Peru: The Making of a Low-Volatility Currency

Research evidence excerpt

Peru: The Making of a Low-Volatility Currency

ershooting – the exchange rate may deviate

substantially from levels justified by medium-term fundamentals. In these cases,

intervention can improve welfare by limiting excessive volatility and preventing financial

amplification through balance sheets, credit conditions, and inflation pass-through. By

Source: Armas (2019). Note: There is uncertainty on the contrast, when shocks are permanent – such as a lasting deterioration in the terms of

contractionary or expansionary nature of depreciation and on the trade, a persistent increase in sovereign risk, or a structural shift in capital flows – theshock duration. Policy responses are A1 (“fully floating”) or B1

(“leaning against the wind”). exchange rate must adjust to reflect a new equilibrium. Attempting to resist such

Exhibit 3: External shock impact, 'fully adjustment through sustained intervention is generally inefficient, as it merely delays the

floating' and 'leaning against the wind' necessary relative-price correction and may ultimately deplete reserves. This distinction is

policy, and transitory shock particularly relevant for Peru. Given residual financial dollarization and remaining FX

mismatches, temporary exchange-rate overshooting can generate macro-financial costs

that exceed its informational value, providing a rationale for the BCRP to 'lean against the

wind'. At the same time, the BCRP does not seek to defend a specific exchange-rate level;

rather, it allows the PEN to adjust to permanent shocks while intervening to smooth

excessive volatility associated with temporary disturbances, consistent with the logic of

the IMF’s Integrated Policy Framework.

Source: Armas (2019)

Peru entered inflation targeting in 2002 with exactly this institutional backdrop.