With strong fundamentals, the economy is set to see continued growth

Following the end of the commodities super-cycle that sustained Peru’s economic growth at an average rate of 6.4% per annum since the mid-2000s, the country saw growth fall sharply over the course of 2014. However, this slowdown is widely seen as a temporary lull, attributable in part to delays in some major mining developments, and the government has sought to counteract the current situation by introducing a range of measures that are designed to stimulate both private and public investment.

In 2015 growth is expected to pick up again, ensuring Peru retains its place among the fastest-growing economies both within the region and globally. Nevertheless, certain long-standing structural challenges, such as the poor quality of education and the inefficiency of regional governments, will need to be tackled soon in order to raise growth potential and sustain the remarkable development the country has witnessed over the past two decades.

Consensus

Impressive growth during this period has given rise to a consensus around Peru’s economic model. Christian Laub, president of the Lima Stock Exchange and CEO of Credicorp Capital, described this shared understanding as a “core strength of Peru that guarantees the sustainability of the country’s development.” Indeed, successive leaders have largely maintained the economic policies instituted by former President Alberto Fujimori in the 1990s. This has led to increasing economic openness and improvements in competitiveness and the quality of Peruvian products, according to Aldo Defilippi, executive director of the American Chamber of Commerce of Peru. “Peru’s development over the past 20 years has shown people that the current development model is the way to create wealth,” said Defilippi, adding that the predictability this has produced with respect to the stabilisation of key macroeconomic indicators is one of the economy’s main strengths. Against this backdrop, “the commodities boom has acted as a helpful tailwind”, he added.

While recognising that Peru’s economic development model is now well established, President Ollanta Humala’s success in winning the presidency by campaigning against the mining establishment may encourage others to follow a similar path in the 2015 elections. However, perhaps what is even more significant is the manner in which Humala then went on to moderate some of his more radical campaign pledges and, since coming to office, has sought to encourage greater investment in the mining sector, reflecting the strength of the economic consensus, even among politicians who may once have espoused more unorthodox views.

Falling Expectations

This political consensus has been tested by the disappointing performance of the economy throughout 2014. “We began 2014 with GDP growth for the year predicted to reach 6% – albeit with the private sector expecting it to come in slightly lower, at between 5% and 5.5%,” Jose Luis Sarrio, a partner and head of the international business centre at Grant Thornton Peru, told OBG. For the second quarter of 2014, growth had slowed to a rate of 2% per annum, the lowest level since 2009, when Peru was feeling the effects of the world financial crisis. Then starting in the second quarter, these predictions began to tumble, falling to between 4% and 4.5% as of the end of July 2014.

In October 2014 the Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP) lowered its growth forecast for 2014 again from 4.4% to 3.1%, blaming weaker-than-expected output levels from the major copper mines. BBVA bank attributed this decline primarily to a fall in mining production during the period due to maintenance work at the Antamina copper mine and the closure of parts of the Pierina gold mine. Besides mining, the construction and manufacturing sectors also saw falling output in the first half of 2014 as a result of decreases in both public and private investment, particularly at the regional government level. This had a disproportionate effect because regional governments account for 60% of government investment.

Consumer spending continued growing in 2014, albeit at lower rates than before and therefore not nearly fast enough to make up for the contraction in the construction and manufacturing sectors in the second quarter. Meanwhile, internal demand’s contribution to GDP growth slowed to its lowest level in 10 years in the second quarter of 2014. This marked the continuation of a trend that began in 2013, when falls in commodity prices led mining companies to scale back some of their plans. With 20% of total investment being directly linked to mining projects, this reduction in mining investment had a knock-on effect on the wider economy.

Another factor behind the declining growth projections was the updating of the base year used for calculating Peru’s real GDP by the National Institute of Statistics (Instituto Nacional de Estadística e Informática, INEI), which occurred early in 2014. “This change tripled the weighting given to mining relative to other sectors of the economy,” Mario Alberto Guerrero, head of economic studies at Scotiabank, told OBG. “Whereas at the time this occurred it was expected to boost the country’s growth figures, the subsequent slowdown in mining investment has led to the opposite effect.”

