Sol Must Be Lower to Face World Financial Whirlwind 

Nuevo solBy Nicholas Asheshov—

The world’s finances are barreling along a rollercoaster, the most serious since the 2008 sub-prime collapse.   The ride is twisting, gathering speed with not just the Russians and the usual suspects aboard but, as of last week, the Swiss, too.   The Swiss jumped on, followed by the equally prim Danes, making their gold-plated francs and Krones even more expensive, a shock that sent the Euro into a new dive.  U.S. Treasury Bonds, already at recent highs, leapt anew. Computers at Citibank broke down, smoking from the stress. The first of a possible new wave of banking failures hit New York, London and even New Zealand.

Peru is also aboard this runaway, though to listen to the Minister of Finance and to watch the Banco Central de Reserva del Peru, you would not know it.  The ministry says Peru will be growing this year at five or six percent.  The Nuevo Sol is one of the world’s strong currencies  —see chart— up there with the  GBP Sterling and only a bit behind the US dollar, the inscrutable Renmimbi and the Swiss franc itself.

If the Swiss and the Danes are panicking, or at least biting their fingernails, trying to stop their economies from slipping into no-growth deflation, there is certainly cause for concern for everyone else, including Peru

But Peru’s Central Bank has, it seems, not got the message.  It has been Re-valuing the Sol against the Euro and the Yen, as if it was Beijing, Copenhagen and Zurich. The Nuevo Sol is much stronger, more expensive, than the made-in-Frankfurt Euro and the Tokio Yen, representing the world’s greatest economies apart from the United States.  The other Latino countries have, like the Japanese and Europeans, allowed the market to devalue their pesos and reales (see chart).

The collapse in commodity prices is the firmest indication of trouble.  It is not just oil and the ruble that are crashing. Copper, for one, Peru’s top money-spinner, whose price held at $3.30/lb for much of last year, has joined the collapse.  It plummeted 11% in the first 12 days of this year and is at a lower price than at any time in the 21st century.  If copper reaches below $6,000/ton, it is bad news. This week it has been approaching $5,300 on the London Metals Exchange, LME.

Copper is traditionally a useful crystal ball.

Iron ore, the biggest of all the commodities, has slipped to below $64.50/ton CIF China port, one-third of its traditional price and below the all-up $85/ton typical cost level.  As with oil, production, however, remains at high levels, setting up great stockpiles in China, Australia and Brazil for the world economy.

The prices of other commodities, metals, minerals and bulk foodstuffs like soya, wheat and corn, are descending as stocks overhang the market.  In Zambia, farmers are feeding export-grade soya to their pigs.   The Bloomberg Commodities Index is at its lowest level since 2002 and heading lower on many market days.   There is overproduction, financed by cheap money, in Australia, Brazil, China itself, as well as in Chile and Peru. Production levels continue as normal, sending stockpiles ever higher, creating mountains of products and lakes of red ink.

The price of the key item, money, is lower than at any time in history.  Uncountable trillions of euros, yen, renmimbi and, of course, US dollars are stashed on the computers of central banks, investment banks and investment and money market funds.  The British government is repaying money it borrowed to finance its wars against Napoleon, supporting too the wars of independence in South America, two centuries ago.  Then, it was paying six percent.  Today the Treasury in London can borrow at just a fraction above zero percent.

As Hemingway put it, this is Nada.

Welcome to the Great Recession 2.0

If anyone has not absorbed that Peru is about to be hit by an avalanche, an international financial shoot-out, they are not alone.  The same has happened, it seems, to the Banco Central de Reserva del Peru, BCRP, which has imposed what amounts to price controls on the Nuevo Sol.  The MEF is still predicting five or six percent growth for Peru for later this year, even as most of the rest of the world is slowing, or has, like Peru, stopped. Or as in Japan and much of Europe, begun to go backwards.    The Banco Central, which is supposed to supervise a free currency market, has been vigorously holding back the price of the dollar.  The price only crept cautiously over the S/.3 line last week as the Swiss central bank caused its uproar by re-valuing against the Euro.

