Peru's resource-rich landscape provides a foundation for recovery

In 2014 Peru was the seventh-largest economy in the Latin America and Caribbean region, with a GDP of $202.9bn. According to data from the World Bank, this represented 3.2% of total regional GDP, behind Brazil (37.2%), Mexico (20.4%), Argentina (8.6%), Venezuela (8.1%), Colombia (6.0%) and Chile (4.1%). On some rankings using purchasing power parity, however, Peru is higher up the table, listed as the sixth-largest Latin American – or fifth-largest South American – economy. The population totalled 30.97m in 2014, and income per capita was $6370 in the same year – 29.2% below the Latin American average of $8995. Three-quarters of the population (75.7%) lived in urban areas, with the rest (24.3%) in rural areas.

In the past decade Peru has consistently been one of the fastest-growing economies in Latin America. In the 10 years to 2014, Peru’s average annual real GDP growth rate was 6.2%, second only to Panama (8.2%), and well ahead of the Latin American and Caribbean average (3.4%). Notably, Peru has been growing much more rapidly than the two largest economies in the region, Brazil (where the 10-year average stood at 3.4%) and Mexico (with a 10-year average of 2.5%). The strong pace of economic growth during a decade-long, commodities-led economic boom tripled Peruvian GDP and led to a major reduction in the poverty rate, which fell from nearly half the population (49.2%) in 2006 to under a quarter (23.9%) in 2013.

Key Areas

Located on the Pacific coast of South America, Peru has three main geographical regions, each supporting a different mix of economic activities. The coast, which includes the capital, Lima, is rich in maritime resources. Despite low rainfall, it is also a key location for agro-industrial processing, including rice, asparagus, cotton, sugar cane and fruit. The mountainous Andean region is best known for its extensive mineral deposits, which include gold, copper, zinc and silver, and also hosts active resources in the livestock industry, while the tropical Amazon region contains a wealth of oil and gas deposits and forestry resources.

Development of the country’s transport infrastructure has tended to lag behind its rapid rate of economic growth. The Amazon port of Iquitos is a major centre of trade with Colombia and Brazil, while Callao, situated alongside Lima, is the main port and also home to the Jorge Chávez International Airport. The Pan-American Highway connects Lima to the northern and southern coast, while the central highway links the capital to the mining areas in the central highlands. There is a rail link between Lima and the highlands, and another railway line that connects the southern cities of Arequipa, Puno, Cusco and the important tourist attraction of Machu Pichu.

In terms of overall GDP by economic activity, Peru has a diversified structure. In 2014 “other services” accounted for nearly half of total GDP (48.7%) while the retail and wholesale trade sector represented 11.2%. Hence, services in total represented more than half the economy. Manufacturing accounted for 14.1% of GDP; mining and hydrocarbons, 11.7% construction, 6.8%; agriculture and livestock, 5.3%; electricity and gas, 1.8%; and fishing, 0.4%. As a proportion of GDP the national savings rate was 22.2%, 5.9% of which was in the public sector and 16.3% from the private sector. Taking into account external savings equivalent to 4.0% of GDP, investment as a proportion of GDP was 26.2% in 2014 (5.6% public and 20.6% private).

Macroeconomic Policies

In May 2015 the IMF concluded an Article IV Consultation process with Peru, delivering a broadly favourable assessment of its macroeconomic policy. It noted that economic growth had decelerated to 2.4% in 2014 from 5.8% in the preceding year, a slowdown that was attributed to lower metal prices, weaker export demand and “an unexpected drop in sub-national public investment…and temporary supply disruptions in mining, fishing and agriculture”.

The IMF said the authorities had responded with a series of fiscal and structural stimulus packages, including tax cuts, increases in fiscal spending, and structural measures to boost investment, consumption and growth. Monetary conditions had also been eased. At that point the IMF was expecting a fairly rapid GDP recovery, with growth of 3.75% in 2015. Looking to 2016 and 2017, the IMF projected the recovery would gather pace, with growth of 3.8% and 5.0%, respectively, based on a scenario where new mines were expected to come on-stream, large infrastructure projects would be implemented, and the impact of the earlier shocks to the terms of trade would begin to fade.