Government Response

Referring to the lower-than-expected growth in the first three quarters of 2014, Laub told OBG that he viewed this as a “transitional period” after which growth would pick up. “We have seen the government become much more active during this period, announcing several new measures to spur investment,” he said. “What is significant about this, beyond the effect of the measures themselves, is that it shows the government recognises that investment – particularly by the private sector – is the primary driver of growth in this country.” Among the announced measures, the awarding of concessions to build the second line of Lima’s metro system, the southern gas pipeline, the Chinchero International Airport in Cusco and the new Port of General San Martín in the city of Pisco should serve to bring greater dynamism to the construction sector in the medium term, although the results may not materialise overnight. Melvin Escudero, CEO of El Dorado Investments, told OBG that the government had increased current spending as a way of seeking to boost growth by raising the salaries of state workers such as teachers, police officers, doctors and members of the armed forces.

Flexibility

Peru’s solid fundamentals mean that policymakers have the necessary tools at their disposal to introduce such measures in an effort to address the challenges posed by the end of the commodities super-cycle and the associated slowdown in the Peruvian economy. Laub told OBG, “Even in the event of a sharp fall in commodity prices, with a debt-to-GDP ratio of under 20%, and a net debt level approaching zero, Peru could easily afford to carry a small budget deficit.”

Fundamentals

In fact the macroeconomic fundamentals of Peruvian economic policy are very solid, according to Escudero. He told OBG, “Peru stands out as a positive example among Latin American countries in terms of its monetary policy, fiscal policy, balance of payments, and the stability of its financial system and tax measures to attract foreign investment.” He further explained that these fundamentals were reflected in the upgrade of the country’s sovereign ratings in 2014, placing it alongside Chile and Mexico as one of the three highest-rated Latin American economies.

In upgrading Peru’s rating by two notches in July 2014 from “Baa2” to “A3”, Moody’s highlighted the strengthening of government finances, the sustained drive for structural reforms that should raise the country’s growth potential and the expectation that growth will accelerate by 2016. Meanwhile, BBVA noted that even after the latest upgrade to A3, Peru’s debt-to-GDP ratio of 20% was considerably lower than the 55% average level for other countries with similar sovereign ratings.

“Despite suffering severe recessions in 1994 because of the tequila crisis, between 1998 and 2002 following the fall of Fujimori, and between 2008 and 2009 due to the global financial crisis, throughout this period Peru has experienced strong growth overall, and this is a trend that looks set to continue,” Escudero said.

Bond Issue

Capitalising on such positive investor sentiment, in October 2014 Peru issued PEN8.8bn ($3.14bn) in bonds, marking the country’s largest issuance in its history and first since January 2012. The issue also followed a similar move by Colombia to sell $1bn in dollar bonds to help fund investments in 2015. Besides saving the government $28m on servicing its debt, the bond issuing was designed to raise the proportion of Peru’s debt in soles to 52%, compared to the 47% level it stood at in 2011.

Budget Discipline

With respect to government finances, Laub told OBG, “Peru was one of the few countries in the world able to post a budget surplus in 2013.” He also predicted that the government would balance its budget in 2014, even after taking into account the stimulus measures that have been announced over the course of the year, although a fall in the prices of commodities could change this.

Beyond 2014, BBVA predicts that Peru will post moderate fiscal deficits in the future, but not exceeding 1-2% of GDP. Meanwhile, recent years have seen a decline in the government’s dependence on the natural resources sector for income, with this income stream falling as a share of government revenue from 22.6% in 2007 to 12% in 2013. It follows that this trend means the country should be less dependent on commodity prices to balance its budget.

Monetary Policy

In a October 2014 announcement the BCRP left its main reference interest rate unchanged at 3.5%, following a rate cut of 25 basis points in September and July of the same year. Luis Manuel Ordoñez, head of research at brokerage firm Inteligo, told OBG that the significance of the central bank’s decision to cut its reference interest rate to 3.75% in July 2014, coming at a time when most economists had expected it to remain unchanged at 4%, lay in the message that it sent to the market.

