Risk drivers and outlook

Over the last decade, Peru has experienced an extraordinary macroeconomic boom. Owing to beneficial external conditions and supported by a solid policy framework, the country has combined low inflation with high growth rates. Moreover, economic activity has proven relatively resilient to an adverse evolution of commodity prices and international financing conditions, and buffers in the form of international reserves and room for countercyclical policy measures remain large.

Because ample liquidity is combined with a very limited reliance on short-term debt, Credendo Group assigns to Peru the most favourable classification for short-term political risk (Cat. 1). When considering the medium to long term, key additional Peruvian strengths include a high investment rate and low external indebtedness. But dependence on the mining sector and a sizeable current account deficit make for some vulnerability to external shocks. Furthermore taking into consideration the prevailing social tensions (mainly related to inequality as well as environmental and indigenous community concerns), Credendo Group assesses the MLT political risk for Peru as moderate (Cat. 3).

As for overall indicators of competitiveness and doing business, Peru traditionally ranks among the region’s best. Yet institutional quality remains to be improved. Combined with the recent depreciation of the sol and the relatively high cost of credit in Peru, this explains why Credendo Group classifies the systemic commercial risk for Peru in its middle category (B on a scale from A to C).

Facts & figures

Pros

  • Strong liquidity position
  • Low external debt
  • Sound policy framework
  • High investment rate

Cons

  • Natural resource dependence
  • Limited manufacturing activity
  • Growing current account deficit
  • Social conflicts

Main export products

  • Copper (18.3% of 2013 current account receipts), gold (15.0%), manufactures (11.9%), petroleum and gas (9.7%), tourism (4.7%), lead (3.3%)

Income group

  • Upper middle income

Per capita Income

  • USD 6,390

Population

  • 30.4 M

Description of electoral system

  • Presidential: 5-year term, no consecutive terms allowed, next election: April 2016
  • Legislative: 5-year term, next election: April 2016

Head of State and of government

  • President Ollanta Humala

Country risk assessment

Frail political stability

After alternating between democracy and militarism for five decades, Peru definitively opted for civilian rule in 1980. Since then, it has been the decade under the rule of Alberto Fujimori that started in 1990 that has most decisively shaped Peruvian politics. To the great benefit of his popularity, Fujimori effectively dealt with the recession and hyperinflation legacy of the late 1980s. But ever more autocratic ways (he closed Congress and suspended the Supreme Court as part of a 1992 ‘self-coup’, and in 1993 he changed the Constitution to allow his own re-election in 1995) eventually undermined support. Fujimori ultimately resigned shortly after winning another re-election in 2000, when evidence of widespread voting irregularities and corruption surfaced.

Still delicate political institutions notwithstanding, transitions of power have been exemplary since democracy was consolidated in 2001. Three presidents have been elected in the meantime: Alejandro Toledo in 2001, Alan García in 2006 and incumbent Ollanta Humala in 2011. Representing the left-of-centre Gana Perú alliance, Humala won the presidency thanks to a narrow election victory over Keiko Fujimori, daughter of Alberto and leader of the right-wing Fuerza 2011 bloc. In Congress however, Gana Perú depends on the backing of the centrist Perú Posible party for a thin legislative majority. Moreover the resulting cabinet fragility – manifested by no less than six reshuffles in the last three years – is being compounded by an economic slowdown that weighs on Humala’s approval rating. As such, the President faces the risk of becoming a ‘lame duck’ in sight of the 2016 general election.

While widespread political stability is broadly expected to prevail, Peru remains much affected by social conflicts that often turn violent. Tensions mainly relate to the issue of the fair distribution of the benefits of economic  growth: rural poor versus urban middle-class, informal miners versus extractive industries, indigenous and environmental concerns versus multinational corporate interests. Social inequality has also been the leitmotiv of the Maoist Shining Path insurgency that emerged in the 1980s. Despite a severe military crackdown on the rebels – particularly by the Fujimori administration – the armed conflict is still lingering. The Shining Path is, among other things, involved in the lucrative production of coca leaves, the raw material used to make cocaine. According to the UN, Peru has in recent years become the world’s leading producer of coca as successful eradication efforts in Colombia have driven the production southward.

