Peru's Sol Flirts With 18-Month High in Defiance of Central Bank

  • Inflows seen persisting even with expected rate cuts
  • Intervention seen curbing gains; unlikely to reverse trend

Peru’s central bank faces an uphill battle in its efforts to stem gains in the sol.

The currency has risen 3.3 percent this year, propelled by demand for higher-yielding assets in countries with predictable policies, even as central bankers signal they’ll likely cut interest rates and the monetary authority steps up sol sales to meet investor demand.

After surging to an 18-month high of 3.2321 per dollar in February, the currency is likely to gain another 3 percent to end the second-quarter at 3.15 per dollar, according to Morgan Stanley, which called the sol one of its favorites in emerging markets in October ahead of the rally. That could frustrate central bank President Julio Velarde, who has cautioned against rapid swings in the currency.

"Although they’re going to lean against the wind, I don’t think they’re going to change the trend," Cesar Arias, an economist at Deutsche Bank AG, said in an interview.

While the sol’s gains this year are moderate compared with advances for some peers, such as the Mexican peso’s 10 percent rally, it entered the year from a position of strength. The currency rose 1.6 percent last year, when most emerging-market currencies lost ground, and extended gains by another 2.5 percent in January.

The currency is only about 0.5 percent away from its 18-month high, despite active intervention from the central bank. Over the past month, the institution bought $738 million in the spot market and started using derivatives that allow dollar buying without much impact on official foreign-exchange reserves.

While the interventions could cause the sol to under-perform regional peers, they likely won’t be enough to curb gains, Citigroup Inc. strategists led by Dirk Willer wrote in a note last week.

The sol gained 0.5 percent last month. Historically, it strengthens the most in March, when individuals and firms tend to buy the currency to meet tax obligations.

Unlike past years when gains tapered out after March, the currency could get an extra boost as local pension funds reduce their U.S. dollar holdings and return to the sol. Usually, they’ve held about 35 to 40 percent in dollar assets. That surged to 72 percent in August 2015 when the sol was in the midst of two years of depreciation. Now, with the currency appreciating, dollar holdings decreased to 63 percent in February, according to Arias.

Investors have earned a carry-trade return of 8.8 percent over the past year as volatility declined after last June’s election of President Pedro Pablo Kuczynski, a former Finance Minister and central bank director with extensive Wall Street experience. Peru’s local bonds have jumped 9.7 percent this year, the fourth-most among all developing nations.

An uptick in growth and trade, spurred by rising commodity prices, will also support the currency. Despite a likely economic slowdown this year amid devastating floods and an ongoing corruption scandal with Brazilian builder Odebrecht SA, Peru is forecast to post the continent’s fastest expansion in the coming year. The economy will likely grow 4 percent to 5 percent next year, Kuczynski said in an interview on Wednesday.

Last year, the nation’s trade balance flipped to a near $2 billion surplus from a $2.5 billion deficit two years prior. That surplus could double this year as the nation benefits from an increase in copper production at a time of higher prices, Deutsche Bank estimates.

"This is an environment supportive of EM in general and commodity exporters in particular," Arias said. "Peru has relatively healthy growth, low inflation, a solid external balance sheet and manageable debt. When we look at real returns from investing in Peruvian assets, they’re now among the highest in South America."

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