The IMF also predicted a gradual reduction in the rate of inflation, which stood at 3.2% at the end of 2014 just above the 1-3% target band, with consumer price growth falling back within the band to 2.2% in 2015 and to 2% in 2016.

Positive Views

The assessment by the IMF Executive Board was positive, with directors reported to have concluded that “if negative shocks materialise, exchange rate flexibility should be the main line of defence, and liquidity could be provided to avoid an undue contraction in credit, while acknowledging that Peru’s dollarised economy increases the risks from exchange rate volatility”. The statement also said Peru should “continue to implement ambitious structural reforms to sustain inclusive growth and diversify the economy”, as well as seek to reduce the level of dollarisation.

Road To Recovery

In the months following the May Article IV Consultation, it became evident that while the overall scenario of an eventual recovery remained in place, it was going to take rather longer for it to materialise. In October 2015, in its World Economic Outlook, the IMF consequently cut back its 2015 growth forecast for Peru to 2.4%, down from 3.8% previously, with GDP expected to rise by 3.3% in 2016, down from the 5% that had been expected in May.

In this modified scenario the bottom of the economic cycle was now expected to last longer, taking up a full two years – 2014 and 2015 – both of which would end up seeing GDP growth at a historically low level of 2.4%. The fund also acknowledged there would be slower progress in bringing inflation down to the target band, predicting it would remain above the band at 3.3% in 2015, up from the 2.2% projected in May, and fall to 2.5% in 2016, remaining within the target range but still being higher than the 2% projected in May.

Signs Of A Pick-Up

Hard data on the economy revealed the first preliminary signs of a recovery coming through in 2015. GDP grew by 2.4% yearon-year (y-o-y) in the first half of 2015. Within that period growth accelerated from 1.8% in the first quarter to 3% in the second, largely reflecting a pick-up in the mining sector.

Apart from tracking overall GDP, the central bank also monitors “primary GDP” and “non-primary GDP”. Primary GDP is defined to include agriculture and livestock; fishing; mining and hydrocarbons; and “primary manufacturing” (that part of manufacturing which directly involves processing raw materials). Non-primary GDP is everything else, and is heavily weighted towards the greater value-added and services sectors of the economy.

Primary Concerns

An analysis of the relative performance of these sectors suggests the economy received a major external shock to its primary sector – caused by the drop in commodities prices in 2014 – but had already begun to recover from that in 2015. In effect, in 2014 primary GDP contracted by 2.3%, while non-primary GDP grew by 3.6%. However, in the first half of 2015, both were in positive territory: primary GDP recovered quite strongly with growth of 4.1%, while non-primary GDP was still positive although it slowed a little, expanding by 2% y-o-y. Slower non-primary growth was attributed to lower levels of public spending, lower private sector investment and lower non-traditional exports. An important feature of this particular downturn has been that despite government attempts to boost fiscal spending, this initially fell, rather than rose (see analysis).

By sectors, growth in the first six months of 2015 was led by fishing (+19.2%, rebounding from a sharp contraction in 2014); mining and hydrocarbons (+5.5%); electricity and water (+5.1%); services (+4%); retail and wholesale trade (+3.7%); and agriculture and livestock (+1.9%). Two sectors contracted: manufacturing was down by 2.6% on year-ago levels, while the construction sector experienced a fall in activity of 7.9%. The relatively strong performance of mining and hydrocarbons reflected a 10.1% surge in mining, offset by a 9.3% fall in hydrocarbons, which was affected by the fall in international oil and gas prices.

For the economy as a whole, the indications were that the recovery of the primary sector would continue through the second half of 2015 and into 2016. Important factors in this process were the expectation of growth in the anchovies catch – where the government authorised a second fishing season – and the expansion of copper output coming from the Toromocho and Constancia mines. Gold output would be supported by increased activity at the Yanacocha and Anama mines. The poor performance by manufacturing was attributed in part to the weakness of private-sector investment, while construction was hit by the downturn in public works.