The world economy, including Peru, may be on the verge of the worst kind of slump, where prices begin to edge, then to spiral down. This is the opposite, the Alice Through the Looking Glass version, of the stagflation with which Latinos became familiar in the 1980s and 1990s.   With deflation, the face value of your property goes down while the cost of your debts increases. Deflation is even more difficult to stop than inflation. Central banks around the world have been pushing against it with increasing desperation, using cheap money and devaluations, some of them huge —see box.

The only country in Latin America   that has not devalued much is Peru.  This is at the time of the most persistent price collapse in the 21st century.  The Peruvian economy may already be in reverse.  Japan and Europe are  trying to keep their  economies from slipping further into deflation, trying to create, not stop, inflation, as is the Fed in Washington, D.C.

Meanwhile the BCR in Lima is still selling United States dollars at a giveaway S/.3.  Unique among world currencies, Peruvians can buy a dollar for less than it cost 20 years ago, S/.3.50

Xchange Rate chart - Five YearsThat is the level, S/.3.50, it ought to have been, if the market had been allowed to work properly, already well before this past Christmas, in order to give a much-needed push to the economy, above all to exporters.  At this rate Peru would have an exchange rate in line with the rest of the world, with a target of S/.4 before Christmas 2015, and perhaps S/.5 before a new government takes over in July 2016, whatever the market, not the BCR, decides.   Anything else, anything less, will not keep the economy from stagnating.

Every other Latin country is supporting its economy  and protecting its reserves, encouraging the market to push up the local price of the dollar.  If Peru had followed the Colombians and the Chileans, over the past five years a dollar would be costing today 3.67 (Chile) or (Colombia) 3.43.  If the Sol had followed the Brazilians, it would be 4.28, Japan 3.73, Europe, 3.57, and Russia 6.32.   If Lima had followed Brazil, the world’s eighth largest economy, also over the past five years, the dollar would be costing S/.4.28.  The Euro, the world’s second-largest currency, has devalued against the dollar by 17% just in the past several months.  If the Sol had kept pace with the Euro over five years it would today be S/.3.57.  Or with the Yen, the third-largest currency, the Sol would be S/.3.73.  Russia, S/.6.32.

For different reasons, Peru, Brazil and most of the rest of South America, did well after the 2008-10 Recession, thanks mostly to those nice Chinese who continued to buy oil, agricultural products and iron ore and copper.

But, today, that is over.  The Peruvian cabinet has put out a handful of regulations aimed at smoothing out bureaucratic holdups in the hope that these might get projects going. These include huge multi-billion copper, gold and silver mines.  Peru is moving towards becoming a world mining centre.  But putting out a few anti-red-tape regulations while playing ducks and drakes with the exchange rate is not going to help, much less during a world pull-back.  At least the BCR and the government could and
should have  signaled that it was preparing for bad times by not blocking the market and devaluing the currency forcefully.  It is going to prove to have been an expensive mistake.

Why did the Banco Central and the MEF do this? They have been less than transparent about it.

The BCR is reluctant to let the dollar go because they, like the local banks, are frightened.   They think it might set off a wave of inflation.  That is what, anyway, they say. But inflation is yesterday’s battle in the face of worldwide falling prices.  The government in any case should, according to this view, be lowering the pump price of diesel, as well as corn and wheat, instead of propping up — à la Velasco— inefficient Petroperu and other subsidized importers of bulk foodstuffs. These have turned, in any case, into rackets.

More to the bureaucratic point, allowing the dollar to become more expensive would lower tax collections. The government wants to avoid politically delicate social inclusion spending cuts.

Among Peru’s top 10 imports three are basic foodstuffs like corn (for chicken feed), wheat (for bread, noodles, crackers) and soy bean oil and paste. BTW, #7 on the list of imports is cellular phones, at $1,000 million.

Also, a lot of companies and Lima households have big debts in dollars. They all believed, in the heady pre-Humala days, that Peru was on the path to sustained development.  This has created a major bubble, part of a worldwide bond bubble.  According to Bloomberg,  Peruvian companies, which had $200mn in bonds in 2010, issued an impressive $16,000 million (sixteen thousand million) in dollar bonds through mid-2014, though this figure may include direct bank loans from abroad.  Many of these dollar obligations are owed by entities whose income is in soles.   A Sol devaluation could create a knock-on bubble havoc in banks here and even abroad.

