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Chapter 14. Capital Flows, Monetary Policy, and Foreign Exchange Intervention in Peru

Alejandro Werner, and Alejandro Santos
Published Date:
September 2015
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Information about Western Hemisphere Hemisferio Occidental
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Renzo Rossini, Zenón Quispe and Donita Rodríguez 

This chapter explains the main features of sterilized interventions in the foreign exchange market by the Central Reserve Bank of Peru (Banco Central de Reserva del Perú [BCRP]), in a context of an economy with a financial system that operates with two currencies.1 The interventions took place in an environment in which the BCRP developed a policy framework based on a risk management approach that balanced the vulnerabilities associated with partial dollarization of the banking system with the incorporation of nonconventional policy tools such as intervention in the foreign exchange market, accumulation of international reserves, application of different forms of reserve requirements, and different forms of liquidity sterilization. This policy framework controlled the risks of deterioration in the quality of bank assets linked to the balance sheet effects of sharp movements in the exchange rate on the partially dollarized nonfinancial private sector portfolio of assets and liabilities. The policy framework also kept the conventional transmission mechanism with the short-term interest rate as the operational instrument to control inflation, and isolated the Peruvian economy from the effects of the global financial crisis in such a way that Peru was able to recover growth with low inflation and avoid major disruptions from the surge of capital inflows.

In an environment of partial dollarization, the possibility that local banks can extend credit in foreign currency complicates the normal transmission mechanisms of monetary policy. On the one hand, the policy rate cannot affect these flows and their interest rate. On the other hand, a sharp depreciation can produce a credit contraction resulting from deterioration in the quality of bank assets linked to balance sheet effects on the partially dollarized nonfinancial private sector portfolio of assets and liabilities.

As a result of the risks and vulnerabilities related to partial dollarization, the BCRP has adopted a policy framework that adds several instruments to the conventional policy rate as a tool. These instruments can be grouped as quantitative or nonconventional. For example, higher reserve requirements on short-term foreign exchange liabilities are used to modulate this source of credit, and the BCRP also intervenes in the foreign exchange market, sterilizing excess liquidity with its own instruments that are restricted to local participants. Foreign exchange intervention aims to reduce the volatility of the exchange rate and accumulate international reserves, without any type of signaling or commitment about the level or tendency of the exchange rate.

This policy framework allowed the BCRP to prevent major disruptions and maintain the flow of credit during the global financial crisis. The conventional transmission mechanism is also in place, with the interest rate as the instrument to control inflation.

This chapter discusses four issues related to this policy framework, with the first issue being the selection of a discretionary type of foreign exchange intervention vis-à-vis a rule-based one. Second, the chapter examines sterilization with respect to its cost, the instruments used, and the degree of access to nonresidents. The chapter then looks at the use of reserve requirements as a complement to the conventional policy rate tool, before turning to the issue of competitiveness in an environment marked by strong capital flows.

Monetary Policy Under Partial Dollarization

Persistently high inflation and severe macroeconomic imbalances in Peru during the 1970s and 1980s, along with the lack of inflation-adjusted instruments, led households to hold foreign currency as a store of value. This process of financial dollarization increased significantly during the hyperinflation of 1988–90. In the years that followed, a wide-ranging package of financial system and monetary and fiscal policy reforms were introduced to stabilize the economy. After achieving macroeconomic stabilization during the 1990s, the BCRP implemented a fully fledged inflation-targeting regime in 2002 with an initial point target of 2.5 percent, and since 2007 a continuous point target of 2 percent, both with a tolerance range of ±1 percent. As a result, during the past decade the average annual inflation rate has been 2.3 percent. However, despite improved economic conditions and stable macroeconomic fundamentals during the past 20 years, inertia, transaction costs, and still-underdeveloped capital markets explain the slow but continuous decline of the share of deposits and credits in dollars, from a peak of 82 percent in 1999 to 44 percent in 2010 (Figure 14.1).

