Frequently Asked Questions

Updated: May 14, 2007

1. What is the mission of the BCRP?
2. What are the functions of the BCRP?
3. What does the BCRP’s autonomy consist of?
4. Which is the highest institutional authority at the BCRP?
5. What is the BCRP’s inflation target?
6. Why did the BCRP reduce its inflation target of 2.5 percent –in 2002-2006– to 2.0 percent?
7. How is monetary policy designed to meet the inflation target?
8. What is the interbank interest rate?
9. How does the BCRP get the interbank reference rate to converge to the level set by the Board of Directors?
10. What window facilities does the BCRP provide banks?
11. How is the interbank interest rate connected with the rates on deposits and loans?
12. Should the BCRP establish controls for interest rates on bank operations in order to reduce these rates?
13. What is the monetary base?
14. Does an increase in the monetary base necessarily bring about higher inflation?
15. What type of dollarization is there in the Peruvian economy?
16. Is monetary policy ineffective when the economy is highly dollarized?
17. What risks does financial dollarization entail?
18. What are net international reserves (NIRs)?
19. Why are net international reserves important?
20. What is reserve requirement?
21. What is the role of foreign currency-denominated reserve requirement?
22. What is the remuneration rate on the foreign exchange component of reserve requirement?
23. Why does the BCRP make exchange operations?
24. Why is it important to develop long-term instruments in soles?

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1. What is the mission of the BCRP?

As established by the Peruvian Political Constitution of Peru, the objective of the BCRP is to preserve monetary stability. To do so, the Central Bank has established an inflation target of 2.0 percent, with a tolerance margin of ±1 percent. BCRP actions are oriented towards maintaining this level of inflation in the Peruvian economy.

Inflation is detrimental to economic development because it prevents money from adequately fulfilling its functions as a medium of exchange, as a unit of account, and as a store of value.

Inflation discourages investment and promotes speculation because it generates distortions in the price system, as well as an inefficient allocation of resources. The devaluation of money resulting from generalized and continuous rises in the prices of goods and services affects mainly lower-incomes groups as these groups have usually no easy access to inflation hedging mechanisms. Thus, by maintaining inflation low, the BCRP creates the necessary conditions for normal economic activity which, in turn, contributes to achieve higher levels of sustained economic growth.

2. What are the functions of the BCRP?

The BCRP functions, as defined by the Constitution, include the following: to regulate money and credit in the financial system, manage international reserves, issue notes and coins, and periodically report on the country’ finances.

3. What does the BCRP’s autonomy consist of?

In order to fulfill its mission, the BCRP must enjoy autonomy. It is essential to ensure that the Central Bank decisions be oriented towards compliance with its constitutional mandate of preserving monetary stability.

The BCRP Organic Law states that the Central Bank is an autonomous public institution, and stipulates that members of the Board of Directors can only be removed due to serious wrongdoing, criminal offense, or should they:

• Finance the Public Treasury, except in the case of purchases of Public Treasury securities in the secondary market up to a limit of five percent of the previous year’s monetary base;
• Finance public development financial institutions;
• Allocate resources to establish special funds aimed at financing or promoting non-financial economic activities;
• Issue securities, bonds, or contribution certificates of mandatory acquisition;
• Impose sector or regional coefficients on the loan portfolios of financial institutions;
• Establish multiple exchange rate regimes or discriminatory treatments in foreign exchange regulations;
• Issue guarantees, bid or performance bonds, or any other kind of guarantees; use any other form of indirect financing; or provide any form of insurance.

These prohibitions provide the Central Bank with the operational independence the bank requires to carry out its monetary policy-related responsibilities. The Bank is therefore not subject to fiscal restrictions (such as financing the Public Treasury) or to any other type of restrictions that may prevent it from complying with its mission.

4. What is the highest authority of the BCRP?

The Board of Directors is the highest authority of the Central Bank. As such, the Board is not only responsible for determining the policies required to fulfill the Bank’s mission, but also for its general activities. The Board is integrated by seven members. The Executive and the Legislative Branches each appoint three members to the Board. The Chairman is designated by the Executive and ratified by the Permanent Commission of the Congress.

