Financing Deficits in Peru CARLOS BOLOÑA
In the 1980s in Peru, the populist model was applied during the first half of the decade by President Fernando Belaunde and by Alan Garcia during the second five-year period. It was a pure populist model that came hand-in-hand with democracy. Democracy has been connected with a populist model since the 1970s, when we had a socialist military regime that failed completely. Belaunde gave us a fiscal deficit of about 7.1 percent of gross domestic product (GDP), an average yearly inflation of 108 percent, and a growth rate of zero during his administration. He also defaulted on our debt after the Mexican crisis in 1982. Garcia went further with the populist model. He decided not to pay the country’s debts, or to pay only 10 percent of exports, which meant defaulting on all the banks, defaulting on all the Paris Club members, and defaulting on international financial institutions like the World Bank, the Inter-American Development Bank (IDB), and the International Monetary Fund (IMF). Thus, thanks to Garcia, we became members of the Pariah Club. Along with Libya, Haiti, Liberia, and North Korea, we were members of the group of ineligible countries that did not receive a single cent from the world economy. Therefore, getting access to capital markets in order to finance our deficit was hard, to say the least. Yet Garcia managed to get some international capital. Then he decided that he was going to apply a heterodox approach to the economy in which it didn’t matter how large the deficit became. What was important was to give the people what they wanted. Not surprisingly, the fiscal deficit and the quasifiscal deficit reached 16 percent of GDP. The GDP per capita reached US$720, an amount lower than that of 1960. One can’t really look at the gross numbers, which don’t mean anything after hyperinflation. Garcia’s legacy was 2.2 million percent inflation in five years, minus 7 percent GDP growth, and a loss of US$300 million in net reserves. This meant isolation in every way. They didn’t even accept our collect calls. “Peru? Sorry, we don’t accept collect calls from Peru.” So, that was Alan Garcia’s legacy. We definitely had an inflation tax. Since taxation in Peru was reduced to 4 percent of GDP, the inflation tax was very easily around 10 percent or more of GDP. Inflation reached almost 8,000 percent in 1990, 60 percent a month, and 2 percent a day. We started to look at inflation on a daily basis. A long-term bank loan was five days, medium-term was two days, and short-term was measured in hours. Moreover, the interest rate was 60 percent a month (see Chart 1).
As you can imagine, this was a lot to deal with. When Alberto Fujimori ran for elections, he won by saying what he was not going to do. He said, “I am not going to produce a shock, I am not going to privatize, and I am not going to fire public employees.” His program was very simple: Trabajo, tecnología, y honestidad. Work, technology, and honesty—that was his program. And that’s the best way to win elections: Not saying anything and doing things afterward. Carlos Menem in Argentina and our good friend Fujimori did it the same way. How I ended up working with Fujimori is a long story. I didn’t vote for him, I didn’t believe he was right for Peru, and I thought he was going to be more of the same as Garcia. But circumstances led me to discuss his economic program in the Radisson Hotel in Miami. We were ten economists in his little bedroom—five orthodox and five heterodox. Fujimori asked, “How do you cope with hyperinflation?” The heterodox side said we should run an econometric model, and in one month we would increase the price of noodles, the next month we would increase the price of oil, and so forth. But I simply told the president that hyperinflation is a cancer and that you must take out that tumor and do it as fast as you can because Peru is dying of cancer. Taking out the tumor requires fiscal and monetary discipline. Moreover, there was terrorism in Peru and we were losing the war against terrorism. The main rebel group, the Shining Path, had 10,000 men and US$60 million a year in income, and it was winning the war against our army of 200,000 men. The military had six German submarines, four ships with missiles, twenty Mirage fighter planes, and they were asking for more money. The big issue was: How do we enter government and cope with this deficit? Maybe I can contribute by sharing my experiences in coping with the deficit. The theory says to reduce expenditure, increase taxes, and you’ll get your act together; the deficit will be reduced. Okay, but how did we do it? In order to reduce the deficit, it’s necessary to focus on simple ideas. We were in hell. For me the definition of hell is terrorism. The Shining Path was controlling more than 50 percent of our territory, and hyperinflation reached almost 8,000 percent a year. That’s hell, believe me! The problem is that hell can continue to go down. There is no limit to the number of levels of hell. It’s very dynamic. The first thing we had to do was to deal with the payroll problem, and there were two big aspects that needed to be cut from the beginning. Military salaries were indexed to the salaries of the Senate and the Congress. That meant that when the Senate met, they’d raise their salaries. And because they were the first power of the nation, I couldn’t stop them. They would raise their salaries 50 percent or as much as they wanted. Of course, I did not pay them, and they went after me and took me to jail. I was released but I was still trying to withhold