Action Plans

The evolution of the Peruvian economic cycle has attracted the attention of many economic analysts. “The Peruvian economy has slowed down for two main reasons: because of the slowdown in the global economy and because of the lack of a new wave of domestic structural reforms,” Oscar Chávez Polo, senior economist at the Lima Chamber of Trade, told OBG. In his view, more needs to be done around what he describes as the “three I’s”: institutions, which require modernisation; infrastructure, which needs development; and innovation, which needs promotion. Action in these areas is required to give the country more of a competitive edge. Chávez nevertheless said he is moderately optimistic about the future, stressing the importance of the country’s macroeconomic stability along with good key indicators such as a low level of debt-to-GDP, a small fiscal deficit and a comfortable level of foreign currency reserves.

Weather Woes

Analysts noted, however, that the 2016 outlook is uncertain for a number of reasons. One of these is the El Niño weather pattern, expected to have an important impact on the economy in the last quarter of 2015 and first half of 2016. While El Niño is a well-known feature of Peruvian and global meteorology (on average it occurs once every five years) bringing heavy rains and storms, its precise impact is difficult to predict. In August 2015 the US-based National Oceanic and Atmospheric Administration (NOAA) said that the 2015-16 El Niño “could be among the strongest in the historical record dating back to 1950”.

Alberto Morisaki Cáceres, chief economist at Asbanc, the Peruvian association of banks, told OBG that a strong El Niño could take as much as two percentage points off Peru’s 2016 growth rate. On the other hand, Carlos González Mendoza of Adex, the association of Peruvian exporters, told OBG that the effects may not be as bad as feared. “El Niño initially leads to two things: higher temperatures and heavier rainfall,” he said. “It all depends on timing. Higher temperatures may help bring the harvests in earlier than usual, in December and January, and there is a chance that they could be completed before the heavy and disruptive rains that are expected in February and March”.

Political Risk

Another factor of uncertainty relates to political risk, with Peru’s general elections due on April 10, 2016 and a new government scheduled to take office in July. Even so, each of the three or four main potential candidates – those leading in the opinion polls in the last quarter of 2015 – had adopted market-friendly economic policy positions. “If you imagine Peru moving forward on a big highway called macroeconomic stability, what you’ll find is that the main presidential candidates may position themselves differently on the highway. Some are a little to the left or to the right of the other ones, but the fact is that they are all on the same road,” Chávez told OBG. Other analysts noted that, like in many other countries, uncertainty around the elections had led to a pause in the flow of private sector investment as companies adopted a “wait-and-see” attitude before committing to move forward with big projects.

In The Pipeline

There is a very large pipeline of proposed mining and infrastructure investment projects in Peru, which has gained both praise and criticism from economic analysts. Some lament the slow and bureaucratic approval process and the fact that some major mining projects have been held up by opposition from local communities and concerns over their environmental impact. Those who take this position suggest that if Peru had moved faster, some of these projects could have softened the impact of the downturn in 2014-15. Others, however, welcome the fact that such a pipeline exists at all, and see it is a major positive for the future. The pipeline, they argue, means the authorities will be able to count on some large-scale projects to give the economy greater resilience and growth in 2016-17.

Some major projects are already in the works. The Gasoducto del Sur, a $7.3bn 1134-km pipeline linking the Camisea gas fields to the Pacific coast, was awarded in late 2014 to a consortium formed by Odebrecht of Brazil and Enagas of Spain, and is now 25% complete. Another major contract awarded in 2014 was for the construction of the second, 34-km line of the Lima metro system, with an overall cost of PEN20bn ($6.38bn). A consortium formed by Spanish companies ACS and FCC, Impregilo and AnsaldoBreda of Italy, and Cosapi of Peru won that contract. The first 5 km are due to be completed by the end of 2016.