The Board Members do not represent any particular entity or interest, and their term in office is similar in duration to that of the President of Peru.

The Central Bank’s General Manager is in charge of both the technical and administrative operations of the BCRP.

5. What is the BCRP’s inflation target?

The Bank’s inflation target is to reach an annual accumulated inflation rate of 2.0 percent, plus or minus 1 percent. The BCRP is permanently monitoring that this target be met as this inflation range allows the country to have a regular economic performance, without inflationary or deflationary pressures, within a context of monetary stability similar to the one enjoyed by other countries with stable currencies.

The inflation target is continuously measured against the last-12-month Consumer Price Index (CPI) for Metropolitan Lima to evaluate if the target has been met. Should inflation deviate from the target range, the Central Bank will take any necessary action to make it return to the target range, taking into account the lags of monetary policy.

6. Why did the BCRP reduce its inflation target from 2.5 percent –in 2002-2006– to 2.0 percent?

By reducing the inflation target from 2.5 to 2.0 percent, the Central Bank reinforces its commitment of preserving monetary stability as this action will allow providing the nuevo sol with a higher purchasing power in the long-term.

The reasons for adopting this new target are that:

1. A lower inflation target will contribute to the dedollarization of financial transactions and savings, as the domestic currency will be more robust. In turn, this will reduce vulnerabilities associated with the financial dollarization of the economy, improving monetary policy transmission and efficiency.
2. Developing the capital market and promoting savings require a sounder currency to prevent the devaluation of long-term investments. The impact of this in a longer period of time, i.e. 20 years, would mean preventing about a 10 percent loss in the value of our currency.
3. The rate of inflation in the country is equated to the inflation rates guiding the monetary policies of our main trading partners, and thus the value of the nuevo sol against other currencies will not depreciate in the long term to compensate for higher inflation levels in our country. Over 60 percent of our trade is made with economic blocks that show inflation rates lower or equal to 2.0 percent. Moreover, this 2.0 percent inflation rate is used (explicitly or implicitly) by central banks that have been successful in keeping inflation expectations under control, such as the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Canada, the Bank of England, etc.
4. The credibility generated by the BCRP in controlling inflation allows setting an inflation target of 2.0 percent.

7. How is monetary policy designed to meet the inflation target?

The announcement of a quantitative inflation target, making monetary policy decisions on a timely basis so that the inflation target may be achieved, and communicating the rationality of said decisions to the public are the core actions of the framework used by the Central Bank to preserve monetary stability.
In line with these criteria, the Central Bank has implemented Inflation Targeting since 2002. Under this scheme, an inflation target of 2.0 percent, plus or minus one percentage point, has been announced since early 2007. This target, which is calculated by the National Statistics and Information Institute, is measured as the percentage change observed in the Consumer Price Index for Metropolitan Lima. Both announcing the target and systematically meeting it contribute to anchor the public’s inflation expectations at this inflation level. Until 2006, the inflation target was 2.5 percent, plus or minus one percentage point.

In order to achieve price stability, the Central Bank seeks to prevent possible deviations of inflation vis-à-vis the target on a timely basis, given that BCRP’s monetary decisions will affect inflation only after some quarters.

Monetary policy actions consist of modifying the reference interest rate for the interbank market, just like the other central banks following this scheme do. Depending on whether inflationary or deflationary pressures are observed in the economy, the BCRP will preventively modify the reference interest rate to maintain inflation at the target level.

At the beginning of every year, the BCRP publishes the dates when the Board of the Central Bank will make monetary policy decisions –usually at the first meeting of the Board every month. The Board’s agreements and decisions are then immediately announced to the public through press releases explaining the main reasons that support said decisions. These press releases are also published on the Central Bank’s web site (http://www.bcrp.gob.pe).

