GDP in 1999 and 2000.

Figure 1. Peru: Internal and External Public Debt

10 0 20 30 40 50 60

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005*

Percent of GDP

External debt Domestic debt Source: Central Bank and MEF.

Although the current debt-to-GDP ratio of about 38 percent may be thought an acceptable level for Peru, research has shown that high levels of debt can have signif-icant negative impact on growth (Patillo, Poirson, and Ricci, 2004), and that coun-tries with high inflation and default history have higher risks of a debt crisis even with low external debt levels of 15 percent of GNP (Reinhart, Rogoff, and Sevastano 2003). IMF research suggests that the conditional probability of a crisis is zero with debt levels of less than 18.7 percent of GDP, and increases to 10 percent at debt els above that threshold (IMF 2002). In Latin America, only Chile has reached lev-els of debt to GDP below these levlev-els. The recent crises in Argentina and the Dominican Republic illustrate the fact that debt-to-GDP ratios of 40 and 27 percent cannot be considered safe levels (See Figures A.I.1–A.I.3 in Annex I). In the case of Peru, further declines in debt-to-GDP ratio would be beneficial. Ultimately, fiscal surpluses must be achieved according to the government lifetime budget constraint to ensure fiscal sustainability.

Debt Structure and Risk Analysis

The estimated 2005 total public debt in Peru stood at US$30 billion: US$22.27 bil-lion (28.1 percent of GDP) external and the remaining US$7.68 bilbil-lion (9.7 percent of GDP) domestic (see Figure 1 and Table 1).⁶External debt thus represents 75 per-cent of the total, but the total funding raised in foreign currencies is even higher, since more than 22 percent of the domestic debt is denominated in dollars.

The issuance of dollar-denominated liabilities in the local market is a reflection of the financial dollarization process underway in the Peruvian economy since the early 1990s. Conscious of the increased vulnerabilities due to dollar-denominated public and private sector debt, the authorities have adopted a number of measures to grad-ually reverse this process, including actions to promote a broader and deeper local currency market for government securities.

Figure 2. Public Sector Overall Balances (percent of GDP)

4.0 3.0 2.0 1.0 0.0 1.0

94 95 96 97 98 99 00 01 02 03 04 05

NFPS General government

Source: Central Bank and MEF.

The greater use of local currency instruments started in 2001 and has accelerated since 2003 (through the Programa de Creadores de Mercado), as evidenced by the greater size and longer terms of local currency bonds. However, because of the large debt stock relative to the borrowing flows, external debt in Peru is still dominant (see Figure 4).

Although the external debt is mainly denominated in dollars, 36 percent of exter-nal liabilities from official funding sources and the Paris Club are denominated in other currencies (Figure 5). Currently the Peruvian Debt Management Agency (Dirección Nacional de Endeudamiento Publico—DNEP) lacks a benchmark for the currency composition of the overall portfolio.

The portfolio structure by funding source is changing rapidly as a result of Peru’s greater access to the international capital markets and the refinancing and prepay-ment of Paris Club loans with the proceeds of bonds denominated in dollars and nuevos soles. As shown in Table 2, Paris Club was the main government creditor in 2002, but in 2005 outstanding bonds and multilaterals were far more important.

This trend is expected to continue for the next 10 years, reflecting outstanding Paris Club loans coming due, and highlights the importance of increasing the size of the Figure 3. Tax Revenues of the NFPS

12 13 14 15 16

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Percent of GDP

Tax revenues Non-tax revenues

Source:Central Bank and MEF (2006a).

Table 1. Public Debt (in US$ millions)

Debt 2000 2001 2002 2003 2004 2005

Total Public Debt 24,273 24,756 26,502 28,896 30,905 29,967

(% of GDP) 45.4 46.1 46.9 47.5 44.4 37.8

Domestic Debt 5,068 5,79 5,787 6,128 6,439 7,688

(% of GDP) 9.5 10.8 10.2 10.1 9.2 9.7

External Debt 19,205 18,967 20,715 22,768 24,466 22,279

(% of GDP) 35.9 35.3 36.6 37.5 35.1 28.1

Source: MEF (2006a).

domestic market and the need to strengthen access to the international capital markets.

Refinancing exposure relates principally to maturing Paris Club loans. Following the prepayment of US$1.55 billion worth of Paris Club debt in August 2005, refi-nancing risk has been reduced significantly for the period 2005–09. The stream of annual repayments fluctuates around US$350 million from 2006 to 2009; however, it surpasses US$600 million from 2010 to 2013, as illustrated in Figure 6, and these Figure 4. Composition of Public Debt, 2000–05

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000

2000 2001 2002 2003 2004 2005

Million US$

Domestic debt External debt Source:MEF (2006a).

Source:MEF (2006a).