Pedro Luis Rodríguez, lead economist for Bolivia, Chile, Ecuador, Peru and Venezuela at the World Bank, takes an optimistic view. “This is a country that has built up fiscal savings, that has built up its foreign currency reserves, that has used foreign borrowing intelligently but has also developed internal savings,” he told OBG. While he stresses that the World Bank does not predict a return to the global commodities price boom, he noted that a number of major mining projects will help boost the economy, and that some $14bn of PPP projects that have formal approval will support the country’s growth rate going forward.

Terms Of Trade

The end of the commodities boom has seriously affected external accounts. IMF data shows Peru’s terms of trade began to deteriorate in 2012 and fallen each year since then. The value of exports shipped fell by 9.6% in 2013 and by a further 7.8% in 2014, with IMF projecting they would fall a further 9.9% in 2015. Data from the Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP) showed that the trade balance slipped into deficit in 2014, with exports dropping to $39.53bn and imports at $40.81bn. This generated a trade deficit of $1.28bn and contributed to a current account deficit of $8.03bn.

A report by the UN Economic Commission for Latin America and the Caribbean (ECLAC) stresses that the region as a whole is experiencing a fall in trade. The report said that, in terms of regional export performance, the 2013-15 triennium would be the worst in eight decades. Peru has suffered a sharper fall in exports than the region as a whole. ECLAC said that in 2013 regional exports fell by 0.4%, while Peru’s fell by 9.6%, and in 2014 the region recorded a fall of 3%, compared to a contraction of 7.8% for Peru.

ECLAC predicted that in 2015 Latin America and Caribbean exports would contract by 14.0%, compared to a fall of 16.3% for Peru. The commission said that the fall in commodity exports placed increasing pressure on local economies to seek more active international trade, diversification and intra-regional integration. On the import side, both the region and Peru experienced a contraction in 2014, and were forecast to experience a further fall in 2015. ECLAC projected regional imports to fall by 10.0% in 2015, while Peruvian imports would decrease by a smaller 5.5%.

Foreign Investment

Due in part to the global conditions prevalent in 2015, foreign direct investment (FDI) inflows into Latin America fell significantly. According to ECLAC, total inward FDI fell by 21% to $88.72bn in the first half of 2015, which it attributed to the fall of investments in mining and hydrocarbons because of low international prices, the deceleration in China and the recession in Brazil, the region’s largest economy. According to ECLAC FDI flows into Peru fell by 11% over the same period, to $4.04bn.

Monetary Policy

After keeping its reference interest rate unchanged at 3.25% for over three years, the BCRP made a first 25-basis-point (bps) upward move in September 2015, taking the rate to 3.5%. This tightening of monetary policy came at a time when inflation had exceeded the bank’s 1-3% target band, with 12-month retail inflation rising to 4.04% in August 2015 before easing back to 3.9% in September. The BCRP attributed higher inflation to seasonal and one-off factors including higher food prices and the temporary effects of the El Niño weather pattern. The interest rate was then left unchanged in October, with analysts suggesting that there wouldn’t be any further upward moves until the very end of 2015 or early 2016.

While the central bank and its president, Julio Velarde, are widely seen as credible, experienced, and prudent, it is clear that it has been facing some difficult monetary policy choices and will continue to do so in 2016. The ongoing issue is how to keep interest rates at a level consistent with economic recovery and low inflation against the background of potential global turbulence and an expected tightening of US interest rates.

During the course of 2015 the Peruvian sol depreciated against the US dollar, a trend that has had mixed effects for the Peruvian economy. The positive effect is that depreciation is a natural way to react to a sharp fall in commodities export prices. By making imports more expensive in local currency terms and exports less expensive in US dollar terms, the imbalances in a country’s external accounts can more easily be corrected. The negative effect is that in an open and quite highly dollarised economy like Peru’s, a rise in the prices of imports can have an upwards “pass-through effect” on the domestic inflation rate.