“This cut showed the market that the central bank is prepared to take action to sustain growth, thus giving companies more confidence to invest at this point in time. The practical impact of a 25-basis-point drop in interest rates is less significant than its symbolic message,” Ordoñez told OBG.

In the medium to long term, the anticipated economic recovery beginning in 2015, coupled with a rise in global interest rates, is expected to push the BCRP to raise rates. “We have grown accustomed to a low interest rate environment, to the extent that low rates have become addictive like a drug,” Laub said. “But we forget that 10 years ago interest rates stood at 6% and everything worked fine. This is because higher rates are a reflection of a robust and growing economy.”

Therefore, Laub views the anticipated raising of interest rates over time as a natural reflection of positive market sentiment. Meanwhile, continuing credit growth and the de-dollarisation of corporate loans during this period should mean that monetary policy becomes a more effective tool.

Federal Reserve Influence

However, even while accepting that rates will rise, many are still wary of the speed with which rate rises could unfold in the US. “A drastic rise in US interest rates could trigger severe repercussions in emerging markets. However, Janet Yellen, chair of the board of governors of the US Federal Reserve, seems more dovish, so I would expect her to be more cautious in her approach to raising rates,” said Laub.

Escudero shared some of these concerns, telling OBG that “the rapid raising of interest rates by the US Federal Reserve represents one of the principal risks to Peru returning to growth at a rate of 6% per annum. Such a move would lead to a damaging withdrawal of investment from Latin American and other emerging markets.” Indeed, the potential for US Federal Reserve policies to rattle the Peruvian economy was demonstrated in May 2013 by the announcement of the reserve’s tapering of asset purchases, which took the markets by surprise. In the five weeks that followed, the sol depreciated by 5% and the yield on local currency 10-year bonds rose by more than 160 basis points.

Foreign Exchange

According to Guerrero, currency volatility was a secondary risk to a sudden rise in international interest rates. However, he also noted that the relative stability of the sol over the year up to August 2014 had also tempered fears of such volatility returning. “We should consider that even though the sol may have been volatile by historical standards in the past couple of years, compared to other regional currencies such as the Chilean peso or the Colombian peso, it has been remarkably stable,” Guerrero told OBG.

In the past, the BCRP has sought to counter currency volatility by intervening in the foreign exchange markets – a policy that looks set to continue, partly with a view towards maintaining the stability of the financial sector. Robust reserves and continuing inflows of long-term capital should carry on supporting the sol over the medium term, although these considerations may be insufficient to counteract downward pressure on the currency’s value exerted by investor concerns over slowing global growth. If the combination of these factors produces a slight depreciation in the sol’s value, then this is expected to have a positive effect, particularly on the non-energy sectors of the economy.

This is the scenario that BBVA predicted for the sol in August 2014. The bank expects the sol to end 2014 at PEN2.95:$1 then weaken further before stabilising at PEN3.10:$1 by 2015. BBVA based this prediction on their estimate that the current account deficit will widen to 5% in 2014 and 2015. A slightly more expansionist monetary policy in the coming years, a fall in foreign investment in mining and the likely normalisation of the US Federal Reserve’s monetary policy in due course, which would push the dollar higher, are also expected to affect the sol.

External Risks

Besides a sudden rise in interest rates by the Federal Reserve, the possibility of a greater-than-expected deceleration in Chinese growth is the other principal external risk to the Peruvian economy because of the impact this would have on commodity prices. This concern is borne out by data from the IMF that has shown the growth rates of Peru and China to be highly correlated to each other. According to the IMF, a one-percentage point decline in China’s real GDP growth in one year is likely to reduce Peru’s real GDP growth by about 0.4 percentage points over the year, mainly through its impact on Peru’s terms of trade. The IMF also suggested that a prolonged slowdown in China would have a similarly detrimental sustained effect on Peru, with Peru’s potential GDP growth rate falling by between 0.2 and 0.4 percentage points with each permanent reduction of one percentage point in China’s rate of growth.