Figure 14.1Peru: Credit Dollarization, 1993–2010

(Percent of total credit)

Source: Authors’ calculations.

Dollarization magnifies the reaction of financial intermediaries to sharp movements in their funding or to high exchange rate volatility. As a result, the economy is prone to credit booms and busts associated with flows of foreign currency deposits, foreign credit lines, or other capital flows. It is also prone to exchange rate movements that affect the quality of the credit portfolio. Dollarization therefore alters the transmission mechanism of monetary policy and increases the liquidity and solvency risks of the financial system because:

  • The maturity mismatch generated in foreign currency introduces higher liquidity risks.

  • Solvency risk increases when the assets of nonfinancial economic agents are mainly denominated in domestic currency, while their liabilities are denominated in dollars.

After various external shocks, especially the Russian crisis of 1998, the BCRP designed an action plan to prevent a credit contraction during events of financial stress. Thereafter, the monetary policy framework in Peru, in addition to the common features of an inflation-targeting regime, began to include a set of measures to deal with the risks of financial dollarization. The strategy included three levels of liquidity: accumulation of international reserves by the BCRP, high liquidity requirements of financial intermediaries, and a solid public sector financial position resulting from disciplined and coordinated fiscal policy. In line with this strategy, international reserves increased from 12.9 percent of GDP in December 1994 to 28.8 percent in December 2010 (Figure 14.2).

Figure 14.2Peru: Net International Reserves

(Millions of U.S. dollars and as a percent of GDP)

Source: Central Reserve Bank of Peru.

Note: NIR = net international reserves.

The set of monetary policy instruments can be separated into the normal price instrument of the interest rate and nonconventional quantitative instruments such as the reserve requirement or the structure of the central bank balance sheet. The importance of the latter group of policies has gained attention with the innovative actions performed by central banks during the subprime financial crisis aimed at avoiding or limiting a collapse of credit. The motivation to consider measures that act more directly on credit flows—rather than waiting for the more indirect impact through changes in interest rates—is that during credit booms or crunches, short-term interest rates became less effective in signaling the stance of the monetary policy to financial intermediaries. These intermediaries become insensitive to policy actions based on movements in the interest rate, but more inclined to react to changes in expectations and risk appetite.

The quantitative instruments are part of a more ample risk management approach of monetary policy that includes preventive and corrective measures oriented toward avoiding a credit boom or crunch and preserving the transmission mechanisms of monetary policy and financial stability. Figure 14.3 illustrates the common transmission mechanism of monetary policy that uses changes in the short-term interest rate to control inflation by influencing the output gap, but adding the effect of nonconventional quantitative policies affecting banking credit, and in this way also affecting the output gap and the inflation rate.

Figure 14.3Monetary Policy Transmission Mechanisms

Source: Central Reserve Bank of Peru.

Foreign Exchange Intervention

Interventions in the foreign exchange market by the BCRP aim to reduce the volatility of the exchange rate without signaling or committing to a certain exchange rate level. A predictable exchange rate would in practice transform the exchange rate system into a type of pegged system, thus ensuring success of one-sided bets by speculators and negating the value of the intervention. One way to avoid predictability and to reinforce the central bank’s commitment only to price stability is to use a rule-based type of intervention based, for example, on prean-nounced amounts of foreign exchange purchases in the market. However, it is possible that different events can make intervention either unnecessary or insufficient, forcing the bank to abandon or change the rule. An alternative type of intervention is one that is more discretionary. Under this approach, having a clear idea that it is important to avoid signaling an exchange rate, the central bank is able and willing to engage in foreign exchange operations without a prean-nounced amount of operations.

The main type of foreign exchange intervention is through direct operations with commercial banks in the spot market and at the prevailing exchange rate (Armas 2004). The BCRP can also make swaps through temporary purchases or sales of foreign currency, using an auction procedure. The latter instrument is used when the forward market in foreign currency is putting pressure on the exchange positions of local banks. It is also important to consider that at maturity the swaps can either be renewed or exercised, with both possibilities having the same characteristics as an intervention in the market.

