Sector development is crucial to economic diversification efforts

While the country’s economy has long been dominated by the mining sector, less attention has been paid to other sectors. However, as commodity prices have fallen, dragging mining output down with them, Peru will have to lean more heavily on manufacturing to drive future growth. This new reality presents both challenges and opportunities. Peruvian manufacturing benefits from a number of free trade agreements (FTAs) with countries from Asia to Europe. The country is also a regional net exporter and economic ties with China have grown, driven by mining exports, to the point that the world’s second-biggest economy has become Peru’s most important trading partner.

The manufacturing sector does, however, face important obstacles. The cost of labour is higher than in many Asian markets; some regulations, particularly regarding labour, are overly onerous; skilled labour is in short supply; a high percentage of the population works in the informal sector; and Peru’s manufactured products tend to lack sophistication and technological content, which makes them highly susceptible to raw material price volatility and foreign competition.

Diversification

The government of President Ollanta Humala is attuned to both the importance that manufacturing will play in Peru’s economic future and to the sector’s shortcomings. In 2014, the government laid out a campaign called the National Plan for Productive Diversification (Plan Nacional de Diversificación Productiva, PNDP) that aims to promote investment and innovation in manufacturing and scale back burdensome industrial regulations. In a report outlining the plan’s motivations and goals, the government observed that, “No precedent exists of a country whose economy has a large natural resources component, is small, and is far away from the world’s primary markets that has made the leap to development without diversifying its production.” Small, distant, resource-dependent economies often experience periods of robust growth driven by commodities price increases followed by stagnating growth and wages during commodity downturns. This is the fate Peru intends to avoid by diversifying its production, particularly in manufacturing.

Peruvian manufacturing production consists mainly of low-value-added, low-technology products. One quarter of value added from manufacturing comes from primary goods, such as flour, oil, sugar cane and mineral processing. Another third comes from processed food, beverages and tobacco, and clothing and textiles. Chemicals; non-metallic minerals, such as glass and cement; and metal-based products, including construction materials and machinery, comprise another quarter. Taken together, the manufacturing sector, which accounts for about 16.5% of Peru’s GDP, has achieved strong growth over the last decade, in concert with the country’s economy at large.

Between 2004 and 2013, value added from manufacturing grew at a compound annual rate of 5.8% in real terms, compared to compound annual GDP growth of 6.5%. However, growth has been uneven among the various manufacturing activities. For example, the clothing and textiles sector, one of Peru’s biggest, has contracted. Growth has also been weak in the machinery and equipment sector, a category that closely tracks the fortunes of Peru’s mining operations. Despite these weak performers, manufacturing has been buoyed by strong growth in basic metal products and in nonmetallic minerals, driven by construction.

Textiles & Clothings

The textiles and clothing segment serves as a case that demonstrates many of the opportunities and challenges of Peruvian manufacturing at large. Some of the factors inhibiting the segment’s growth include low-cost competition from Asia, costly labour regulations and high levels of informality. In the industry’s favour are its growing presence as a regional exporter and international recognition of Peru as a market where high-value garments can be produced at costs lower than those of developed countries. Indeed, industry executives and trade associations agree that the sector’s future will depend on its ability to successfully complete the transformation from a low-cost manufacturer to one that achieves competitiveness in the production of more sophisticated goods, a goal that is aligned with that of PNDP.

Asian Competition

China’s accession to the World Trade Organisation (WTO) in 2001 caused a sharp decline in Peru’s, and the rest of Latin America’s, competitiveness in low-cost textiles and clothing manufacturing. Textiles industries from Mexico to Argentina have struggled to achieve growth since then and have lost market share to cheap imports from China and, more recently, from South-east Asian countries, such as Vietnam. Extremely low-cost textiles and finished goods from Asia have flooded the Peruvian market.

According to the Textile Committee of Peru’s National Society of Industries (Sociedad Nacional de Industrias, SNI), prices have been as low as $0.40 for a square metre of fabric or $0.02 per dozen baby socks. These types of prices led Indecopi, the agency charged with protecting competition and intellectual property, to impose anti-dumping duties on Chinese garment imports at the end of 2013. The duties include a charge of $3.73 on trousers and shorts priced at less than or equal to $15.98, which generated revenue of $9m in the first half of 2014. Other garment categories accounted for $3m of duties on charges of between $0.14 and $1.00 per item. The price threshold for the other items is $6.73 for shirts, $4.33 for t-shirts, $1.59 for undergarments and $1.24 for socks.