Moderate Inflation

According to the INEI, accumulated inflation in the period from January to September 2014 was 2.68%, with the full-year figure expected to come in at around 2.9%. In those nine months, the prices for education increased the most, by 4.71%, followed by those for food and non-alcoholic beverages (3.87%), restaurants and hotels (3.54%), and health care (2.49%). On the other hand, the category demonstrating the greatest stability was communications, where prices dropped by 0.67% during these nine months.

Data for November 2014 alone showed consumer prices falling by 0.15% over the course of the month in Lima, which is broadly representative of the country as a whole. This followed a rise of 0.5% in October 2014 and helped keep the projected annual rate of inflation for 2014 under 3%. Falls in transport costs were triggered by the decline in crude oil prices, while prices of food, communications and other utilities also fell during November 2014.

Until growth begins to accelerate once more, the pressure for wage rises in the private sector will remain subdued, enabling the government to keep inflation within the BCRP’s target range of between 1% and 3%. The principal threats to meeting these targets come from the risk of a currency devaluation, which would make imports more expensive, or a weather event causing food prices to increase.

Current Account

With inflation in check and the government maintaining a prudent fiscal policy, Laub identified the current account deficit, which is expected to reach 5% of GDP by the end of 2014, as the only financial indicator where an imbalance existed, while BBVA described this figure as “relatively high” and pinpointed it as a vulnerability facing the economy in the event that international debt markets were to tighten. However, the current account deficit is expected to fall to 3.8% by 2018 as exports rise due to planned developments in the mining sector. Laub said, “This deficit is being financed by longterm investment, so it is not a concern as long as this continues to be the case. This is why maintaining investor confidence is so important to Peru.”

Private Investment

Indeed, Laub told OBG the need to stimulate further investment, in both private and public sectors, was the most critical factor to sustaining Peru’s growth. Ordoñez highlighted the importance of private investment in particular, and said, “The relative slowdown the Peruvian economy experienced in 2014 has been primarily caused by a slowdown in private investment and exports rather than by a drop in internal demand.”

Nevertheless, the medium-term outlook with respect to private investment remains positive. Guerrero characterised the slowdown in private investment as more of a lull between cycles. “The mining boom peaked in 2013, so it is natural that investment by the big mining companies should have relaxed since then,” he told OBG. “This easing in mining investment will overlap with a new cycle in infrastructure investment, with $11bn of investments in public infrastructure projects already announced as part of this. We expect this will begin to visibly stimulate private investment from the middle of 2015 onwards.”

Mining

Yet even following the retrenchment in investment that accompanied the end of the mining boom, the huge importance of this sector to private investment, as well as to the economy as a whole, will persist. Sarrio highlighted a study by the National Society for Petroleum, Mining and Energy which found that every job in mining directly supported nine jobs in other sectors. However, Laub argued that the mining sector – and, by extension, commodity prices – mattered to Peru principally because of the revenues they generated, which had enabled the government to post budget surpluses in recent years, as opposed to the jobs it creates.

With respect to the sector’s recent performance, Ordoñez described to OBG in August 2014 how “mining has suffered greatly in the past year due to the fall in commodity prices.” This was then reflected in the sector’s financial results and the stock market performance of mining firms, which have responded primarily by cutting costs, primarily in the areas of exploration and people.

Reprioritisation

One of the principal ways in which miners have sought to reduce costs is through reprioritisation of their projects. “Companies have put greenfield development projects on hold and focused on brownfield expansion projects instead,” Roberto Flores, head of strategy and economic research at Inteligo, told OBG. “These operational changes and cost reductions by mining firms started to come through in their results from the second quarter of 2014, indicating that they have succeeded in adapting to lower commodity prices.”

As a result of these changes, some projects have been scrapped altogether, while others have been delayed. For example, China’s Minerals and Metals Group announced that its Las Bambas copper project, which is located in the south of Peru, would start operating in early 2016, as opposed to the previously projected start date of late 2015.

New Mining Projects

“After commodity prices stopped falling towards the end of 2013, we believe that a turning point was reached halfway through 2014,” Ordoñez told OBG. Sarrio further explained, “Compared to 2013, when investment in mining virtually froze, we are now seeing investment cautiously returning to the sector. This means money is once more available for sound projects – those which will deliver a return even if the price of gold falls to $1000 per ounce, for instance.”