In order to generate credibility regarding the inflation target and contribute to anchor inflation expectations, it is important that the BCRP inform the public how it intends to meet the target, as well as the arguments explaining the Central Bank’s decisions. Therefore, in addition to the press releases, the BCRP publishes an Inflation Report every four months. This document, which is also found on the Bank’s web site, analyzes the recent evolution of inflation and the actions adopted by the Central Bank, as well as the Bank’s vision on the evolution of economic variables and on how they might influence on inflation’s future trend. Moreover, the Inflation Report also examines the main factors that could deviate inflation one way or another, which is called risk balance.

The BCRP monetary decisions are taken in a transparent manner, in line with the inflation target, taking into account the forecasts published in the Inflation Report. Therefore, the monthly press releases on the monetary program for the month are usually based on the Inflation Report or refer to it.

8. What is the interbank interest rate?

The interbank interest rate is the interest rate charged on loans between banks. These short-term operations, usually with one-day maturities, ensure that liquidity flows transitorily from banks with surpluses to banks with liquidity shortages. Given the dynamism of high-value payments in the banking system (checks clearing and other transactions), it is common for interbanking markets to be relatively large.

Central banks’ monetary operations (open market operations) determine the aggregate volume of funds in the market and, therefore, the interbank rate is directly influenced by said operations. That is why many central banks, including the BCRP, use the interbank interest rate (or another short-term rate associated with it) as the operational target of their monetary policies. In these cases, central banks establish a reference level for the interbank interest rate which is consistent with the objectives of monetary policy.

9. How does the BCRP get the interbank interest rate to converge to the reference level set by the Board of Directors?

The BCRP conducts open market operations to induce the interbank interest rate’s adjustment to the level of the reference interest rate. The supply of liquid funds in the interbank market is modified through these operations, either through injecting liquidity to the banking system or through sterilizing liquidity, depending on whether the reference interest rate is subject to upward or downward pressures. Open market operations (OMO) include the following:

1. Injection Operations. These operations are carried out when there is a shortage of liquidity in the interbank market in order to avoid upward pressures on the interbank interest rate that may increase it over the reference interest rate. In order to inject liquidity to the system, the Central Bank purchases securities from financial entities and thus provides them with liquid funds. These operations are carried out through repo auctions in the financial system (temporary purchases of BCRP Certificates of Deposits or Treasury bonds, sold under repurchase agreements).
2. Sterilization Operations. These operations are carried out when there is a liquidity surplus in the interbank market in order to avoid downward pressures on the interbank interest rate that might lead it to a level under the reference interest rate. To withdraw liquidity and induce a rise in the interest rate, the Central Bank auctions off BCRP Certificates of Deposits (CDBCRP) among financial entities: liquid funds are exchanged for Central Bank securities which pay an interest rate, and are thus withdrawn from the interbank market or sterilized.

10. Which window facilities are offered to financial entities by the BCRP?

Window facilities are the operations that financial entities carry out with the Central Bank when they require additional liquidity or have a liquidity surplus upon closing their daily operations,.

These operations entail an opportunity cost in terms of the lending transactions produced in the interbank market. When the BCRP provides liquidity to a financial entity through window operations, the latter is charged an interest rate which is higher than the reference interest rate. Conversely, if a financial entity closes its operations with a liquidity surplus, it may deposit these liquid funds at the Central Bank with an interest rate that is lower than the reference interest rate.

Window operations include the following:

1. Injection Operations. These operations are carried out when a financial entity requiring liquidity is unable to obtain it in the interbank market under the desired conditions. The BCRP may provide the financial entity with the required liquid funds through direct repo operations (temporary purchase of CDBCRP or Treasury bonds, sold under repurchase agreements), through rediscount operations, or through foreign currency swaps (temporary purchase of foreign currency, under repurchase agreements). For these operations, the BCRP charges a higher interest rate than the reference rate.
2. Sterilization Operations. These operations are carried out when a financial entity having a liquidity surplus cannot place it in the interbank market under the desired conditions. The BCRP may withdraw this liquidity surplus from the system by allowing the financial entity to make an overnight deposit (one-day deposit) in the Central Bank. For these operations, the financial entity will obtain a lower interest rate from the BCRP than the reference interest rate.