Figure 14.4 illustrates the momentum and types of foreign exchange intervention of the BCRP together with the evolution of the exchange rate since 2007. Three clear episodes can be identified: before the collapse of Lehman Brothers, after the collapse, and after the announcement of the second round of quantitative easing by the Federal Reserve. The figure also identifies direct intervention in the foreign exchange spot market and placements or maturing swap operations. During these three stages, the BCRP did not attempt to reverse the tendencies, but rather to reduce the degree of volatility. It can also be seen that the daily amount of interventions does not follow any particular type of rule.

Figure 14.4Peru: Exchange Rate and Central Bank Net Foreign Exchange Intervention

(Exchange rate in nuevos soles per U.S. dollar; foreign exchange interventions in millions of U.S. dollars)

Source: Authors’ calculations.

Note: QE = quantitative easing.

Table 14.1 shows the three recent stages of surges and contractions of capital flows, how they materialized in the exchange markets, and the amount of foreign exchange intervention by the BCRP. The amount of purchases was US$8.7 billion before the Lehman Brothers collapse. During the period of acute crisis in the last quarter of 2009, following the collapse of Lehman Brothers, the BCRP sold US$4.8 billion (or US$8 billion if we include the US$3.2 billion in balances at maturity of swaps). The amount of purchases then rose to US$6.5 billion (including US$200 million in swaps) with the arrival of signals of normalization and the announcement and implementation of the second round of quantitative easing.

Table 14.1Peru: Spot and Forward Exchange Markets(Millions of U.S. dollars)

Post–Lehman Brothers
Capital Inflows to

Emerging Markets

(Jan 2008–Apr 2008)
Deepest Stage of the

Crisis and QE:1

(Oct 2008–Mar 2009)
Full Recovery in Emerging

Markets and QE:2

(Jun 2010–Dec 2010)
Pension Funds−1,5962,541−768
Nonresident Investors−1,0131,944−1,871
Other Residents−6,1193,499−3,830
Private, Nonfinancial−6,1192,489−4,450
Financial Institutions−11,010619
Central Bank Interventions8,728−7,9846,469
Source: Authors’ calculations.Note: Positive figures imply net demand; negative figures imply net supply positions. QE = quantitative easing.
Source: Authors’ calculations.Note: Positive figures imply net demand; negative figures imply net supply positions. QE = quantitative easing.

The BCRP’s foreign exchange intervention has been effective in reducing the volatility of the nuevo sol. As Figure 14.5 shows, the Peruvian currency has been very stable in comparison with those of other countries in the region. The coefficient of variability has been close to 5 percent, whereas for other economies it has reached values between 8 percent and 13 percent.

Figure 14.5Nominal Exchange Rate

(Variability coefficient, standard deviation/average)

Source: Authors’ calculations.


To avoid side effects of foreign exchange intervention on the ability to control inflation, the central bank needs a sufficient capacity for sterilization. There are two crucial factors that helped to accomplish this goal in the case of Peru: a solid fiscal position and the increasing demand for a monetary base. Table 14.2 presents a simplified balance sheet of the BCRP that shows that fiscal deposits in the central bank represent 10 percent of GDP, which is close to 35 percent of international reserves. The fiscal contribution to sterilize the liquidity created by intervention in the exchange rate market also helps reduce pressure on the real exchange rate.

Table 14.2Balance Sheet of the Central Reserve Bank of Peru as of January 2011(Percent of GDP)
Net international reserves28.8%Treasury deposits10.3%
Central bank securities1.8%
Term deposits of banks4.2%
Reserve requirements6.1%
Other liabilities1.0%
Currency (notes and coins)5.4%
Source: Central Reserve Bank of Peru.
Source: Central Reserve Bank of Peru.