Guerrero highlighted the increased levels of production from Chinalco’s Toromocho development as one of the main drivers of mining growth anticipated in 2015. According to him, this reflects a wider shift in the way that the mining sector will contribute to Peru’s economy in the future. “Up to 2014, mining has supported the economy primarily by attracting investment,” Guerrero told OBG. “Following a period that saw the opening and expansion of many major mines, we can now look forward to a phase of rising output in 2016 and 2017, particularly with respect to copper. This will alter the nature of mining’s economic contribution from investment to income from production, although the sector’s overall importance will persist.”

While Toromocho’s reaching of full operational capacity is predicted to account for three-quarters of the mining sector’s growth in 2015, there are substantial additional projects in the pipeline to sustain growth in the years beyond 2015. These include the Inmaculada silver and gold project and the Constancia and Las Bambas copper mines, followed in 2016 by the planned expansion of Cerro Verde and Toromocho. BBVA estimates that the developments at Las Bambas, Cerro Verde and Constancia will account for 90% of the mining sector’s growth in 2016. Looking further ahead, Sarrio emphasised the likely to be one of the main full operational capacity, it potential for future mineral exploitation that still exists in Peru, where “only 3% of Peru’s land area has been exploited for minerals so far”.

Commodities

These developments are planned to take place within the context of lower commodity prices. “We do not expect to see another metals super-cycle like the one that we have just experienced,” Flores told OBG. “What we are beginning to see already is that mining companies’ profits are increasingly being determined by their production costs rather than commodity prices, and this is a trend we expect will continue as prices remain stable.”

Looking To Precious Metals

“We view the high price of gold in recent years as having been due to unusual political and financial factors and not supported by fundamentals. Therefore, we expect to see more of a downwards correction in the gold price towards a range of between $1200 and $1250 per ounce,” Ordoñez told OBG.

Furthermore, the expected strengthening of the dollar could further dampen the price of gold. In regard to silver, it could mirror gold’s performance in so far as it is also a precious metal; however, unlike gold, silver benefits from having a wider variety of industrial uses. Therefore, sustained industrial demand for silver could counterbalance this.

Base Metals

As for base metals prices, Ordoñez expects these to recover gradually over the short to medium term. “Base metals will benefit from the anticipated stabilisation in China’s economy and an encouraging economic outlook in the US,” he said. Notwithstanding this, Ordoñez expected China’s significance as a factor in driving base metals prices upwards would begin to fade over the longer term. “Previously, it was the acceleration in China’s growth that caused these price rises, but now China has stopped accelerating and the market has adjusted to a steady rate of Chinese growth of around 7.5% per annum,” Ordoñez told OBG. “Over time, the emergence of other engines of global growth besides China, such as India and other emerging markets, will supplant China as the main source of support for base metals prices,” he added. “However, this process will be gradual, with China still accounting for around 40% of global base metal demand as of 2014.”

Government Support

Although commodity prices will inevitably remain a major factor in determining the level of future investment by mining companies, government policy has a part to play in this area too. “The government should recognise the role that it has to play in encouraging perpetual investment by mining companies rather than simply trying to extract as much as it can from investments that have been made,” Sarrio told OBG. Specifically, Sarrio added, “The government has a critical role to play in promoting the rule of law and efficient spending by the regional governments, without which the benefits of mining royalties will be wasted.”

As Laub pointed out to OBG, “If mining revenues are inefficiently spent, then the people living near the mines are left wondering what benefits they gained from having a mine open in their area.” In a December 2013 report titled “Reverse the curse: Maximising the potential of resource-driven economies”, international consultancy McKinsey highlighted the regulatory burden as a factor that adversely impacts the operating costs of mining companies in Peru. According to McKinsey, firms must work with at least 10 government agencies in order to obtain the permits necessary for a new mine, a process that can take as long as six years. McKinsey also suggested that this had led to the backlog of 133 environmental impact studies in 2013.

