How ‘Dirty Floating’ Helps Peru Keep Currency Stable and Hold Inflation

How ‘Dirty Floating’ Helps Peru Keep Currency Stable and Hold Inflation

Peru represents a rare example of economic stability in Latin America.

Many experts even speak of a “Peruvian economic miracle” due to the country’s sustained growth in recent decades, only interrupted by the Covid-19 pandemic.

Although in broad sectors there is discontent with the maintenance of inequalities, the macroeconomic numbers of Peru’s recent history are cited as an example of success around the world.

One reason, according to experts, is the stability of the Peruvian currency, the sun.

Waldo Mendoza, an economist at the Pontifical Catholic University of Peru and former Peruvian Minister of Economy, told BBC News Mundo, the BBC’s Spanish-language news service, that “if we look at the behavior of the exchange rate in Latin America, that of Peru is the least volatile”.

In other words, the Peruvian currency is the one that sees its value fluctuate the least in relation to the reference currency, the US dollar, and does not have a tendency to sharp devaluations in adverse economic moments typical of other economies in the region.

This year, the behavior of this currency so far seems to support Mendoza’s claim.

According to the currency ranking prepared by Bloomberg, the sol is the second best-performing Latin American currency against the dollar in 2022, surpassed only by the Uruguayan peso.

The stability in the price of its currency is achieved thanks to a strategy of the Central Bank of Peru (BCRP) known as “dirty float”.

How does “dirty float” work?

The value of the dollar measured in units of the local currency (exchange rate) is a key aspect of the economy, especially for countries like Latin America, where the US currency plays a key role and is widely used.

In economics, there are three main models of exchange rate regime.

With a fixed exchange rate, the price of foreign currency remains constant over time, but this requires permanent intervention by the central bank in the market, buying or selling dollars as needed to regulate supply and demand and thus maintain the exchange rate. exchange rate at the desired level.

Few places apply this model. A typical case is that of the autonomous Chinese territory of Hong Kong. In Latin America, Bolivia still has it and it was in effect in Chavista Venezuela for years.

In the floating exchange rate model, the exchange rate fluctuates freely, without intervention by the Central Bank. It is followed by the European countries that share the euro, or in Latin America, for example, by Chile. This can lead to large fluctuations influenced by the current situation or external economic factors.

Finally, there is the dirty floating exchange rate model that Peru follows, where the exchange rate also fluctuates, but in a very limited way.

The “dirty float” is also adopted by the Central Bank of Brazil (Bacen).

Why is it called “dirty float”?

Due to also limited intervention by the central bank in the market. In Mendoza’s words, “the central bank fights against the current in the foreign exchange market. It tends to buy dollars when the exchange rate falls and it tends to sell when the exchange rate rises.” That way, you can keep your price relatively stable.

It is a common model in emerging economies, where authorities use it to protect their currencies from large unwanted fluctuations.

One hundred soles banknote
Unlike other Latin American currencies, the price of the sun does not undergo large variations

Some of the largest “dirty floating” economies include, in addition to Brazil, India, Singapore, Turkey and Indonesia. In the latter two, central banks intervened in 2014 and 2015 to support their respective local currencies.

In Peru, this model has been adopted by the Central Bank of Peru (BCRP) and experts agree that it can explain the country’s monetary stability in recent years, in marked contrast to what happened at other times in history, such as the hyperinflation of the late 1980s, which still brings back bitter memories for many Peruvians.

When did “dirty flotation” start in Peru and how has it been used so far?

The Central Bank of Peru began to intervene in the foreign exchange market during the economic stabilization policy of the 1990s, when the government of Alberto Fujimori (1990-2000) carried out an aggressive liberal economic reform.

When Fujimori came to power in 1990, Peruvians were living under the hyperinflation inherited from the first government of Alan García (1985-1990), which devoured the purchasing power and credibility of the Peruvian currency at the time, the inti. In 1991, a new national currency, the new sun, was created and stabilizing its value became a priority for the new government.

Person surrounded by food at a market in Peru
Hyperinflation during Alan García’s government devoured Peruvian purchasing power

Initially, a fixed exchange rate model was implemented, which ended up being relaxed. The dirty floating exchange rate model was then adopted, which remains to this day and has helped the sun face some of the financial turmoil of recent years.