Considering that:

• the Central Bank carries out open market operations with the aim of adjusting the interbank interest rate to the level of the reference rate,
• for banks, using window facilities constitutes the opportunity cost of exchanging liquidity in the interbank market, and that
• the reference rate is lower than the interest rate on injection operations, and higher than the interest rate on sterilization operations,

financial entities will prefer to operate in the interbank market where they may obtain or place liquidity at more convenient interest rates. For example, in March 2007, the reference interest rate for the interbank market was 4.5 percent, a level between the interest rate on direct repo operations and the Central Bank’s rediscount facilities (5.25 percent), on the one hand, and the interest rate on overnight deposits (3.75 percent), on the other hand.

Both the interest rate on BCRP window operations and the reference interest rate are announced through a monthly Press Release displayed on the Bank’s website.

11. How is the interbank interest rate connected with the rates on deposits and loans?

Although the deposit and lending rates are determined by the market and not by the BCRP, the Central Bank can induce some changes in these rates because the bank is the main supplier of liquid funds. Because these funds are transacted in the interbank market, the Central Bank has more influence over the interest on operations carried out in this market. Therefore, the BCRP has a great capacity to induce changes in the interest rate on operations maturing in the shortest term (overnight).

In other markets, where less liquid and more risky assets are exchanged, other aspects not associated with monetary policy play a more important role in determinining the interest rates. However, the Central Bank may generate gradual changes in the interest rates paid to operations with longer maturity terms by influencing the shortest-term interest rate, because the latter is used as reference to determine the former.

The Central Bank’s impact on relevant interest rates affecting public spending-related decisions –generated by stimulating changes in the shortest-term interest rate– will be greater if there is little “inflationary noise”. Therefore, the Inflation Targeting scheme that is currently being used contributes to increase the impact of monetary policy through the interest rate mechanism by anchoring people’s inflation expectations at the target level.

12. Should the BCRP establish controls on the interest rates on bank operations in order to reduce them?

Experience has demonstrated that controlling the interest rates on bank operations reduces financial intermediation and favors informality. In the case of credit, for example, small and medium-size businesses would only have the option of informal credit –not subject to controls–, which generally means significantly higher interest rates in both local and foreign currency.

Therefore, controls on interest rates prevent the market’s efficient allocation of resources between agents with surpluses (savers) and the agents requiring these resources (demanding credits). This not only discourages savings, but also has an adverse effect on the growth of economic activity.

Free competition in the financial system –without interest rate controls– has allowed reversing the process of financial repression, which had reduced people’s access to the financial market. Thus, credit to the private sector grew from 3 percent of GDP in the early nineties to 19 percent of GDP in 2006.

The decrease in the levels of interest rates has been paralleled by a decrease in the expected levels of inflation. However, the level of the real interest rate also depends on the country risk and on microeconomic factors such as the credit risk, the cost of nonperforming loans, and the operational costs of financial intermediation, factors which are not controlled by monetary policy.

13. What is the monetary base?

The monetary base comprises the banknotes and coins held and/or circulated by individuals and financial entities.

The monetary operations carried out to provide the economy with funds (or to withdraw funds from the economy) are aimed at maintaining the interbank interest rate at the level of the reference interest rate, and, therefore, the monetary base adjusts to economic agents’ demand for money. This demand for local currency is influenced by factors such as the process of financial dedollarization and the growth of economic activity.

14. Does an increase in the level of the monetary base necessarily bring about higher inflation?

International evidence shows that an increase in the level of the monetary base does not necessarily imply a similar increase in the level of inflation in the short run.

There is wide consensus in economic literature regarding the fact that, in the long term, money is neutral (it neither affects the output level nor other real variables) and that inflation is a monetary phenomenon. However, recently developed theories and the monetary policy schemes currently implemented by most central banks do not consider the behavior of money to be preponderant in explaining the short-term dynamics of inflation.

When the evolution of the growth of the monetary base and currency is analyzed in the case of the Peruvian economy in this decade, we can see that monetary aggregates do not show a close relationship with the evolution of inflation.