Prevailing pro-trade and pro-market stance

Peru’s longstanding territorial disputes with Ecuador and Chile have been settled, which strengthens the prospect of peaceful external relations. Peru has also demonstrated openness to international trade and, over the last four years, Free Trade Agreements with the US, China and the EU have entered into force. Of further interest is the dynamic drive towards regional integration within the Pacific Alliance (PA) – a trade bloc of four also including Mexico, Colombia and Chile that in total encompasses 36% of Latin American GDP. In February 2014, the partners agreed to eliminate trade tariffs on 92% of goods and services. What sets the PA apart from MERCOSUR (the bloc built around Brazil and Argentina), is that it is characterised by openness to the rest of the world and a commitment to pro-market policies.

Liberal economic principles introduced by Fujimori have indeed prevailed in Peru, with all three most recent presidents notably steering a more pragmatic course than initially anticipated. Humala in particular had campaigned on a leftist political agenda before abruptly shifting to the centre upon taking office. This alleviated foreign investors' fear of increased interventionism. But the conciliatory stance towards the private sector has disappointed radical supporters and fuelled disruptive protests. This illustrates the political tightrope Humala is walking. Aiming to combine continued macroeconomic stability with more inclusive growth, he needs the extractive industries' revenues to fund welfare programmes. This model is under pressure though, as increasing social and environmental opposition to mining projects is weighing on the investment climate. It is against this backdrop that regional and municipal elections will be staged in October 2014.

Policy framework supportive of growth

Despite somehow illustrating the frailty of the Peruvian democracy vis-à-vis the strength of the business lobby in Lima, continued adherence to orthodox policies has all in all clearly benefitted development. It enabled the rapid economic growth that in turn allowed for a broadening of the social agenda. With the unemployment rate at a historic low (projected at 6% end-2014) and the number of Conditional Cash Transfer beneficiaries increased by 50% between 2011 and 2013, much headway has definitely been made. Though universal inclusion is not yet achieved and tackling extreme poverty remains an issue, living conditions have greatly improved and the poverty rate has dropped by more than half since 2005, to 26% in 2012.

Sound public finance management constitutes a prime element of the much lauded macroeconomic policy framework. Crucially, a fiscal responsibility and transparency law in place since 1999 has fostered a prudent countercyclical stance. This is well exemplified by the significant fiscal savings undertaken as of 2003, when prices for Peruvian commodity exports started soaring. A primary fiscal surplus has since then been maintained and as a result, public sector debt declined from more than 47% of GDP in 2003 to less than 20% in 2013. Moreover, the established fiscal stabilisation fund has allowed for mitigating the impact of economic downturns. Stimulus measures effectively softened the impact of the global financial crisis of 2009, and as of recent the fiscal stance turned accommodative again in order to counteract the adverse effects of declining metal prices (the overall surplus declined from 2.2% of GDP in 2012 to 0.5% in 2013 due to increased infrastructure and social spending, and the downward trend is expected to continue in 2014). At the regulatory level, recent steps were taken to strengthen tax law compliance and fiscal responsibility and transparency have been improved to further discourage pro-cyclical policies and improve the fiscal relationship between the national and subnational levels.

Peru_Graph1EN

Source: IMF/IFS

When not at odds with inflation objectives, monetary authorities, too, have pursued countercyclical policies. As such, the expansionary stance that applied during the 2009 crisis was duly phased out when economic activity picked up again as of 2010 and conversely, the Central Bank has repeatedly lowered the policy interest rate since late 2013 in order to support the slowing economy. Owing to policy credibility, even with that stimulus, inflation expectations have remained anchored well within the Central Bank target range of 1% – 3%. Monetary authorities have also engaged in active exchange rate management. Over the past decade, substantial capital inflows motivated the Central Bank to massively accumulate international reserves. But financial conditions abruptly changed in May 2013, as global risk aversion surged following the US Federal Reserve announcement that it would gradually scale back its extremely accommodative monetary policy. With the sol subsequently suffering depreciation pressure, the Peruvian Central Bank switched from buying to selling US dollars. Yet reserves still covered more than eleven months of goods and services imports in June 2014, evidently a very comfortable level given the standard threshold of three months.

Central Bank interventions to smooth the exchange rate should be seen in light of the relatively high level of dollarisation in Peru. Though the latter has decreased from about 70% in 2005 to little more than 40% in early 2014 (not in the least owing to prudential measures such as setting higher reserve requirements for USD deposits), excessive volatility leading to disruptive currency mismatches is indeed still the most important threat   to financial stability. All in all however, the Peruvian banking system seems well capitalised and profitable, with adequate provisions. Furthermore, the regulatory and supervisory framework has been strengthened substantially in recent years.

