Improving governance and education are crucial to strengthening overall competitiveness

Peru’s overall ranking of 65 out of 144 countries surveyed in the World Economic Forum’s (WEF’s) “Global Competitiveness Report 2014-15” belies some serious weaknesses, in institutional capacity and education in particular, that have prevented the country from climbing further up the table. Despite gaining recognition from the WEF for its “very strong macroeconomic performance and high levels of efficiency in its goods, financial and labour markets” – all categories in which Peru was ranked in the top 40% globally – the country’s overall ranking slipped by four places since the 2013-14 report as these strengths failed to offset institutional and educational weaknesses.

There is growing recognition that the government will sooner rather than later have to pass reforms that address these twin challenges. Indeed, in a statement following her visit to Peru in December 2014, Christine Lagarde, the managing director of the IMF, commented, “Peru’s economic prospects and progress in addressing the important social needs hinge on the continued and timely implementation of an ambitious reform agenda to enhance potential growth.”

Critical to the successful reform of Peru’s institutional capacity will be improving the functioning of its regional governments, which account for at least 60% of government investment. This could prove more difficult than raising education standards due to the contentious nature of reforms perceived as reversing the decentralisation of power that began in the early 2000s.

Challenges Of Decentralisation

Of the four issues that the WEF termed Peru’s “most long-lasting challenges”, all of them are closely related to the performance of the regional governments. These issues were the strengthening of public institutions, increasing government efficiency, fighting corruption and improving infrastructure, in which the WEF ranked Peru 127th, 116th, 103rd and 88th, respectively.

The regional governments frequently find themselves accused of wasting public funds. “The problem is that regional administrations do not know how to spend properly,” stated Luis Sarrio, a partner and head of the international business centre at Grant Thornton Peru. “They struggle to deliver necessary large-scale infrastructure projects within a defined budget, so instead they embark on smaller-scale projects, such as the redevelopment of town squares,” he added. While he acknowledged that this situation is slowly improving, Sarrio told OBG that the regional governments need more support in this area.

Christian Laub, president of the Lima Stock Exchange and CEO of Credicorp Capital, said of the problem with the regional governments, “Good intentions can sometimes produce bad results”. He explained that while decentralisation was a good idea in principle, in Peru it had resulted in some of the regional governments controlling a large amount of funds that either they do not know how to spend or that they spend inefficiently. “For example, there have been cases of regional governments building new stadia that have a larger capacity than the surrounding population, even though the local community still does not have running water, electricity and telephone lines,” Laub told OBG.

Building Institutional Capacity

Alberto Rhor, the head of structural and market risk at Banco Financiero, similarly views the limited administrative capacity of the regional governments as a downside risk to growth prospects. He suggested that there be stricter qualification criteria for individuals seeking to run in regional elections. “At present, we have candidates with criminal records running for regional office, and parties that are set up and then dissolved within the space of three months,” Rhor explained.

“Without seeking to recentralise power once more, it should be possible to introduce a system of mentoring for the regional governments to assist them with their spending plans. Organisations such as ProInversión or the Ministry of Economy and Finance could take the lead, ensuring that spending by regional governments is coordinated where appropriate and that projects are thoroughly evaluated,” Rhor noted to OBG.

The challenge of addressing this situation is complicated by political factors, according to Laub, as any attempt by the central government to reassert control over the regional governments’ budgets is bound to provoke a backlash. “However, this is a battle that needs to be fought,” Laub insisted. “It need not involve reducing the regional governments’ budgets, but rather rules could be devised that require the regional governments to spend a certain proportion of their funds on basic services, for instance,” he said.

Indeed, the political sensitivity of the decentralisation of power means that any reforms requiring legislation on this subject will require significant political capital to be pushed through Congress. For this reason, Rhor told OBG, such a reform would have to be initiated at the start of a presidential term to stand any chance of being successfully passed.

Escaping Middle-Income Trap

The lack of appetite for addressing such politically charged issues that has prevailed up to now may be partly the result of what the country has managed to achieve despite carrying these challenges. “Peru has been on a kind of auto-pilot for the past few years, riding the commodities super-cycle on a path to greater wealth,” Luis Manuel Ordoñez, head of research at Inteligo, a brokerage, told OBG. “However, now that the super-cycle has ended, factors such as productivity will become increasingly important if we are to avoid falling into the middle-income trap, now that the country stands on the threshold of middle-income status,” he added.

As noted by the WEF, there is a sense that Peru is reaching “a certain exhaustion of the sources of the [its] competitiveness gains of the past years”. Key to reversing this trend will be improving education, an area in which Peru ranked 134th, and technological adoption, in which it ranked 92nd, according to the WEF.

Education & Innovation

The government already recognises the need to develop alternative sources of economic growth besides mining. “Technology and innovation-based industries could be one such alternative,” suggested Melvin Escudero, CEO of El Dorado Investments, while noting that these industries were still relatively new to Peru. “We have already seen some universities and government agencies launching initiatives to foster entrepreneurship based on innovation, as opposed to entrepreneurship based solely on consumption,” said Escudero.

Long-Term Rewards

Escudero suggested that the achievement of such a vision will require the support of the government. “The public and private sectors working together in this endeavour to produce technology clusters and a whole ecosystem of innovation will necessitate collaboration between universities, families, technology companies and venture capital funds. However, it is important to recognise from the outset that this is a long-term project, many of the results of which will start to become apparent only in three, five, 10 or even 15 years,” Escudero told OBG. Meanwhile, whether or not substantial reform of the way the regional governments operate in Peru is achievable within a similar timeframe is rather less certain.