The impact of such measures, however, has been relatively small, according to industry executives who spoke with OBG. The volume of imported garments continues to increase at high rates. “What has changed somewhat is that the prices have increased slightly – that is, they’ve become more rational,” Felipe James, president of the Garments Committee of the SNI, told OBG. In only one category, he added – stockings and similar goods – has there been a marked fall in import volume that appears to be related to the measures.

Toward High-Value Exports

In a country such as Peru with GDP per capita of $6660 in 2013, according to the World Bank, ($11,400 when adjusted for purchasing power parity), consumers are highly price-sensitive. As a result, low-cost Asian imports have forced Peruvian textile and garment companies to look for growth opportunities abroad. Peru has been most competitive in high-value exports to developed markets and the textile and garment trade relationship with the US is longstanding. Historically, Peruvian businesses had exported cheap textiles and commodity-like garments to the US. As cheap Asian goods have reached that market as well, Peru’s industry has had to adapt. Drawing on a tradition of garment manufacturing, Peruvian firms have been able to position themselves as competitive options for the production of upmarket goods. For example, Devanlay, the US licensee for Lacoste, has a significant portion of its production capacity in Peru. Peruvian clothing manufacturers have also been able to leverage one of Peru’s flagship textiles, pima cotton. Upmarket t-shirts and other articles made of pima have become profitable, high-margin exports to markets throughout the developed world.

Regional Exports

Peruvian consumer goods businesses from various sectors – including textiles and garments, food and beverages, paper products, and basic chemical goods, such as cleaning products – have looked to expand their presence as regional exporters. They have faced some challenges in this endeavour, as the same problems they have faced in their home market – competition from cheap imports and high price sensitivity – also exist throughout Latin America. José Ignacio Ilosa, general manager of Creditex, a Peruvian textiles company, told OBG that Mexico had at first appeared to be an attractive market to enter. However, as growth has stagnated there and purchasing power has failed to increase as much as some analysts had predicted, it has become a difficult market for its products. “It has turned out to be much more price-sensitive than originally expected,” he said.

Instability has also presented problems. Venezuela had been an important driver of growth for consumer goods exports. However, due to the protectionist measures the government implemented in 2014, exports may fall. Brazil would be a sensible target for export growth due to its size and proximity to Peru, and some Peruvian companies have penetrated that market, but, as in Venezuela, the country’s protectionist measures make it hard to compete. Peruvian businesses have fared better in neighbouring Colombia, Ecuador and Bolivia. In Colombia, Peruvian firms are able to compete on a roughly equal footing with local businesses as a result of the similar cost structures between the two countries, particularly in terms of labour. Additionally, thanks to the Pacific Alliance, the free trade bloc of which both countries are a part, Peruvian firms face low barriers to market entry. “The Pacific Alliance presents a great opportunity for Peru, not only for trade purposes, but to import technology and knowledge to improve process efficiency and promote innovation.” Dario Lareu, managing director for Peru, Ecuador, Bolivia and Paraguay of manufacturing company 3M, told OBG.

Although Ecuador and Bolivia are small markets, they have been profitable for Peruvian exporters in part because their domestic manufacturing sectors are less developed. Price-sensitivity, protectionism and low levels of wealth limit the upside of Latin American export markets. As a result, the greatest opportunities for export growth appear to be in the developed world, where many large markets remain untapped. Exports to Japan, for example, have shown signs of growth. Ilosa told OBG that Russia could present a significant opportunity for exports if the FTA with Peru, for which negotiations began in 2013, is signed.

Labour Challenges

Labour costs, regulations and low productivity are among the most significant issues facing Peruvian manufacturing. Regulations that make it costly to hire and fire workers and an entrenched culture of working on a short-term basis for cash have contributed to high rates of informality in Peru.

Informality fell slightly over the past decade but remains at high levels. According to the latest data, as of 2012, the proportion of the economically active population working in the informal sector was as high as 69%, according to the WTO. Using Peru’s legal definition, the figure is generally about five percentage points lower. Only Honduras had a higher level of informality among Latin American countries. The high level of informality has a damaging impact on Peruvian productivity. The informal sector accounts for 59% of total employment but only 19% of GDP. Similarly, according to the Ministry of Production (Ministerio de Producción, PRODUCE), the median value generated by workers in small businesses, where many informal workers are concentrated, is only 8.5% of that produced by workers in large firms, which employ their workers almost exclusively on a formal basis. This has undermined manufacturing productivity.

As a percentage of the economically active population, the manufacturing workforce increased by four times between 2004 and 2012. However, value added per manufacturing worker fell slightly in real terms during this period. As long as informality remains at such high levels, it will be difficult for manufacturing growth to be sustained. One of the goals of the PNDP is to reduce informality by ten percentage points by 2021.