A possible explanation for this is that, under the inflation targeting framework and using an interest rate operational target, money supply adjusts to the demand for money. In other words, in a framework where money supply is exogenously established, if money supply is deliberately increased above the demand for money –with the subsequent rise produced in monetary aggregates–, inflation is then generated, as established by the quantity theory of money.

15. What type of dollarization is there in the Peruvian economy?

Money has three functions: it serves as a medium of payment, as a unit of account, and as a store of value. The type of dollarization observed in an economy depends on the main function ascribed to the dollar. In our economy, domestic currency is mainly used for the first two functions, that is, as a means of exchange and as a unit of account; but the third function of money, being a store of value, is mostly carried out by this foreign currency. Therefore, dollarization in Peru is mainly a financial dollarization.

 

This financial dollarization is mainly the result of past situations when the domestic currency was devalued as due to high and volatile inflation rates. Given the lack of financial instruments that could cover agents from the risk of inflation, a greater preference for foreign currency as a store of value was generated.

However, financial dollarization has continuously declined in recent years. Thus, the ratio of dollarization of bank obligations with the private sector has decreased from 72 percent in 2000 to 54 percent in 2006. Inflation Targeting has contributed to reduce financial dollarization since this scheme involves a permanent, clear, and credible commitment with the goal of maintaining the purchasing power of the nuevo sol over time.

16. Is monetary policy ineffective when the economy is highly dollarized?

Despite the fact that the dollar has partially taken the place of the nuevo sol as a store of value, our domestic currency is used as a medium of payment and as a unit of account.

This is evidenced in the payment of salaries and in the transaction of the most important goods and services of the average consumer basket, where the domestic currency is mostly used. The dollarization of payments is therefore relatively less important in the Peruvian economy, and the local currency serves its purpose as a medium of payment. Likewise, the prices of most goods and services are expressed in soles and are not dollar-indexed.

In this way, monetary policy may be used to achieve the goal of preserving monetary stability, as has been demonstrated by the fact that the inflation target has continuously been met in recent years. Gradually recovering the use of domestic currency as a store of value will contribute to increase the effectiveness of our monetary policy.

17. What risks does financial dollarization involve?

Financial dollarization involves risks for the economy because it generates two types of mismatches in the balance of economic agents: a currency mismatch and a maturity mismatch.

A currency mismatch generates exchange risks: families and non-financial companies generally have incomes in local currency, but their debts with the financial system are mainly in foreign currency. This currency mismatch implies that a significant and unexpected depreciation of the domestic currency will considerably increase the amount of their obligations (in terms of soles), although a similar increase is not produced in terms of incomes. This is called “the balance-sheet effect”.

Additionally, when loans are made to companies or families having currency mismatches, a bank may experience losses as an indirect consequence of the depreciation of local currency, even if the bank itself is does not have this mismatch: a significant depreciation causes losses in borrowers who have no protection against exchange mismatches, negatively affecting their capacity to pay their debts to the bank and thus increasing their probabilities of non-payment. In this way, banks are exposed to credit risks due to the exchange risk of debtors. Moreover, the credit risk associated with a depreciation of local currency is enhanced if the value of the loan’s collateral decreases as a result of depreciation.

A maturity mismatch, on the other hand, generates illiquidity riks. Financial entities have obligations in foreign currency (people’s deposits and debts with banks abroad), which usually have shorter maturity terms than banks’ placements. Although the maturity mismatch –and the subsequent risk of illiquidity– is a phenomenon inherent in banking systems, the risk is greater when liabilities are not denominated in local currency, that is, when the central bank issuing the intermediated currency is a foreign bank.

Because of these risks, a financially dollarized economy is more vulnerable to abrupt exchange rate variations. Therefore, the Central Bank of Peru has implemented measures to prevent these risks. Inflation targeting is included among a first group of measures aimed at reducing financial dollarization. Not only does it contribute to “reinstate confidence” in the domestic currency, but also to develop long-term domestic currency-denominated financial instruments.

A second group of measures is geared towards promoting a more adequate capacity of response to situations of strong depreciation pressures on domestic currency, or to situations of liquidity constraints in foreign currency. These measures include a high level of international reserves in the central bank; a banking system with a high level of liquid assets in foreign currency; and a floating exchange regime that will allow to reduce abrupt exchange rate fluctuations. Furthermore, a sound fiscal position and an adequate bank supervision will also contribute to reduce the risks associated with financial dollarization.