Star performer, resilient to shocks

Over the past decade, with inflation under control and annual GDP growth averaging 6.6% since 2004, Peru has been South America’s star performer. As discussed, sound macroeconomic policies have been instrumental to this achievement. Yet it is the benign external conditions in the form of booming commodity prices and favourable financing terms that have been the key driver.

Peru_Graph2EN

Source: IMF (IIF for Argentina and Venezuela, EIU for Cuba)

Peru is rich in natural resources. It has significant reserves of natural gas and petroleum, and recently became a net fuel exporter. Minerals are abundant, too. The country occupies a leading global position in the production of copper, silver, tin, zinc, lead, molybdenum and gold. In 2013, Peruvian mining exports amounted to more than USD 23 billion, the equivalent of over 11% of GDP and almost 44% of current account receipts. In this context, it should come as no surprise that the so-called commodity supercycle of the 2000s benefitted economic growth. It also encouraged substantial investment into the mining sector, in turn making for thriving capital goods imports and profit remittances. As a result, despite the strengthening terms of trade, the Peruvian current account has been in deficit since 2008. Considering external debt dynamics, the current account deficit has consistently been covered by Foreign Direct Investment inflow and total external debt has remained below 30% of GDP. In addition, ample global liquidity has allowed Peruvian banks and corporates to finance themselves at record low costs and to reduce their reliance on short-term funding. To illustrate the high level of capital market confidence with regard to Peru, note that 56% of local currency debt is held by non-residents.

Peru_Graph3EN

Source: IMF

In recent years, external conditions have taken a turn for the worse. For one thing, lower metal prices have weighed on export growth since 2012, causing the current account deficit to broaden from 1.9% of GDP in 2011 to 4.9% in 2013. Furthermore, US Federal Reserve ‘tapering’ has driven up financing costs for Peruvian debt. Non-resident capital inflows have moderated as a result, with the slowdown mainly reflected in lower private  sector and bank borrowing abroad. Unsurprisingly, economic activity has suffered. GDP growth slowed from 6.3% in 2012 to 5% in 2013 and the government expectation for 2014 is no more than 4%. Though the decline is apparent, that is still high by Latin American standards. Besides, Peru remains well placed to mitigate the impact of the deteriorating external environment, with large international reserves serving as a buffer against excessive exchange rate volatility, and low debt ratios providing room for continued countercyclical stimulus measures.

Balanced medium-term outlook

Over the medium term, owing to continued adherence to prudential policies, public debt stands to continue its downward trajectory and inflation is expected to evolve to the 2% centre of the Central Bank target range. GDP growth is projected to achieve its potential of 5.8% from 2015 onwards, the rebound hinging on the coming into operation of a few big mining projects. While this forecast may prove too rosy, the mechanism of investment boosting growth also sheds light on how the extraordinary Peruvian track record came about. Indeed, Peru grew faster than other Latin American commodity exporters in part because it invested more. With gross domestic investment averaging more than 26% of GDP since 2010, Peru has more closely resembled fast-growing Asian economies than regional peers. The same holds true for what has been another important growth driver, the substantial increases in Total Factor Productivity that – in Peru – to a large extent can be attributed to reduced (though still high) labour informality.

Peru_Graph4EN

That being said, even the optimistic growth forecast entails a clear slowdown in comparison to the commodity boom heyday. With abated Chinese demand driving down metal prices – thereby hurting exports and discouraging mining investment – a transition towards lower trend growth indeed seems inevitable. This holds true even when taking into account the recent government push to facilitate investment, among other things by reducing red tape and accelerating the approval of permits for mining, energy and infrastructure projects. Natural resource dependence thus remains a key vulnerability for Peru.

Helping to address the concern of a lack of economic diversification – manufactures comprised less than 12% of Peruvian current account receipts in 2012 – important structural reforms are being implemented with the aim of improving competitiveness and productivity. The agenda is centred on infrastructure development (the government projects to allocate concessions worth some 5% of GDP in 2014), labour market reforms (to reduce the cost of employment and foster human capital accumulation), deepening of capital markets (to facilitate the issuance of new securities) and reforms of the civil service law and the private pension system. Moreover, a pending industrial development law specifically aims to diversify production.

Analyst: Sebastian Vanderlinden, s.vanderlinden@credendogroup.com