Sterilized interventions should not affect the ability to use the short-term interest rate as a policy tool. To assess the impact of foreign exchange intervention on the variability of the interest rate, we computed a ratio indicating the volatility of the interbank interest rate relative to the variability of the exchange rate in different economies with floating exchange rates. Figure 14.6 indicates that Peru has the lowest ratio.

Figure 14.6Volatility of Interest Rates Relative to Volatility of Exchange Rates

Source: Authors’ calculations.

Another concern about sterilization is the financial cost from the carry cost or interest rate differential from returns of international reserves with the interest rate paid to the different liabilities of the central bank (Rossini, Quispe, and Gondo 2008). In a situation with higher local interest rates, the central bank could face financial losses. One component that eases this burden is the currency, which is a liability free of interest rate. As shown in Figure 14.7, the return on foreign assets held by the BCRP exceeds the average cost of its liabilities.2

Figure 14.7Central Bank Net International Reserve Yields and Cost of Funds


Source: Authors’ calculations.

Finally, an important issue with sterilized interventions is that they can create an incentive to attract further capital inflows due to the interest rate differential between the local and international interest rates. This possibility could neutralize monetary policy either by paralyzing the use of the policy rate or by attracting further foreign financing. These capital flows have an additional incentive, which is the expectation of appreciation of the local currency.

The surges of capital inflows before the collapse of Lehman Brothers and the effects of the second round of qualitative easing in Peru resulted in the growth of demand for different financial instruments in local currency by nonresident participants, including the sterilization papers of the central bank. To avoid the circularity of sterilized intervention attracting more capital inflows, the central bank implemented three measures: (1) imposition of a 4 percent fee for the purchase or sale of BCRP paper to participants different than local financial institutions in order to reduce resale to nonresident players, (2) an increase to 120 percent of the reserve requirement on deposits in local currency to nonresident agents, and (3) substitution of certificates for term deposits as an instrument of sterilization to avoid the resale of other instruments in local currency to nonresident agents, and their subsequent replacement by BCRP paper.

Other macroprudential measures were put in place by Peru’s Superintendency of Banking, Insurance, and Private Pension Funds and by the Treasury. The former cut the limit for the long position in net foreign position for banks from 75 percent to 60 percent, limited the amount of daily and weekly foreign exchange operations by pension funds, and recently prepublished a norm that limits the long position in derivatives for banks to 40 percent of their net worth.

For its part, the Treasury has taxed the capital gains generated by forward contracts with a rate of 30 percent, and recently issued bonds in the international markets denominated in domestic currency but paid in foreign currency. This operation increased the demand for foreign currency by domestic agents that purchased those bonds. The BCRP increased the limit on foreign investment of pension funds from 17 percent to 30 percent in 2010.

Reserve Requirements

The accumulation of liquid foreign currency by financial intermediaries has been determined mainly by macroprudential policies. In particular, the BCRP uses reserve requirements to manage capital flows and at the same time accumulate a buffer stock of international reserves. For instance, during the capital-inflow episode of the first quarter of 2008, the central bank raised the reserve requirements in domestic and foreign currency, combining this policy with a series of other measures aimed at discouraging holdings of central bank instruments by nonresident investors. The rate of marginal reserve requirements in domestic currency was raised from 6 percent to 25 percent (Table 14.3), the rate of reserve requirements for deposits of nonresidents was raised to 120 percent, and the rate of marginal reserve requirements in foreign currency was raised from 30 percent to 49 percent.3

Table 14.3Peru: Monetary Policy Interest Rate and Reserve Requirement Ratios, 2002–11(Percent)
Reserve Requirements Ratios
Foreign Currency
Domestic CurrencyGeneral RegimeExternal Liabilities
Monetary Policy

Interest Rate:

Reference Rate

for the Interbank

Money Market
Legal Minimum

Required Ratio


for Deposits

Increases in

the Average


Ratio for



for Deposits

Increases in

the Average



I. Pre–Lehman Brothers: Capital Inflows and Inflationary Pressures in Emerging Markets
May 20064.506.0030.0030.0030.00
Jul. 20074.756.0030.0030.0030.00
Sep. 20075.006.0030.0030.00
Jan. 20085.256.0030.0030.00
Mar. 20085.258.0015.0015.0040.0040.00
Apr. 20085.509.0020.0040.0045.0045.00
Jun. 20085.759.0020.0040.0045.0045.00
Jul. 20086.009.0025.00120.0049.0049.009.00
Aug. 20086.259.0025.00120.0049.0049.009.00
Sep. 20086.509.0025.00120.0049.0049.009.00
II. Post–Lehman Brothers and QE:1
Post–Lehman Brothers: Deepest Stage of the Crisis and QE:1
Oct. 20086.509.00120.0035.00
Dec. 20086.507.5035.0030.00
Feb. 20096.257.5035.0030.00
Mar. 20096.006.0035.0030.00
Post–Lehman Brothers: Quick Recovery of Emerging Markets and QE:1
Apr. 20095.006.0035.0030.00
May 20094.006.0035.0030.00
Jun. 20093.006.0035.0030.00
Jul. 20092.006.0035.0030.00
Aug. 20091.256.0035.0030.00
Dec. 20091.256.0035.0030.00
Feb. 20101.256.0035.0030.0035.00
III. Post–Lehman Brothers: Full Recovery in Emerging Markets and QE:2
May 20101.506.0035.0030.0035.00
Jun. 20101.756.0035.0030.0035.00
Jul. 20102.007.0040.0035.0040.00
Aug. 20102.508.0012.0050.0045.000.1050.00
Sep. 20103.008.5015.00120.0050.000.2065.00
Oct. 20103.009.0025.00120.0055.000.2075.00
Nov. 20103.009.0025.00120.0055.0075.00
Dec. 20103.009.0025.00120.0055.0075.00
Sources: Authors’ calculations.
Sources: Authors’ calculations.

In addition, due to the quantitative easing measures in the developed world, there was a resurgence of capital inflows during the second half of 2010. In this case, the BCRP reinstated its reserve requirement policies, raising the requirement to 25 percent in domestic currency, 55 percent in foreign currency, and 75 percent for external short-term liabilities of the financial system. It also reinstated the reserve requirement ratio for domestic currency deposits of nonresident investors to 120 percent. Noting greater dynamism of lending to the domestic market from domestic bank subsidiaries abroad, the BCRP also included their liabilities within the total liabilities subject to reserve requirements.4

Rossini and Quispe (2010) describe the credit crunch in Peru in 1999–2001 as being caused by the combination of an initial surge of capital inflows and a subsequent expansion of banking credit, followed by a sharp contraction of credit produced by a sudden stop of capital flows and a sharp currency depreciation caused by the 1998 Russian crisis. Figure 14.8 shows the evolution of banking credit as a proportion of GDP, including a band of ±2 standard deviations of the credit-to-GDP ratio over the sample constructed around a series smoothed by a Hodrick-Prescott filter, which can be used to identify periods of excessive credit expansion or contraction. Following the recovery from the financial crisis, credit has been evolving within this band.

Figure 14.8Peru: Credit/GDP Ratio, 1993–2010

(Annual ratios from quarterly data, in percent)

Source: Authors’ calculations.

Real Exchange Rates

The nominal appreciation of the exchange rate caused by capital inflows raised concerns about the negative effect of this situation on the tradable sectors. To assess this impact, we studied data of the real exchange rate and evaluated the deviations from the equilibrium real exchange rate. In both cases, the surge of capital inflows has not involved a major negative effect on competitiveness for Peru.

Figure 14.9 presents the evolution of the index of the effective real exchange rate. The rate was around ±5 percent of the average level over 1993–2010. This relatively stable real exchange rate holds up in international comparisons. In Table 14.4, the comparative coefficient of variability among 22 countries shows that the real effective exchange rate (REER) of the Peruvian currency was the third least volatile from December 1994 to December 2010. Moreover, for a shorter period, from January 2001 to December 2010, Peru had the least volatile REER.