18. What are net international reserves?

Net international reserves (NIRs) are defined as the difference between BCRP foreign liquid assets and foreign short-term liabilities. Net international reserves are the international liquid assets required by a country to face adverse macroeconomic shocks. NIRs have three components:

• the Central Bank’s international position, which mainly represents the counterpart to the monetary base and BCRP Certificates of Deposits (CDBCRP) balances;
• deposits in foreign currency made by financial entities, formed mainly by reserve requirements in foreign currency; and
• public sector deposits in foreign currency.

By December 31, 2006, the BCRP’s international position (US$ 11,086 million) accounted for 64 percent of net international reserves, while deposits from the financial system (US$ 3,481million) represented 20 percent of NIRs. Public sector deposits (US$ 2,778 million), on the other hand, accounted for 16 percent of NIRs.

19. Why are net international reserves important?

Increasingly growing financial globalization has brought about greater capital mobility that is not always associated with economic fundamentals (the fiscal and monetary disciplines), but in some cases rather with adverse events developing in other countries which are “passed on”. In these circumstances, the possibility of experiencing an abrupt outflow of capitals is always present, and liquid assets in foreign currency are therefore required to face the effects of such a capital outflow.

In the 70s and 80s, the indicators on international liquidity emphasized a country’s potential capacity to finance imports of goods over a determined number of months (NIR-to-imports ratio). Since the 90s, however, due to increased globalization and to the integration of capital markets, the focus shifted to indicators reflecting a country’s capacity to meet its short-term financial obligations. In this way, by December 31, 2006, Peru’s net international reserves (US$ 17,275 million) were 3.2 times bigger than the total of one-year obligations with both the public and private sectors.

20. What is the reserve requirement?

The reserve requirement is the quantity of liquid assets that financial institutions must hold with the Central Reserve Bank for monetary management purposes. According to BCRP provisions, a percentage of financial entities’ obligations in both domestic and foreign currency must be held as reserve requirements, either as cash in their vaults or as current account deposits in the Central Bank.

In force regulations distinguish between legal reserve requirements and marginal reserve requirements. Legal reserve requirements are not interest-bearing, and are equivalent to 6 percent of banks’ total average liabilities in each term of reserve requirement. At least 1 percent of this 6 percent must be deposited in the Central Bank as current account deposits. On the other hand, when marginal reserve requirements are demanded, they are remunerated.

In the case of obligations in domestic currency, the Central Bank requires financial entities to comply only with the legal, non interest-bearing reserve requirements. However, in the case of foreign currency-denominated obligations, banks are also required to have marginal reserve requirements (remunerated at a rate of 3.0 percent since February 2007). Given that the Central Bank issues soles, but cannot issue foreign currency, the BCRP should have a high volume of liquid assets in foreign currency that may allow it to support the financial system in the event of liquidity shortages of foreign currency.

Reserve requirements are calculated on a monthly basis. The amount of liquid assets banks should have as reserves during a month are called reserve requirement. In order to calculate this amount, the Central Bank determines first which bank liabilities are subject to this requirement.

The daily average of total liabilities subject to reserve requirement in foreign currency in a month is called average total reservable liabilities in foreign currency. This variable is compared with the average total liabilities in foreign currency in the base period, which currently is September 2004. (In the case of debits abroad, the higher amount resulting from the comparison between the average balances of February and September 2004 is used as the base).

Up to the equivalent of the amount recorded in the base period, the required reserve ratio of a financial institution is obtained by dividing the legal reserves for the period by the average total reservable liabilities in the same month. The financial system had an average rate of legal reserve requirements of 31.2 percent in September 2004.

When a month’s total reservable liabilities exceed those of the base period, a marginal reserve requirement is applied. Since November 2004, this marginal rate has been set at 30 percent. In this way, if the marginal reserve required ratio is modified, it will only affect the banks’ liabilities in foreign currency that were increased with respect to the base period, and not the actual balances.