the money. The problem was that not only those 500 congressmen were affected but also 300,000 military employees. Every time the congressmen raised their salaries, they raised the salaries of 300,000 military personnel. Thus, my first measure was to switch that indexation. Let me tell you that you cannot try to convince the military to cut indexation; it’s a little bit risky. They really throw you out. So we sent a decree to the president instead of to the Congress—a very important decree, in which the whole military structure was indexed to the president’s salary. And of course the president’s salary was frozen. Luckily we passed the decree on Friday, and between Friday and Saturday at 5 a.m., their salaries were indexed to the president’s salary. The military moved their tanks over the weekend, but they accepted that we were going to be, to an extent, reasonable with the president’s salary. That was the first move. Once they swallowed that—and we were alive after that—that was our first step. We had dealt with the situation for 300,000 people. I know they were earning ridiculous salaries after hyperinflation, but that’s what hyperinflation means—the bankruptcy of a country. The second big step was a very simple definition, an important definition, which says that if you don’t work one day, you don’t get paid that day. It’s a biblical definition. If you don’t work, you don’t eat. Why? Because during the Garcia regime, many people went on strike and they still got paid. Imagine a million public employees going on strike and continuing to be paid. Even though the strike lasted for months, nothing happened. The turning point for the deficit was to cope with the 400,000 teachers that went on strike. The teachers were earning US$150 a month, which was reduced to US$30 because of hyperinflation. It’s true that the teachers couldn’t survive on US$30 a month—that’s one dollar a day—and they asked for a tenfold raise to US$300 a month. Imagine, if you multiply by ten the salaries for the teachers: then come the nurses, the doctors, and then comes the army, and then you have a big, big problem. So we definitely had to deal with the teachers. The minister of education paid the teachers during the first month of the strike. And that was a bad move. Why should they bother to return to work? So we sent a very clear message saying that we were not going to pay their salaries while they were on strike, and in the second month, we didn’t pay. We said we could only pay a raise from US$30 to US$45, not from US$30 to US$300. The teacher’s union was totally controlled by the Shining Path. And, of course, there was a big confrontation with the government. During the first month, 400,000 teachers were marching on the streets, burning cars, and 7 million students were at home. That was the first month. Violence was awful in May 1991. Both the Ministry of Economy and Finance, my ministry, and the Ministry of Education were hit by rockets. They blew out the eleventh floor in the Ministry of Education, and they missed my floor, which was floor number nine, because they hit floor number seven. That was what we had to cope with. But after one month the teachers realized what fiscal discipline was, and then we negotiated with the Shining Path. Those were tough negotiations. I knew that they couldn’t keep the strike going for two or three months; it was impossible for them. Even so, everybody was watching us and everybody was betting against us, betting that we wouldn’t get our act together. Thank God the president backed me up. He said, “Go all the way, I’ll back you.” Thank goodness because, you know, presidents tend to chicken out when you have 7 million students at home and 400,000 teachers marching in the streets. Nevertheless, the negotiations were not complicated. My meeting with the Sindicato Único de Trabajadores (SUTEP), was a simple one that lasted only fifteen minutes. The first comment was, “Minister, we have you here at the negotiating table?” “Yes, I am here.” The second comment was, “Because of your stubbornness we are going to miss the whole academic year.” My reply was a short one, a very short one: “Look, for what you have been teaching for the past twenty years, we’ve been wasting all the academic years.” That was tough. And the third exchange was that they were going on an indefinite strike. My reply was, “Look, every month you’re on strike I save US$40 million. I need three more months to balance my budget.” Although they left very annoyed, I knew that SUTEP was going to go down and that the whole strike was going to go down. And one month later, the strike was over and there were no more strikes by the teachers’ union for five years. We raised their salaries to US$45, which was ridiculous, but that was the only way to get out of hyperinflation. Amazingly, the minute we got the situation with the teachers’ union under control, the expectations of all the economic agents started to change. Inflation started to go down from 7.7 percent a month to around 5 percent. It moved slowly due to all the schemes that were in place, but the change was very important. The other important element was the policemen’s Christmas bonus. I ran out of cash on December 24 at 8 p.m. The Banco de la Nación didn’t have a single sol. Imagine trying to explain monetary discipline to 80,000 policemen at 8 p.m. on Christmas Eve. So I called my friend at the Central Bank and asked him to lend me some money until Monday. It was a Friday and he said, “Minister Boloña, you are always preaching about monetary discipline. That means that I am not going to