Works For Taxes

One highly publicised scheme that is designed to deliver tangible benefits to communities is called Obras por Impuestos, or Works for Taxes. The initiative is a critical mechanism when it comes to improving the effectiveness of regional governments’ spending. Public works projects are prioritised through the Work for Taxes programme after having been approved by the National Public Investment System, and private companies are allowed to finance projects anywhere in the country, thus associating the benefits of the public works undertaken with those companies.

The programme redirects companies’ taxes to projects, rather than to the Treasury. Works for Taxes is funded by money from regional governments and indeed, it has accelerated the implementation of funding for projects. Still, some local governments have viewed the scheme negatively as a form of competition. However, given the considerable benefits that the scheme has delivered, Laub said that in such instances, “Peruvians should recognise that the interests of the country are best served by supporting Works for Taxes and stand up for the scheme.”

Public Investment

In contrast to the successful implementation of the Works for Taxes programme, the record for public investment is more uneven. Guerrero told OBG that the lack of new, government-initiated projects planned for the period between mid-2014 and mid-2015 had created a gap in between two investment cycles. “The contracting process for planned large-scale government projects ought to have started earlier to avoid this scenario, as this phase of projects typically takes between one and one-and-a-half years to complete before work can begin,” said Guerrero.

Sarrio agreed with this view, saying, “We have seen no rise in public investment in 2014 compared to 2013, even though much greater public investment was both expected and needed in 2014.” Guerrero also drew a parallel between Colombia today, where investments in infrastructure are having a multiplier effect on the broader economy, and what he hopes Peru will be like in 2016.

Infrastructure Improvements

There is widespread recognition of the need to improve the country’s infrastructure, with Peru ranked 88 out of 144 countries in infrastructure in the World Economic Forum’s “Global Competitiveness Report 2014-15”. According to Peru’s own National Infrastructure Plan for 2012-21, $88bn is required in infrastructure investment over the coming years.

Several government-sponsored megaprojects have already been announced with the specific aim of addressing this challenge. Among the most prominent of these are the Gasoducto Sur Peruano gas pipeline, costing $5bn; the second line of the Lima metro, costing $5.7bn; and PetroPerú’s planned $3.5bn investment in the modernisation of the Talara refinery. In the short to medium term, these are some of the infrastructure investments that will help offset the lull in mining investment, enabling Peru to sustain a level of total investment as a proportion of GDP above 27%, while in the long term the improvements in infrastructure will help to raise Peru’s growth potential.

Construction

Public investment in infrastructure is expected to help the construction sector in particular. For example, Guerrero highlighted the relationship between real estate developments and new infrastructure as a trend that is set to gain importance in the future, with many real estate projects planned to take place along the routes of the new Lima metro lines. As a whole, construction is a sector in which performance has reflected that of the broader economy. “There has been a drop in the number of construction projects under way,” Ordoñez told OBG. “This reflects the fall in private investment, so we would expect to see an uptick in construction once investment picks up again.”

Meanwhile, Flores told OBG that this slowdown in construction was healthy in some respects. “Particularly in the case of the real estate sector, growth in recent years had been extremely strong and people had started speaking of bubbles. While I do not think we had reached that point yet, we were heading in that direction. This situation was exacerbated by the availability of cheap loans in dollars,” said Flores. Looking ahead, Flores expects the construction sector to pick up again, especially in areas where there are opportunities to build housing for lower-to middle-income people, which in Peru are classified as social bands “C”, “D” and “E”.

Export Infrastructure

A further consequence of Peru’s infrastructure deficit has been reduced export growth. “To handle exports, a country needs efficient ports and airports. Currently, we really have only Lima’s Jorge Chavez International Airport, where a second runway is yet to be built, and the port of Callao. So as a country we are a little behind where we would like to be in terms of our export infrastructure capacity,” said Sarrio. Further development of ports and airports, as well as roads, railways and cold storage transport infrastructure, will be critical to raising Peru’s growth potential for the long term.

Outward Bound

At a corporate level too, Peruvian firms have tended to find obstacles to cross-border expansion. “Our companies up to now have been very focused on the Peruvian market. We have seen some firms seek to expand organically abroad, while others have made a small number of foreign acquisitions,” Laub told OBG. “However, we have reached a point where more firms are increasingly looking at international expansion, starting with markets such as Colombia and Chile.”