Figure 5. Composition of External Public Debt as of March 2006 (percent of currency)

Other, 9.1 Yen, 11.4

Euro, 11.3

USD, 68.2

flows, combined with maturing bonds, produce an important concentration of repayments in 2012, 2014, and 2015.

Refinancing is also a preoccupation in the domestic market, even though there is no short-term concentration of repayments. Figure 7 illustrates principal repayments exceeding US$300 million per year for the six years following 2005; these liabilities may pose significant refinancing risk if market conditions turn less favorable. Close to US$400 million have been rolled over as of 2005, and US$320 million will need to be rolled over during 2006.

Of the total debt, 41 percent has a floating interest rate, while most of the remain-ing 59 percent has fixed rates.⁷Floating-rate debt consists of the external debt con-tracted with multilateral institutions. This percentage takes into account Paris Club loans refinanced with funding from the international and domestic capital markets.

Table 2: Public Debt by Sources of Funds 2000–05 (US$ millions)

Year IFI Paris Club Bonds Other Subtotal Loans Bonds Subtotal Total 2000 5.830 8.391 3.727 1.257 19.205 1.047 4.022 5.069 24.274 2001 6.536 7.688 3.727 1.004 18.955 1.023 4.766 5.789 24.744 2002 7.044 8.188 4.424 1.059 20.715 937 4.851 5.788 26.503 2003 7.359 8.658 5.630 1.121 22.768 968 5.160 6.128 28.896 2004 7.875 8.508 6.944 1.139 24.466 929 5.541 6.470 30.936

2005 7.983 5.696 8.393 207 22.279 890 6.799 7.689 29.968

Source: BCNP and MEF.

Figure 6. External Debt Amortization Profile (US$ millions)

0 500 1,000 1,500 2,000 2,500 3,000 3,500

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040

IFIs Paris Club Bonds Others

Source: MEF.

With 84 percent of the total debt denominated in foreign currencies, currency risk is the authorities’ main concern. To reduce currency risk, the debt management unit is developing a market for securities in nuevos soles and is gradually changing the portfolio’s currency mix. The share of local currency debt rose from 8 percent to 16 percent between 2003 and 2005. Issuance of dollar-denominated debt in the domestic market has been suspended since 2000, when dollar-denominated debt accounted for over 80 percent of the domestic debt; by September, 2005, this per-cent had fallen to under 25 perper-cent. As well, a portion of the external bonds is being refinanced with local currency bonds. An illustration of the government’s efforts in this regard is the debt exchange conducted in 2005, which allowed it to redeem US$262 million worth of dollar-denominated bonds in exchange for bonds in nuevos soles (S/. 851 million), including a bond with a 10-year maturity; and an additional US$119 million exchange of dollar-denominated bonds for inflation-indexed bonds (VAC) maturing in 2024.

Going forward, currency risk may increase if the Central Bank (BCRP) lessens its intervention in the exchange rate market and implements a monetary policy more oriented towards domestic goals.⁸In addition, a downturn in commodity prices or a relaxation of capital controls may result in net foreign currency outflows that would pressure the exchange rate. Given its currency structure, this clearly represents the debt portfolio’s chief exposure.

Refinancing risk is benign. With the exchange of internal debt and the prepay-ment of some Paris Club obligations, the borrowing requireprepay-ments for 2006 are mod-Figure 7. Redemption Profile of Domestic Debt as of September 2005

Source: MEF.

0 100 200 300 400 500 600

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034

Million USD

Loans Bonds

erate. Close to 20 percent of outstanding Paris Club debt to be refinanced in the market between 2005 and 2009 has been prepaid with the proceeds of long-term paper, half of which was issued in local currency. As a result of the exchange referred to above and the replacement of external debt, the average maturity of the domestic debt portfolio increased from 5.9 years to 8.9 years (BCRP 2005).

The debt management strategy has also significantly reduced interest rate risk.

On the one hand, prefinancing and substituting short-term maturing Paris Club loans with long-term, fixed-rate bonds has reduced the share of debt that will be repriced in the next few years. On the other hand, there is a consistent drive to increase the share of fixed-rate debt, not only using new borrowing, but also through interest rate swaps on existing debt.⁹The percentage of fixed-rate debt increased from 47 percent in 2002 to 59 percent in 2005.

Key Issues for Debt Sustainability, Debt Management, and Debt Market Development

Following from the above discussions, a number of key questions can be asked from a policy maker’s standpoint: (i) Taking into account the potential impact of a down-turn in the economy driven by the end of the current external boom,is the debt fis-cally sustainable under the current fiscal policy stance?(ii) Given the potential for higher funding needs (end of current external boom), and the market’s limited capacity to absorb domestic debt,how can debt management practices contribute to improving debt sustainability?(iii) Taking into account that the domestic debt market is relatively small and illiquid and that macroeconomic or financial shocks may result in a debt market squeeze, what can be done to ensure the government has sustained and increasing access to funding in local currency in the domestic market?The following sections attempt to answer these questions.