give you money to pay salaries.” So I had to call big companies and ask them to advance some taxes on Friday night. I could do this because I had moral persuasion with those companies, and they gave me those taxes and I paid the bonus. On the expenditure side, it was very, very tough. But if we had not controlled expenditure we would have been in deep problems. We also looked at what was going on with pensions. We had 300,000 people receiving US$15 a month as their pension. The whole social security system was bankrupt, but that’s the pay-as-you-go scheme. We were really taking advantage of the pensioners because of hyperinflation, but that’s how we got into a new scheme. We privatized the pension funds and raised their salary to US$150 a month, and today it may be up to US$200 a month. In terms of terrorism, the military was asking for US$2 billion to fight terrorism. They wanted to buy ships; they wanted to buy planes; they wanted to buy everything. We said no, that we were going to buy helicopters and machine guns. We also said that we were going to buy shotguns to arm the ronderos (that is, self-defense groups formed by campesinos). That was also a big decision. The president persuaded us that we should give shotguns to the ronderos. He was right because the Shining Path would go into the small towns, take their livestock and their sons, and rob them. This plan worked: it helped with our intelligence, and we started to focus on a different type of war that didn’t involve the big toys that the military wanted to buy. The situation with Ecuador was also a big problem. Ecuador saw that we were in very deep trouble, and they realized that this was the time to wage a war. It was hard for us to get our act together, especially when terrorists were our first enemy. But peace with Ecuador, for me, is a very good thing, and it’s going to save each country US$500 million a year. Although peace was achieved later, we still had it very clearly in our minds that we had to cope with military expenditures. So, really, our deficit, which was 16 percent of GDP, was mainly financed by taxes and by the inflation tax. We had to get our inflation tax down, and that definitely meant reducing expenditures. But we also needed to work on taxation. Taxation was a joke. With tax collections of only 4 percent of GDP, nobody was paying taxes and inflation was eroding our tax base. We had two hundred taxes, and we reduced them to seven in only a few months. We eliminated all earmarked taxes. Incredibly, we realized that we were collecting taxes for the Shining Path. For example, we had taxes on shoe polishers, which were collected by the government and given to the Union of Shoe Polishers. The president of that union was a well-known Shining Path member. The things we were doing were amazing. We simply eliminated a lot of nonsense taxes and concentrated mainly on four important ones. These were the value-added tax, a two-tiered income tax, import duties, and a tax on petrol, beer, and sodas. Another element of our internal financing was the Central Bank. The Central Bank was directly responsible for several subsidies, which we had to cut in the name of fiscal and monetary discipline. Our four development banks were also increasing the deficit. We had a bank for culture, industry, mining, and construction. And guess what? Every five years they would go bankrupt to the tune of 500 million to a billion dollars. Then the new government would recapitalize them and they’d start the party once again. These banks lent money in a very free manner. We realized that if we really wanted to cut the deficit, we needed to eliminate the development banks, which had around 7,000 employees. We closed them all in three months. It was very simple. I asked the Central Bank if they wanted to capitalize the banks and they said no. We didn’t have the money at the Ministry of Economy and Finance, either, so we just liquidated them. A lot of people in agriculture were very annoyed because these banks maintained their standard of living. They would take out a loan and not repay it, but they also went to Europe and had nice cars and whatever else. They would simply get a congressman to say that the agricultural sector was in a state of emergency and that the loans should be forgiven. That happened every other year, and the same happened in each of the sectors. Social security, as I mentioned, was a similar story. It was completely bankrupt with a net worth of minus US$20 million. So we simply had to eliminate the pension funds, keep social security as a safety net, and privatize the whole thing. The other big problem was the public enterprise deficit, which was around 5 percent of GDP. Of course, the required measure was just to privatize everything, but the president was not convinced about it. He allowed us to privatize only twenty firms at first. But afterward we convinced him to privatize all two hundred state-owned enterprises. We took in US$8 billion from privatization and another US$7 billion from new investments. So that was a nice measure that gave us positive results in the short run and started to give good results in the medium term. The other element for the deficit was the private sector. The private sector, such as it was, exerted big pressure for the government to run a deficit. As liberal economists we were assuming that we had a private sector, and then we realized that what we had was a quasipublic sector. So we had to privatize the private sector. This was a very important measure to keep our deficit under control. What do I mean? In the previous