1. Asset Prices and Monetary Policy in Peru Adrian Armas Central Reserve Bank of Peru October 2007 XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries

2. I.Monetary policy in the presence of a bubble II.Peru: some asset price indicators III.Credit growth

3. Definition of a bubble Garber, P.M. (2000): A bubble is present when the price of an asset differs significantly from its fundamentals. Kane, Edward and Kindleberger, Charles (2004): bubbles appear in the last stage of an economic boom, when expectations are irrationally optimistic. The bursting of a bubble is accompanied by recession, low inflation (even deflation).

4. Should monetary policy be used to abate asset price bubbles? Or should the central bank act only after the bursting of a bubble?

5. Policy rate Inflation Economic activity Interest rates, liquidity and credit Exchange rate Inflation expectations Asset prices Monetary Policy Transmission Channels Regulator’s policies Central bank communication?

6. Rudebusch (2005) Monetary Policy and Asset Price Bubbles. FRBSF Economic Letter 18

7. Peru: some asset price indicators

8. Asset prices in Peru The stock market has increased, but company earnings have risen as well (i.e., P/E ratios have not had significant increases). Housing prices evolve around “normal” levels.

9. The Lima Stock Exchange Index has almost tripled since 2005.

10. However, earnings have been increasing. The P/E ratio (15.9) is still below its 10-year average (17.4) P/E ratio and Earnings Index : 1995 – Sep. 2007 Earnings Index: Jan, 1995=100

11. The P/E ratio in Peru is lower than in most emerging markets Source: Bloomberg, Economatica and BCRP calculations * September

12. There is no evidence of a housing price boom.

13. In developed countries, asset prices – mainly equities and housing- affect economic activity through the wealth effect. Since asset markets are small in Peru, their impact is lower than in developed countries.

14. Market Capitalization/GDP Sources: Augusto de la Torre et.al. (2007) “Capital Market Development: Whither Latin America?. WPS 4156 Lima Stock Exchange Market. * Assets registered in CAVALI for market negotiations.

15. Residents’ shares registered with CAVALI represent about 17 percent of GDP Residents’and nonresidents’ shares as percentage of GDP 0% 5% 10% 15% 20% 25% 30% 35% 40% 2001200220032004200520062007* Non residentsResidents * August.

16. Pension funds are the largest resident investors at the stock exchange and the bond market.

17. Mortgages represent less than 3 percent of GDP. The construction sector represents about 5 percent of GDP. Latin America: Construction /GDP (Average 2000-2004) Source: CEPAL.

18. Asset price booms are usually accompanied and sustained by credit booms (e.g., a vicious circle of credit and price of collateral) in the context of rapid economic growth and high confidence.

19. Credit growth has been dynamic during the last two years. *August.

20. At the same time, as a percentage of GDP, credit to the private sector is still below previous peaks, and also below the level in similar emerging economies.

21. In partially dollarized economies, such as Peru, foreign currency is a relevant asset and its price (exchange rate) also plays a role through the balance sheet effect.

22. Credit dollarization has diminished by 20 percentage points over the last years, reducing currency mismatches in the economy. 57.7 50 55 60 65 70 75 80 85 199920002001200220032004200520062007* Credit Dollarization of the Financial System: 1999-2007 *August.

23. The market for long-term bonds has weathered well the recent volatility (July-September). In September yields and volatility decreased.