Culture also plays an important role in this. “People are still accustomed to owning 100% of their companies, being able to make all the decisions themselves and not needing to be accountable to the markets,” Laub said. However, with the advent of a new generation of business leaders, he expects these attitudes to begin to change. An additional factor acting as a restraint on these companies’ international ambitions has been how much debt they are able to take on to make a foreign acquisition.

“So the question for these firms becomes, ‘What happens if I raise new capital equivalent to 15%, 20%, 30% or even 40% of my company’s value?’ This way, a firm’s capacity to expand increases substantially,” said Laub. These growing ambitions in turn will translate into more companies becoming active in the equity markets in the coming years. “The big jump will come when companies start looking to make acquisitions equivalent to their own size, which cannot be done without raising capital,” he added.

MILA

The ongoing development of the Integrated Latin American Stock Market (Mercado Integrado Latinoamericano, MILA) is expected to contribute to this process. “The MILA should help our capital markets enormously,” Aldo Ferrini, deputy CEO of pension fund provider AFP Integra, told OBG. “Firstly, it will create greater demand for Peruvian stocks and bonds among foreign investors, by making it easier for Chileans, Colombians and Mexicans to participate in Peruvian markets. This in turn will stimulate greater research and coverage of the markets in Peru. Secondly, the harmonisation of tax regimes across the MILA should address the uncompetitiveness of Peru’s capital gains tax.”

The issue of differing tax regimes in MILA countries represents an obstacle to realising the MILA’s potential. “For example, we have a 5% tax rate on capital gains from trading, whereas in Colombia they have no such tax,” said Ordoñez. However, he noted that the reason current volumes of trading across MILA platforms are low is “due in part to the fact that we find ourselves in a risk-off environment, so it is not a fair reflection of the market’s potential”.

Ordoñez also pointed to the entry of Mexico into the MILA – announced in June 2014 and expected to take effect by the end of 2014 – as a particularly positive step in the market’s development and popularity. He told OBG, “This will make the MILA larger than the Brazilian stock market and thus more eye-catching to global investors. People will recognise that the fundamentals of the Peruvian, Chilean, Colombian and Mexican economies are among the soundest in Latin America.”

Trade Friendly

The internationalisation of Peru’s capital markets as part of the MILA is a natural step for a country that is already outward facing in its trade policies. Some 95% of exports are to countries with which Peru has signed free trade agreements (FTAs), therefore there is not too much potential in terms of additional significant FTAs that remain to be signed. However, additional double taxation agreements could be signed to complement these FTAs. At present Peru has agreed on tax treaties with a few countries, such as Canada and Chile, but not with many significant partners like the US and the UK.

Attaining Hub Status

Besides double taxation agreements, there remain other areas that the country could address to make itself more attractive to multinational investors relative to both regional and global peers. “Peru currently finds itself somewhere between Chile and Brazil among Latin American countries in terms of the time and effort required to set up a business,” Sarrio told OBG. “On the one hand, in Brazil it can take up to eight or nine months to set up a business, and that does not take into account the complexity of the Brazilian tax system. On the other hand, in Chile it takes around two weeks to complete the same process, and the taxes there are not such a burden.”

The result of these discrepancies is that many multinational companies are selecting Chile as the headquarters for their South American operations, from where they direct investments to Peru and Colombia. According to Sarrio, these same companies will tend to locate their regional back office functions in Peru, due primarily to its geographical location, but the country is missing out on becoming a hub for the directors and senior management of these companies, who prefer to remain in Chile.

Carlos San Román Orams, country manager at Adecco, agreed, telling OBG that “although there has been a boom in the number of international companies coming to the country in the past 20 years, many still have only representative offices. We need to make sure there is good regulation and that there are enough high quality professionals to fulfil demand. This will help improve the country’s competitiveness.” The lower corporate income tax rate and more established family offices are two additional attractions that Chile holds for directors compared to Peru. “To stimulate investment, the government should look at bringing Peru’s rate of corporate income tax, which currently stands at 30%, into line with those of Colombia and Chile, where it is 25%,” Sarrio told OBG.