model, profits were privatized but losses were socialized. When they earned money, it was theirs, but when they lost money, the government took care of the losses. There were many other problems with the private sector model. They did not pay taxes, they received subsidized credit, they did not compete, they did not pay back their loans, and they received subsidized public services. This was a very populist model. It was cheaper for us to send them a check at home instead of having them work because it was too expensive for the country. So we had to change the rules by privatizing profits and losses: if you earn a dollar, it’s yours; if you lose a dollar, that’s your problem. Also, you’ll pay your debts, your interest will be a positive, real interest rate, you’ll pay your taxes, you’ll compete, you don’t get to have monopolies, and the prices you pay for public utilities will reflect their costs and scarcity levels. These changes were very important to avoid bigger deficits. Now, in terms of financing the deficit, the problem was that even though we reduced our deficit to around 2 percent of GDP, we were also paying around 2 percent of GDP for foreign debt service. Remember that we were ineligible to get new loans. So first we had to collect a billion dollars from the Grupo de Apoyo and make the gesture of paying the international financial institutions to start the whole process once again. Then we received loans from the IDB, the World Bank, and the IMF. But we also had to solve some problems with the private banks and then solve the problems with other countries, like the Russians. We applied market economy to our Russian debt. They had loaned us a billion dollars in rubles some twenty years earlier, and we paid them with today’s exchange rate. So we only paid them US$100 million. However, even when we got our act together, meaning that we had achieved a deficit of 2 percent of GDP and expenditures of around 15 percent of our income, temptations would arise. We would ask ourselves: How about using capital markets or issuing sovereign bonds? I didn’t want to get into sovereign bonds, except for the Brady bonds that were used to refinance debt. Not new government bonds. I didn’t want to do that because it’s like an alcoholic who takes a drink. I thought we should show that Peru could function effectively for a couple of decades and then start to use capital markets to finance its fiscal deficits. So we kept a very simple way of managing our finances. Expenditure was whatever was received as income or as taxes. At most, we would receive maybe 2 percent of GDP in new debt in order to maintain access to international credit markets. And that is how we kept our finances. Temptations always appear, though, and the biggest temptation that we have had is the political cycle. For his reelection in 1994–95, Fujimori overspent and inflated the economy. We almost went into deep trouble. We ended up with a balance-of-payments deficit. So we had to slow down our economy in 1996. We lost two years inflating the economy and one year stopping the economy because of the political cycle for Fujimori’s first reelection. And now we are in our second political cycle, and Fujimori’s cycle is a very short one. It seems that, maybe in four or five months, Fujimori will inflate the economy, and then Peru will pay the bill after his reelection. This is a tough reelection because people are feeling the pinch in their pocket with the current recession. We have not yet learned to cope properly with the political cycle in our country, especially when our government is concentrating power instead of decentralizing power. Instead of making institutional reforms, it has been weakening institutions. So that’s how we dealt with our deficit in Peru, and I think maybe the important part of this story is how to do things. The principles are easy: get expenditures down, get income up, and things will be okay. But the implementation is not easy. The politics of how to do things is important. It’s necessary to apply the right phrase at the right moment to convince politicians, to convince the president, to convince the military, to convince congressmen. You need simple ideas that make the right connection at the right moment. And you must be prepared. And sometimes it’s necessary to be in really deep trouble to make big changes. Otherwise, you sometimes just don’t act. So that’s more or less the experience I wanted to share with you. However, in making these changes, you should be very clear what size your state should be, what size government you want. When we were convincing our president of these changes, we said that the size of the Peruvian government should be around 15 percent of GDP. If the goal is clear, then expenditures can be cut in a very neat way. Keep it simple and avoid getting lost in a lot of details. Our financing was mainly internal because we were not eligible for external financing. Later, when we started to open our economy and get external funds, we only used them to help us with the payment of external debts. We have a debt of 50 percent of GDP, depending on which figure you like to use. Regardless, it’s a big debt, and it used to be around 100 percent of GDP. But we reduced it through privatization, concessions, and through other intelligent mechanisms. That’s what we should all be aiming for. |
would like to thank the Federal Reserve Bank of Atlanta for this invitation. It’s my pleasure to be here and share some experiences about deficit finance in capital markets, wherever they may apply. My experience is the case of Peru.