A report published by PRODUCE suggested that this would be achieved by pulling back certain labour regulations. According to industry executives and trade associations this would in fact be the most effective method for tackling the issue. Restrictive labour regulations are one of the primary factors contributing to high informality. For example, in the garments and textiles industries, regulations limit businesses’ ability to hire workers on temporary contracts, except in the case of businesses that produce goods for export. This rule has caused firms producing goods for the domestic market to disproportionately employ workers on an informal basis. The decreased productivity of informal employees has further eroded these companies’ ability to compete with imports.

An additional labour-related challenge faced by manufacturers is the poor availability of skilled workers, a problem that is pervasive throughout the region, but that is particularly acute in Peru. Edgardo Rivera, general manager of HL Ingenieros, a Colombian company operating in Peru that provides electrical and mechanical services to industry, told OBG, “Many times it is cheaper and easier to bring workers from Colombia to Peru than to hire them locally. There is such a shortage of qualified personnel that all the companies compete for them, the turnover is high and salaries are rising. For a medium-sized foreign company, the situation is such that even spending more money by bringing workers from abroad is cheaper than hiring locally.” He added that some large Peruvian companies have mitigated this issue by organising internship programmes with universities, which enable them to recruit talent earlier and improve retention of skilled workers.

Construction Materials

One of the most significant drivers of manufacturing growth during the past decade has been construction materials. Cement and clay account for two-thirds of Peru’s non-metallic minerals category, which increased by around 2.5 times in terms of production value between 2004 and 2013, according to PRODUCE. Investment in construction has driven the sector’s growth. There is perhaps no better evidence of this boom than the transformation of Lima’s skyline from one punctuated by relatively few skyscrapers 15 years ago to one with multiple neighbourhoods packed with them today. Of Peru’s 20 tallest buildings, half have been completed since 2009. However, in the past year growth in the non-metallic minerals sector has slowed somewhat as construction has returned to less frenetic levels. In the first half of 2014, cement production and sales each grew by 1.3% year-on-year, down from double-digit growth in previous years, according to Peru’s cement association, ASOCEM, and below projections for 2014 GDP growth of around 4%.

Metals & machinery

The metalmecánico sector, as it is called in Latin America, refers to a wide range of products, from cables to industrial machinery, which are made of metal. This broad-based sector is an important aspect of Peruvian industry and generally accounts for 10% or slightly less of Peru’s value added from manufacturing. In Peru, the sector is divided into two categories for the purposes of trade policy and statistics. These are machinery and equipment, and non-mechanical metal products. The latter has been another source manufacturing growth in recent years.

Production of metal-based products is mainly focused on the domestic market. About 90% of the sector’s production value comes from products sold domestically. The biggest customers are construction, mining and energy companies. As a result, many metals and machinery businesses have high levels of exposure to domestic economic volatility. During the past decade, this exposure has generally been a boon to the sector, with Peru’s GDP growing by 5-9% in each year save 2009. Nevertheless, during this time the sector’s businesses have actively sought new markets abroad in part to diversify their base of clients.

Exports of machinery and mechanical parts remain low in gross terms, with free on board (FOB) value of $551m in 2013, according to SNI data. But they are growing rapidly, having increased at a compound annual rate of 16.5% in nominal terms from $136m in 2004. The three biggest export markets are Chile, which imports mining equipment, the US and Ecuador, with half of sector exports going to these markets in 2013. The top products exported were civil engineering machinery ($73m FOB), motor vehicles ($67m) and industrial machinery ($60m). Other Latin American markets accounted for another 36% of sector exports.

As has occurred in various Peruvian manufacturing sectors, metals and machinery companies have determined that expanding their presence in developed markets offers one of the greatest opportunities for growth. To this end, several companies have begun the process of opening accounts in Europe, a virtually untapped market, as recently as 2011. The implementation of a FTA between Peru and the EU in March 2013 has facilitated this process. In 2012 Italy was the only EU market that received substantive machinery exports from Peru. The following year, companies in Switzerland and Germany began buying machinery from Peruvian businesses and both countries surpassed Italy as export markets for the sector. Exports to the EU are still very low – Switzerland, Germany and Italy account for $9m, or 1.6%, of the sector’s exports. But, since the relationships between Peruvian metals and machinery businesses and European customers are new, significant growth opportunities may exist. By comparison, in 2013 Peru exported $93m of machinery to the US, an economy of comparable size to the EU.