Consumer Demand

Meanwhile, an area in which Peru’s economy has continued to perform well by regional standards is consumer demand. “The resilience of consumer demand is apparent wherever you look – when a new shopping mall opens it will quickly fill with people and the same thing will happen to a new restaurant. There is little sign that Peruvians are less keen to spend than before,” said Ordoñez. Guerrero agreed, saying, “Based on consumer spending alone, the Peruvian economy feels like it is still growing at between 4% and 5% per annum, even though in reality the figures for the economy as a whole in 2014 have been.” This strength in consumer demand is underpinned by favourable credit conditions (see Industry & Retail chapter). “For instance, low interest rates have enabled many families to borrow in order to make home improvements,” Flores told OBG.

Employment Figures

A further factor in explaining consumer demand is the resilience of the employment market, according to Flores. “Although the employment market has slightly softened in 2014, particularly for low-income workers, it has generally remained stable in the face of the economic slowdown,” Flores told OBG.

According to data from the INEI, the unemployment rate in Lima in the period between August and October 2014 stood at 5.7%, a fall of 0.1 percentage points compared to the same period in 2013. Trends apparent in employment data for Lima, which contains nearly one-third of Peru’s population, are typically regarded as a fair barometer of the situation in the rest of the country.

While the overall unemployment rate may seem healthy, this masks the higher rate of around 9% unemployment among 19 to 24 year-olds. Recognising the problem, Alonso Segura, the finance and economy minister, announced a plan in November 2014 to get young people into work. The plan has been formulated after considering the experiences of other countries, such as Mexico and Chile.

The first element of the plan is designed to encourage employers to hire young people and train them by introducing tax incentives for companies where up to 2% of the payroll is made up of young trainees. The second element is intended to ensure that young people who start working at micro or small businesses become part of the formal workforce. To this end, Segura said the state would cover social security payments for such workers for their first year. It remains to be seen what impact this plan will have, although the continuing buoyancy of the labour market in the meantime, coupled with growth in the retail sector, are factors that have sustained Peruvian consumers’ confidence in the economy. “People recognise that the slowdown we experienced in 2014 was temporary, and they expect growth to pick up again in 2015,” said Guerrero.

Natural Events

Accentuating the temporary nature of the economic slowdown in 2014 were a number of extraordinary factors. “For example, a drought in the northern coastal region of the country has negatively affected rice production, while coffee production has been hampered by the roya fungus,” said Flores. Peruvian coffee production was estimated to have declined by 25% in 2013 because of this fungus, also known as leaf rust. Flores added that “above-average sea temperatures, caused by El Niño phenomenon, have also hurt anchovy production”, (see Agriculture chapter).

Lower Election Year Spending

Meanwhile, unseasonal political spending patterns in 2014 have compounded the economic slowdown. Flores told OBG, “Historically, what we have witnessed in Peru is that in an election year, such as 2014, when regional elections are taking place, the government tends to increase public spending. This acts as an impulse to economic growth. However, in 2014 we did not see this materialise due to a string of corruption cases that resulted in the imprisonment of three regional presidents, which in turn led many of the regional governments to suspend projects and planned investments.”

Outlook

Despite these issues and the consequent reductions in spending by regional governments, recent data suggests that Peruvians may start to see improvements in their economy in the short term. In the second quarter of 2014, encouraging data was beginning to emerge, which indicated that Peru’s economy may be about to turn a corner. For example, seasonally adjusted monthly figures for capital good imports and cement production had begun to rise once more after having declined in the preceding two quarters. The labour market also showed improvement in the second quarter of 2014, with salaries rising 7.1% year-on-year.

However, these positive indicators are tempered by the pessimistic outlook of business leaders, according to data from a June 2014 study conducted by the BCRP and BBVA. The possibility of further delays to returning the Toromocho mine to full capacity could postpone a recovery in exports, while the continued freezing of some regional governments’ accounts could hold back public investment. Yet despite these downside risks, Escudero is not alone in predicting that “Peru’s economy should outperform the rest of the region in the coming years”.

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The Report: Peru 2015

Economy chapter from The Report: Peru 2015

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