Legal reserves are the addition of these two sums, that is, the daily minimum cash requirement that each financial institution is obliged to hold each month. The rate resulting from dividing the legal reserves by the average reservable liabilities in the same month is called the average reserve requirement.

It should be pointed out that foreign-currency denominated liquid assets cannot be used as reserve requirements for liabilities in domestic currency, and vice versa.

21. What is the role of foreign currency-denominated reserve requirements?

Having a foreign currency reserve requirement higher than a local currency reserve requirement is one of the monetary policy instruments used to combat the greater risks generated by the dollarization of the financial system.

First, because this measure has a preventive purpose: as financial intermediation in foreign currency becomes more expensive than intermediation in local currency, this potential higher cost has to be internalized by the individuals and businesses operating in local currency. Second, the use of reserve requirements in foreign currency allows the Central Bank to play the role of a last resort lender of money denominated in a currency that the Bank does not issue, but is widely used in the financial system as a store of value, as a result of which the Central Bank reduces the risk of illiquidity in the financial system.

Since April 2004, debts abroad were included in the concept of banks’ liabilities subject to reserve requirements. This measure unifies the criteria used for the financial system’s domestic liabilities in foreign currency and for liabilities abroad in foreign currency. Thus, current regulation acknowledges that financial dollarization, both domestic (liabilities in foreign currency with residents) and abroad (liabilities in foreign currency with non-residents), represents a series of risks to the economy that financial institutions have to internalize, and for which it is necessary to maintain liquid assets.

However, this expansion of the liabilities that are subject to reserve requirement should not be confused with some kind of capital control. Unlike capital controls involving all private sector liabilities, the foreign currency reserve requirement is applied on financial institutions’ liabilities in foreign currency, regardless of their origin (local or foreign).

22. What is the remuneration rate on reserve requirements in foreign currency?

The Central Bank remunerates additional reserve requirements in foreign currency, that is, the differential between the reserve requirements in foreign currency and the minimum legal reserves in this currency (6 percent of the average total reservable liabilities). The rate of remuneration on reserve requirements in foreign currency is announced on the first Thursday of each month through the Press Release on the Monetary Program for the month. The current remuneration rate on reserve requirements in foreign currency is 3.0 percent.

23. Why does the BCRP conduct foreign exchange operations?

The BCRP purchases or sells foreign currrency in the exchange market through its Front Office. These operations are carried out mainly with the Public Treasury.

Since the mismatch associated with financial dollarization impacts negatively on economic activity through “balance sheet” effects, the BCRP intervenes in the exchange market to prevent any excessive volatility in the exchange rate and to soften changes, although not necessarily pursuing any specific exchange rate level.

The BCRP does not promote any particular exchange rate level as this might not be consistent with the inflation target and, in addition, might reduce its credibility. Furthermore, it would be inconvenient that the Central Bank try to eliminate completely the volatility in the exchange rate as this might lead economic agents to disregard or not internalize the risks of saving or of getting into debts in foreign currency.

When the BCRP purchases foreign currency, the Bank’s net international reserve position is also strengthened. It is also worth noting that quite regularly the BCRP also sells dollars to the Public Treasury, especially for debt payment purposes. These sales are usually compensated with purchases of dollars in the exchange market.

24. Why is it important to develop instruments in soles with long maturity terms?

Instruments in local currency with long maturities make it possible to reduce financial dollarization because, as saving and lending mediums in soles may be generated, our economy becomes less vulnerable to the risks associated with dollarization. Furthermore, they also contribute to increase the effectively of monetary policy to achieve monetary stability.

In order to develop these long-term instruments in soles, it is necessary that an economic agent having very low credit risk conduct similar operations, both in terms of currency and maturity. In this way, interest rates are available that serve as reference for the market. The Public Treasury usually plays this role.

In addition, as the rate of future inflation may be predicted, the currently used Inflation Targeting framework contributes to reduce uncertainty over future inflation’s impact on the interest rates for operations in local currency with long maturities. All of this favors the issuance of long-term instruments in soles.