This is probably the single biggest reason for the blockage in the Peru exchange rate.  The BCR has begun steps to push local banks and their clients out of dollar debt into soles but it’s technically messy,  not easy even on a small scale.  On a big one, the BCR and the Lima banks are looking at the same wall as their counterparts in Washington, Tokyo, London and Frankfurt.

In addition to company dollar debt, many ABC people in Lima, perhaps not so large in number but noisy as opinion leaders, have debts in dollars. Houses, cars, expenses. Nobody in official Lima wants people complaining loudly.

If the dollar were to jump to an equilibrium level, say a moderate  S/.3.40 today, a lot of companies would show (accounting) losses since the diferencia de cambio is calculated over the total debt, not only over the current service of it. Lima banks would  have to run stress tests and increase their loan loss reserves, which would  hit their profits..

In a pre-election year, when Peru is  coming from the first commercial and financial deficit year (2014) in a decade, and the mining sector will not be coming to the rescue with its usual  suitcase of dollars, and when this coming April the income tax “regularization” is due, the MEF definitely is pushing against  a market-driven devaluation, which would lower tax income.

The BCR knows perfectly well that the Sol is seriously overvalued with a handful of financial traumas coming fast.  It was, after all, the BCR that in 2012 had the skill and the guts to buy no less than $13,000 million worth of dollars on the open market to prevent a disastrous revaluation of the Sol as it headed towards S/.2.30.  The BCR has over the past few years become an agile, tough foreign exchange trader, moving between $300mn and $500mn a day sometimes, to smooth the ups and downs of the market.  It has even learned to use CDRs and swaps to fudge and hide many of its deals from the international banking authorities, the B.I.S., the central bank of central banks, in Basle. But today’s exchange rate lag is a sad story. The BCR and Peru have plenty of dollars, no less than $66,000mn all up.

But ferocious quarrelling at the top levels of the administration have  come together with lack of courage, independence and forethought, simply not wanting to see the writing on the local as well as the international financial and commodities wall.

This is not in itself unusual, but there has  been an unfortunate element of political dishonesty that is soon going to cause serious problems for not just a handful of politicians and  bureaucrats but for companies and  their employees.


A version of this report appears in Caretas, Jan 22.

Nick Asheshov was editor of the Andean Air Mail & Peruvian Times during the 1970s and 1980s, and of The South Pacific Mail, Santiago during the 1990s.  He was Latin America Editor of Institutional Investor, New York over the same period.  He lives in Urubamba, where he has been prominent in the hotel and railway business.

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  1. This is a very well done article, well researched. The great unwind in the global financial markets is underway. You don’t have to wait until 2016 or 2018 to experience the global financial turmoil, it is happening now. If the folks at the central bank of Peru are not careful, then the Peruvian economy could quickly become a mirror image of the Venezuela economy. Once the Peruvian central bank uses all of it’s foreign exchange reserves defending the Peruvian sol, a lot of store shelves will be bare. Peru exports mostly raw materials , but produces little in consumer products. Very much like Venezuela and Russia. It seems the Peruvian central bank has painted it’d self into a very messy financial corner. It is not alone, many other countries have done the same thing. It is going to be a very interesting year. I have told many of my local Peruvian friends here in Peru lately, don’t keep a lot of your cash in the local banks, these little banks that have appeared here in Peru in the last several years can go under very quickly, in the present financial environment. The American Federal reserve bank is pulling trillions of dollars back from emerging market type countries banking systems. The great unwind is underway.

  2. Martin Halpern says:

    The most honest presentation of the Peruvian economy that I have read for many years. It is time that the politicians tell the public the truth so that people can slowly prepare for the future — until a time when Peru’s traditional exports begin to increase in price once again. In maybe 5 to 10 years.

  3. If the BCR had not intervened to buy so many dollars and keep the exchange rate from going down in recent years, the sol might now be at 2:1 instead of 3:1. Such intervention was not a free market. And if the BCR had not done that it would not have the huge reserves it now has. Selling the reserves now to keep the sol from falling against the dollar is more like restoring the exchange rate to what the free market might have produced if it had been allowed to operate before. However, that will not restore the economic distortions the previous intervention caused. Peru is not Brazil or Russia and there is no reason why its currency should behave like theirs.

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