Food & Beverage

The biggest segment of the manufacturing sector, the processed food, beverage and tobacco industry, accounted for around $7.6bn of manufacturing value added in 2013, which represented about 3.8% of national GDP. The sector grew at a compound annual rate of 5.3% between 2004 and 2013, with strong growth early in this period and stagnation in the past few years. The sector’s principal product categories are wheat-based goods, dairy products and oils. The majority of the production is sold to the domestic market; however, exports account for around $1.5bn of sales, according to the SNI. The principal export markets are Brazil, Argentina, Colombia and other markets along Latin America’s Pacific coast. Exports to North America, China and Europe comprise a small portion of processed food exports but these markets are substantial consumers of Peru’s lower value-added food products such as fish and produce.

Food and beverage manufacturers are seeking new opportunities abroad as domestic consumption growth of processed foods has weakened in the past few years, especially for non-staples. For example, the packaged cookies segment had been growing at high rates for several years until 2014 when growth slowed to an annualised rate of 1.4% in the period from January to July. “This was very low compared to what had been expected,” Álvaro Delgado, executive advisor at the Food and Drink Committee of the SNI, told OBG. “Other more mature segments have also experienced declining growth, including pasta.” Several explanations for the decline have been proposed, but none is considered definitive. One contributing factor is likely a decline in mining production tied to falling global commodities prices. In this respect, the sector will get relief in 2015 and beyond as several large copper projects come on-line (see Mining chapter).

Plastics, Fertilisers & Petrochemicals

Since the beginning of production at the Camisea gas field (see Energy chapter), Peruvian industry has sought methods to add value to this natural resource. Fertiliser manufacturers have been among the first firms to take advantage of the potential to lower costs by sourcing gas inputs domestically. This sector is set to expand due to a $2bn plant, developed by Spanish firm Fertiberia, that is scheduled to begin operation in the second half of 2017 with gas supplies from the Camisea fields. The plant is expected to produce 1.2m tonnes per year of urea and 1.1m tonnes of ammonia. Of the ammonia production, the plant will consume 700,000 tonnes per year, leaving 400,000 tonnes for export in raw form or for use as an input to produce explosives for the Peruvian and Chilean mining industries.

The plastics sector also stands to benefit from the country’s natural gas resources. Plans are in place for the development of a petrochemical complex in the south that would enable manufacturers of plastic products to source their raw materials domestically, saving the premium paid for imports. The local arm of Braskem has been working on the project, which would include a 1m-tonnes-per-annum cracker. The project could come on-line as soon as 2018 (see Energy chapter).

Metal Processing

Peru’s metal processing segment makes up about 10-15% of Peru’s value added from manufacturing. The biggest player, Southern Peru Copper Corporation, runs both the Cuajone, Totoral and Toquepala copper mines in the south, and, on the southern coast near Cuajone, a copper foundry and copper and gold refinery that processes over 99% of Peru’s copper and nearly all of its gold. In 2013, the foundry processed 412,966 tonnes of copper (266,260 tonnes from the refinery), up from 493,954 tonnes in 2012. Gold refining was at 238,335 fine grams in 2013, up from 184,204 fine grams in 2012.

Despite the facility’s importance to the economy, there was recently talk of shutting it down. In 2008, a new environmental law set lower limits on sulphur dioxide emissions, which applied to Southern Copper’s plant, among others, effective in 2014. In July of 2013, Southern Copper sent a memo to employees suggesting it would be impossible to comply with the new regulations and that it might be necessary to close the Moquegua facility. A week after the circulation of the memo, which was obtained by Reuters, the Ministry of Environment said it would delay implementing the rule in three cities including Ilo, where the plant is located. In 2014, operations have continued at the facility and the government has not said when the sulphur dioxide limits will be enforced. From January to August 2014, refinery output increased 6% year-on-year, though the foundry’s output fell by 27%, returning to levels similar to those of 2011 and 2012.

The other two big refineries are one in Cajamarquilla, which makes zinc, and one in La Oroya, which produces zinc, gold and silver, and has smelters for copper and lead. The latter plant has much potential for copper refining, but would need an operator willing to invest large sums to comply with sulfur dioxide limits.

Outlook

As the government attempts to steer the economy towards a more diversified mix of activities, the manufacturing sector can be expected to continue modernising. This will mean an increased focus on more sophisticated goods with higher added value and less exposure to commodities price volatility.

Policy will have to play a role in this transformation, in the form of liberalising regulations, incentivising the formalisation of the workforce and the continuance of strategies that seek to open Peru’s borders. As these measures are put into place and businesses hunt for new opportunities for growth abroad, manufacturing is likely to play a central role in the economy’s future.

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Industry & Retail chapter from The Report: Peru 2015

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