Big mining investments and extra US monetary stimulus are set to extend a rise in Peru's currency that has already taken the sol to a 16-year high despite sweeping official efforts. Peru's central bank, which has bought a record $11.6 billion this year in interventions on the spot market, faces a dilemma because it has a limited number of tools to avert sharp currency swings in the partially dollarised economy, and the finance ministry has ruled out using capital controls that would limit the sol's advances.
That basically leaves the central bank the option of buying even more dollars on the spot market, allowing pension funds to put more money overseas to boost demand for dollars, or raising reserve requirements for bank deposits or loans. These tools have been employed in varying doses over the last few years. But they have only slowed the pace of appreciation, not stopped it, and the chief of the central bank says the sol might retreat only several years from now.
Though many Latin American countries face appreciation pressures that hurt export competitiveness, Peru's central bank has a more difficult job than most of its peers. That's because more than 40 percent of all bank deposits in Peru are denominated in dollars and loans denominated in dollars are widely available. Right now, with the sol gaining, some Peruvian consumers are rushing into loans in dollars - betting their monthly payments will fall over time in domestic currency terms.
But the central bank says it is worried they may eventually get stung and that it must limit volatility to prevent consumers who get paid in soles but owe debts in dollars from being squeezed. This concern among policymakers outweighs complaints from exporters that a stronger sol will dent the country's economic growth streak of 36 straight months.
"Our primary worry is vulnerability from loans in dollars. We don't want the sol to appreciate beyond what fundamentals merit because at some point it will retreat," Central Bank President Julio Velarde told Congress on Wednesday. "This could happen in three, four or five years. We are concerned about what could happen with the financial system when it does retreat ... so it's better to try to prevent (excessive strengthening)."
In addition to the expected impact from more stimulus announced by the Federal Reserve in September, Peru's large fiscal surplus, low inflation and surging domestic demand have attracted new investors. They have been encouraged by surging domestic demand that has offset a dip in the country's vast mineral exports over the past few months.
"There is a restructuring of portfolios going on in favour of the sol. There is a perception among people in the market that the sol is a stronger currency and therefore they're betting on it and holding assets in soles," said Jorge Chavez, a former central bank president and chief of the Maximise brokerage in Lima. A Reuters poll on October 4 of 17 emerging market economists showed the sol holding almost steady at 2.57 for the next 12 months. But the feeling among nearly 10 Peru specialists consulted by Reuters is considerably more bullish, with their median forecast for late 2013 at 2.45 for a gain of 5.3 percent.
Ricardo V. Lago, a former World Bank official who has long been a fan of Peru's economy, forecast the most gains for the sol - 7 percent to 2.40 per dollar by the end of 2013. It is currently at a 16-year-high of about 2.578 per dollar. It has strengthened 4.4 percent so far this year and is expected to gain another 1.2 percent to 2.55 per dollar by the end of 2012, the local economists said. The sol has appreciated despite heavy and frequent interventions by the central bank. Those purchases, which Velarde has called the biggest in the region for the size of Peru's economy, have averted gains that might have been larger.
In neighbouring Chile, the central bank has refrained from intervening this year and in Mexico it has largely held back from doing so. The peso currencies of both those countries have appreciated about twice as much as the sol in 2012. In the last decade, the sol has gained 26 percent, helping a "de-dollarization" of the economy. Ten years ago, 7 0 percent of Peruvian bank deposits were held in dollar-denominated accounts. Now only 43 percent are. "I would say the sol will be at 2.40 per dollar at the close of 2013," Lago said. "The sol will continue to appreciate, and even if there were a bump in the road in 2013 because of the European crisis we can expect continued economic growth in 2015 and 2016. Plus, the avalanche of mining projects supports this hypothesis."
Peru has a portfolio of mining projects worth $53 billion in coming years, though some of them have been held up by social protests. Foreign direct investment and portfolio inflows over the last 3.5 years were $30 billion, more than neighbouring Bolivia's gross domestic product.
Velarde said he has been intervening frequently in the local spot market because the "appetite for the sol is amazing" and that, unlike years past, it has become a darling of investors. "The situation has reversed and now it's the world's most conventional funds, the most conservative ones, that are buying Peru," Velarde said in late September. Powered by domestic demand, Peru's economy is expected to grow 6 percent this year, the fastest pace in South America, and expand at a similar annual rate through 2014.
At the same time, investment inflows more than cover the current account gap - forecast at 3.9 percent of GDP this year because of a downturn in mineral exports. "These are the elements that will determine the exchange rate in the medium term. They suggest the exchange rate will continue to fall," said Hugo Perea, the head of economic research at BBVA Banco Continental.