IMF COMMENDS PERU, BUT CHALLENGES REMAIN

UNCLAS LIMA 000338

SIPDIS

SIPDIS
SENSITIVE

COMMERCE FOR 4331/MAC/WH/MCAMERON
USTR FOR BHARMAN AND MCARRILLO

E.O. 12958: N/A
TAGS: ECON EINV EFIN ELAB PGOV USTR PE
SUBJECT: IMF COMMENDS PERU, BUT CHALLENGES REMAIN

REF: LIMA 210


1. (U) Summary: On January 26, the International Monetary Fund (IMF)
approved a stand-by agreement with the GOP for 2007-2009 during
which the IMF will support the GOP's economic program. The IMF
commended the GOP for its prudent conduct of fiscal policy in recent
years, which is largely responsible for Peru enjoying its longest
period of economic expansion on record, with low inflation, a solid
external position (a rising current account surplus with strong
foreign investment),and declining indebtedness ratios. However,
the IMF noted that the level of poverty in Peru and the structural
weakness of the economy remain as challenges. End Summary.


2. (U) A stand-by agreement is significant for Peru as it signals
the IMF's support for current macroeconomic policies and that Peru
can borrow funds from the IMF providing that Peru "observes specific
terms in order to be eligible to receive a disbursement." The new
stand-by agreement is the GOP's fourth since 2001. The GOP did not
draw on IMF reserves during the three previous stand-by agreements
nor did it on the Extended Fund Facility of 1999-2001.

IMF PRAISE FOR GOP
--------------


2. (U) A key factor in support of the IMF's decision to agree to a
stand-by agreement was Peru's recent macroeconomic performance which
now has the country "harvesting the results of good economic
policies" established over the past several years. The IMF cites
high commodity prices and strong domestic demand as key factors in
the GOP's economic performance, with prudent fiscal policy playing a
major role, expecting that strong growth may materialize even if
current high metals prices decline somewhat. The IMF pointed out
that Peru's Public Sector debt is estimated to have declined to 31.5
percent of GDP by end-2006, or 15 percentage points below its
end-2002 level. Also, inflation declined from 2.9 percent in April
to 1.1 percent in December.

IMF IDENTIFIES CHALLENGES: POVERTY AND INFORMAL LABOR
-------------- ---


3. (U) The IMF Board noted that major challenges remain, including
the high rate of poverty (51 percent),regional income disparities,
and the still-high dollarization of the economy. Structural reform,
the IMF says, is necessary to address poverty, specifically a
reduction in the size of the informal labor market and a concerted
effort to improve the flexibility of the labor market. The GOP is
currently considering a series of measures to address these labor
market issues. Javier Silva Ruete, an IMF Director, emphasized the
importance of creating better competition in Peru's labor market and
the necessity for creating more employment in the formal sector of
the economy. The report also urged the GOP to decisively tackle the
high poverty rates, improve tax policy and administration by
reducing exemptions, and simplifying the code to broaden the base.
They also warned that fiscal decentralization should be implemented
cautiously.

GOP MINISTER OUTLINES STRATEGIES TO ADDRESS THE CHALLENGES
-------------- ---


4. (U) Luis Carranza, GOP Minister of Economy and Finance (MEF),
stated January 29 that the GOP's policies aim to reduce the poverty
level from slightly over 50 percent to 40 percent during this
administration's term -- ending in 2011. The GOP's economic
strategies for poverty reduction will include a substantial
improvement in social expenditures and improvement of government
investment. The "three pillars" of the GOP's economic plan are
institutionalizing macroeconomic discipline; rationalizing public
expenditures through reduction of administrative expenses; and
reducing economic volatility by maintaining economic growth between
6 and 7 percent.


5. (SBU) Carranza said an integral part of the government's strategy
is to develop, in the near future, a tax framework that is efficient
and equitable so that more workers can be absorbed into the formal
economy through tax simplification. In the meantime, the immediate
strategy is to make better use of existing tax revenues and curtail
the loss of revenues through special exonerations. Silva Ruete
commented that the IMF is willing to provide technical cooperation
to assist the GOP in reducing the impact of exonerations on
potential tax revenue.

COMMENT
--------------


6. (U) The GOP has made steady economic progress as per reftel and
the IMF's assessment. Nonetheless, key challenges remain, of which
some of the most pressing are reducing poverty, broadening the tax
base, and reforming the labor market. Observers, such as former
Prime Minister Pedro-Pablo Kuczynski, give the government high marks
for its efforts; yet admit that while there are program initiatives
and projects, there is no overall plan. The former Prime Minister
and Finance Minister under the previous administration recently
noted that the current government had inherited an economy in
excellent condition, but warned the government that social pressures
would increase if the benefits of the country's economic growth were
not shared more broadly -- precisely Alan Garcia's campaign
platform.
STRUBLE