Figure 14.9Effective Real Exchange Rate

(Index based on 1993–2010 average = 100)

Source: Authors’ calculations.

Table 14.4Coefficient of Variability of the Real Effective Exchange Rate(Percent)
CountryDec 1994-Dec 2010Jan 2001-Dec 2010CountryDec 1994-Dec 2010Jan 2001-Dec 2010
Brazil21.322.7United States8.07.8
Czech Republic20.911.5Israel9.26.3
South Africa14.112.2Thailand10.27.0
Korea11.911.9Euro area7.35.3
United Kingdom9.39.7Singapore5.43.7
Source: Bank for International Settlements.Note: Calculations based on the Bank for International Settlements’ exchange rate indices.
Source: Bank for International Settlements.Note: Calculations based on the Bank for International Settlements’ exchange rate indices.

We use the behavioral equilibrium exchange rate method to estimate the equilibrium real exchange rate. Table 14.5 shows the estimated elasticities of the REER from its fundamental determinants.5 According to the estimations, this approach shows no major misalignments of the REER with respect to its equilibrium path (Figure 14.10).

Table 14.5Empirical Results
Fundamental VariableElasticity
Net Foreign Liabilities/GDP0.20
Terms of Trade−0.24
Trade Liberalization (exports and imports)/GDP0.14
Peruvian GDP/GDP of Peru’s Trade Partners−0.30
Public Expenditure/GDP−0.01
Credit Dollarization Ratio0.08
Source: Authors’ calculations.
Source: Authors’ calculations.

Figure 14.10Peru: Behavioral Equilibrium Exchange Rate

Source: Authors’ calculations.

Note: REER = real effective exchange rate.


Peru’s central bank has developed a policy framework based on a risk management approach. In this sense, the vulnerabilities associated with partial dollarization of the banking system have been taken into account in adding nonconventional policy tools such as intervention in the foreign exchange market, accumulation of international reserves, and application of different forms of reserve requirements and liquidity sterilization. With this policy framework, the Peruvian economy was relatively isolated from the effects of the global financial crisis and able to recover growth with low inflation and avoid major disruptions from the surge of capital inflows.


    ArmasA.2004. “Forex Interventions in Peru: 2002-2004.” BIS Paper 24Bank for International SettlementsBasel, Switzerland.

    RodriguezDonita.2011. “The Determinants of the Equilibrium Real Exchange Rate in Peru.Working PaperCentral Reserve Bank of PeruLima.

    RossiniR. and Z.Quispe.2010. “Monetary Policy during the Global Financial Crisis of 2007-2009: The Case of Peru.” BIS Paper 54Bank for International SettlementsBasel, Switzerland.

    RossiniR.Z.Quispe and R.Gondo.2008. “Macroeconomic Implications of Capital Inflows in Peru: 1991–2007.” BIS Paper 44Bank for International SettlementsBasel, Switzerland.

This chapter was first presented at the Bank for International Settlements Meeting of Deputy Governors, Basel, February 17–18, 2011.

With respect to exchange rate losses that can be generated by a currency appreciation on international reserves valued in local currency, there is not a consensus about the accounting treatment of this valuation effect. Some central banks record it in their profit and losses report, while others record it in a separate item in the capital account. From an economic point of view, the change of valuation in local currency of international reserves is not relevant. For example, it would be meaningless to record and distribute dividends originated in a depreciation of the currency that increased the nominal amount of international reserves.

During the intensification of the global financial crisis in the last quarter of 2008, the reserve requirements were reduced in order to avoid a credit contraction.

In September 2007, the central bank eliminated the reserve requirements for external loans with two-year or longer maturities of commercial banks in order to extend their maturities. The longer-term external funding of banks increased from 17 percent of total external funding in October 2007 to 50 percent in December 2007.

The calculations are based on Rodriguez (2011).

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