In the first few years, limited and sporadic interventions were used, but from 2002 onwards, when the BCRP adopted its inflation targeting policy, with the official declared objective of maintaining price increase levels between 1% and 3%, the fluctuation dirty has just been implemented.

Successive presidents of the Peruvian Central Bank remained faithful to this system, to the point that, according to Mendoza, “there is no central bank that intervenes more in the exchange market than the Peruvian one”.

According to its annual report, the BCRP intervened on 82% of the days in 2021 and so far, in 2022, has sold $1.8 billion in foreign currency to keep the exchange rate stable.

But the Peruvian has some particularities in relation to the “dirty floating” of other countries.

Diego Macera, an expert at the Peruvian Institute of Economics and a member of the BCRP board, tells BBC News Mundo that “the most important difference with other systems is that Peru does not have fixed rules before intervention”.

“In other countries, it was possible to know more clearly the moment and magnitude of central bank intervention, which makes it possible to manipulate the system. The BCRP has more discretion, which allows it to be more effective in reducing volatility.”

As the Central Bank of Peru does not announce in advance when it will intervene in the market, nor with what intensity, uncertainty discourages speculators interested in “betting against” the national currency with short-term maneuvers.

This is what happened to the pound sterling when, in 1992, a speculative attack by financier George Soros ended up forcing its exclusion from the European Exchange Rate Mechanism (ERM), a system agreed upon by countries that ended up adopting the euro before its entry into force.

Real-time quote screen
Peru’s ‘dirty flotation’ system prevents speculators from ‘betting against’ the sun

Macera points out other advantages of the model applied in Peru: “It is less binding than the fixed exchange system, which can lead to a greater risk of rapid depletion of reserves and speculation in relation to our currency”.

The BCRP is also very active in buying dollars at favorable times to maintain its reserve levels and its ability to intervene in adverse times, considering the weight of mineral exports in the Peruvian economy.

“When the price of minerals rises, the value of the dollar tends to fall and that is where the BCRP buys dollars”, explains Mendoza. “In good times, it ends up accumulating a lot and that has allowed it to be one of the central banks with the most international reserves.”

The BCRP has US$ 76.1 billion in international reserves, which represents 30.5% of Peru’s Gross Domestic Product (GDP, sum of goods and services).

Chile, for example, despite having a higher GDP, has approximately US$ 30 billion less in international reserves.

Brazil’s international reserves totaled, in December 2021, US$ 362.20 billion.

Macera explains that the high availability of reserves is essential for the success of the “dirty float”.

“The credibility of BCRP’s intervention in the market is particularly important, and is achieved with the institution’s good track record and a significant level of internationalization of reserves”, he explains.

This is what allowed the bank to act with vigor, as in 2009, when Peru was shaken by the consequences of the global financial crisis, or, more recently, by the flight of capital after Pedro Castillo took office in July 2021.

threat of inflation

But the exchange rate is not the only variable, nor is keeping it stable enough to solve all the economy’s problems. The Peruvian has some currently.

The Central Bank recently lowered its growth expectations for Peru for this year from 3.4% to 3.1%. Experts agree that this is a very low rate for an emerging economy and that, at this rate, the country will have difficulty creating jobs in significant volumes.

Nor is a stable exchange rate sufficient to correct the effects of the drop in mineral production, a fundamental item for Peru, due to the conflicts that paralyzed some of the country’s main mines.

Then there’s the big problem of the present day, inflation, which has been on the rise since Russia’s invasion of Ukraine. Peru is not immune to this either. The forecast is that Peruvian inflation will close the year at 6.4% – the previous forecast was 3.5%.

And the BCRP does not expect inflation to return to normal levels until at least the end of 2023.

“A large part of this is due to the price of wheat, oil and other imported products that represent between 30% and 50% of the local basic food basket and that will follow their own dynamics associated with the war”, says Mendoza.

The BCRP is trying to contain this price escalation, like other central banks, mainly with the increase in interest rates, which indirectly also helps to limit a possible devaluation of the exchange rate.

But, as Mendoza warns, “this is cooling the economy and will have costs, because it is the highest inflation in a long time”.

Source: BBC News Brazil

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