UNCLAS LIMA 000488

SIPDIS

SIPDIS

DEPT FOR WHA/AND, EB/IEP
COMMERCE FOR 4331/MAC/WH/MCAMERON
TREASURY FOR AJEWELL AND MMALLOY
DEPT PASS TO OPIC FOR J BRACHE
DEPT PASS TO EXIM FOR DON HULTMAN
USDA FOR FAS/OCRA

E.O. 12958: N/A
TAGS: ECON EINV EFIN PGOV PE

SUBJECT: FINANCE MINISTER, CENTRAL BANKER TALK TO TREASURY DAS
O'NEILL



1. SUMMARY. Finance Minister Luis Carranza and Central Bank
President Julio Velarde told Treasury Deputy Assistant Secretary
Brian O'Neill March 8 that they were concerned about the
appreciation of the Nuevo sol vis a vis the weakening dollar, and
the inflation that they attributed to increases in global food and
energy prices. Carranza said he believed the GOP had the right
approach in promoting both a tighter fiscal policy and a laxer
monetary policy. The GOP would continue to oppose calls for capital
controls. Velarde's analysis showed that inflation was virtually
100% imported and based largely on rising food prices. END SUMMARY.


2. Treasury Deputy Assistant Secretary Brian O'Neill met separately
with Finance Minister Luis Carranza and Central Bank President Julio
Velarde March 8 in Lima. He also met bank CEOs and economists
(septel) and was accompanied by Economic Counselor and Econ
Specialist.

TIGHT FISCAL POLICY & APPRECIATING SOL
--------------

3. Economy and Finance (MEF) Minister Luis Carranza told DAS
O'Neill that his prescription for Peru's economy in the current
situation was a laxer monetary policy and a tighter fiscal policy.
Recent media coverage has been helpful in this regard by demanding
more restrictive fiscal policies (lower current expenditures).
Carranza is aiming at an over 3% fiscal surplus in 2008. He said
the GOP is containing current expenditures but is also prioritizing
capital expenditures. He fully disagrees with calls for capital
controls to prevent a further appreciation of the Nuevo sol, which
has appreciated from over 3.04 per dollar in February 2007 to 2.82.
However, Carranza asseted that the GOP cannot let the dollar fall
abruptly as the GOP does not know where the exchange rate could end
up.


4. On February's relatively high inflation rates, Carranza
maintained that almost 100% is explained by local food items, whose
normal supply has been affected by road blocka

ges caused by seasonal
landslides. To counter inflationary pressures, the GOP lowered
import tariffs last year but will have to continue these cuts in

2008. The Fuels Stabilization Fund (currently at $400 million),
whereby the GOP pays refiners the difference between the crude oil
purchase price and the stabilized domestic fuels prices, has been a
very important measure to contain inflation.

DEBT REDUCTION
--------------

5. One thing Peru is doing, Carranza explained, is buying out debt,
like the recent Brady bonds operation. This helps to contain the
Nuevo sol's appreciation as it means genuine domestic demand for
dollars. To supplement this operation, the GOP will add 1 billion
dollars in 2008 -- thus creating demand for dollars -- to the Fiscal
Stabilization Fund, so that the Fund will total $1.5 billion at
year's end. (Note: This fund's purpose is to have the means to
respond to major fiscal revenue decreases, domestic emergencies or
international crises that could seriously affect the national
economy. End note.) Another policy action will be the sale of the
remaining shares in several privatized companies, about 30% of their
capital, to generate funds for pensions. 85% of the labor force has
no health, pension or fringe benefits.

CREDIT FOR SMES?
--------------

6. Carranza suggested that both governments could cooperate in
facilitating credit to enable small and micro-enterprises to export.
This way, society's lower classes could feel the benefits of the
U.S.-Peru Trade Promotion Agreement (PTPA) as well as Peru's opening
to trade. O'Neill informed Carranza that OPIC, MIF and Treasury
will attend the early April IDB meeting in Miami, when they could
talk about this subject. Carranza confirmed that he will
participate in the Regional Finance Ministers meeting.

CENTRAL BANK: WE ARE IMPORTING INFLATION
--------------

8. Central Bank President Julio Velarde expressed satisfaction over
the good situation of the Peruvian economy, but contended it is

being complicated by imported inflation of food items. After
Bolivia, Velarde said Peru has the heaviest weight of food in its
Consumer Price Index (CPI), mainly wheat, soy beans and corn, as
well as petroleum-related materials like plastics and fertilizers.
Velarde expressed concern about ethanol in the U.S. and its
inflationary effect on corn, which is poultry's main feedstock in
Peru. He also explained that in the first two months of 2008,
inflation in Peru was zero if food inflation was excluded. So the
Central Bank is maintaining its inflation target range of 2% +/-
1%.


9. On the dollar/Nuevo sol exchange rate, Velarde said the Bank is
prepared to counter any currency attack, like the one of January
(which tried to force a sudden, major appreciation of the Nuevo
sol). He added that there is consensus in the GOP that foreign
exchange controls are not advisable.

ECONOMISTS GENERALLY RATE GOP WELL
--------------

10. Generally, economists support the government's strategy. Chief
economists from banks with large foreign equity Hugo Perea
(BBVA-Banco Continental) and Guillermo Arbe (Scotiabank), and
think-tank director and former Economy vice-minister Roberto Abusada
agreed that policies pursued by the GOP are generally good. Arbe
contended, however, that there is some question as to how farsighted
reduction of current expenditures is, when in an important part of
the country there is still what locals call "absence of the state"
(e.g., insufficient police forces to fight common crime; lack of or
insufficient health services or education; etc.). They expected the
pressure on the Nuevo sol against the dollar to continue, most
expecting the dollar to decline 10-15% by the end of 2008. The only
tool left to the GOP to turn that trend might be Nuevo sol
devaluation, as suggested by Abusada.


11. Deputy Assistant Secretary O'Neill was unable to clear this
message.