Until September 2015 the BCRP’s response was to hold interest rates steady to help the domestic recovery and to try and limit the pace of the sol’s depreciation by selling dollars – in other words, by using up part of the “safety buffer” in the shape of the country’s foreign currency reserves. This was one reason why the Peruvian sol depreciated less sharply than other Latin American floating currencies that had also been hit by negative shocks to the terms of trade.

In the year to November 2015 the Brazilian real had depreciated by 43% against the US dollar, while the Colombian peso had fallen 23.1%, the Chilean peso 15.8%, the Mexican peso 13.7% and the Peruvian sol by a more modest 11.2%. The price for this relatively greater currency stability had been a drawing down of foreign reserves, at a rate of approximately $1bn a month in the first nine months of 2015. The increase in the base interest rate in September of that year signalled that the authorities might have to change the pattern and rely rather more on monetary tightening in 2016.

Down To Business

Peru was ranked 50th out of the 189 countries surveyed in the World Bank’s “Doing Business 2016” report. The Ministry of Economy and Finance (MEF) welcomed the ranking, saying it reflected the government’s efforts to improve the country’s competitiveness. In Latin America Peru came third only to Mexico (38th) and two positions below Chile (48th). The ease of doing business rankings are calculated by examining the time taken, cost or complexity of carrying out 10 different business procedures. Registering property required four separate procedures—an average of 6.5 days—and a cost equivalent to 3.3% of the property value. In the cross-border trading category, companies seeking to ship goods abroad typically required five documents, 12 days time, and an average payment of $890 per container, while importers required seven documents, 17 days, and $1010 per container. Peru also ranked in the top 50% of countries surveyed on paying taxes (50th) resolving insolvency (74th), getting electricity (64th), dealing with construction permits (48th), and enforcing contracts (69th).

Competitive Streak

In the 2014/15 global competitiveness index compiled by the World Economic Forum (WEF) Peru came in 65th position out of 144 countries, representing no change on the 2013/14 index. The overall score, based on both qualitative and quantitative assessments across a range of competitiveness indicators and expressed on a scale of 1 to 7, was 4.24. The score has been broadly stable over the last four years. In the 2014/15 report this means Peru was ranked seventh in Latin America behind Chile (4.60, or 33rd, Panama (4.43, 48th), Costa Rica (4.42, 51st), Barbados (4.36, 55th), Brazil (4.34, 57th), and Mexico (4.27, 61st). Peru was placed just ahead of Colombia (4.23, 66th) and other countries in the region.

The WEF overall competitiveness score is compiled by looking at 12 categories or “pillars”, each composed of a series of sub-measures. Compared to the rest of Latin American and the Caribbean, Peru was close to the average performance in categories such as institutions; infrastructure; health and primary education; higher education and training; and business sophistication. It performed less well than the average in innovation and in technological readiness, but was slightly ahead of the average in goods market efficiency; labour market efficiency; financial market development; and market size. In the category of macroeconomic environment, Peru was most significantly ahead of the pack with a score of 6.

WEF competitiveness reports also involve a regular survey of the most problematic factors in doing business. In 2014/15 these were listed as “inefficient government bureaucracy”, identified by 21.8% of the respondents, “corruption”, 15.1%, “restrictive labour regulations”, 12.2%, “inadequate supply of infrastructure”, 10% and “inadequately educated workforce”, 8%. Other factors were identified as problematic by such a small proportion of the survey sample that they could be considered areas of considerable strength. Only 0.5% of respondents identified “inflation” as a problem, 0.6% were concerned by “foreign currency regulations”, 0.9% by “poor public health” and 1.1% by “government instability/coups”.

Outlook

The year 2016 could be one of economic uncertainty for Peru, largely informed by the El Niño weather pattern, general elections, and economic changes in the US and China. Hugo Perea, chief economist at BBVA Continental, told OBG that El Niño accentuated a degree of economic uncertainty for 2016, and could, if coupled with other negative events such as a greater slowdown in China, create the danger of a “perfect storm” for the country, with the weather pattern having the potential to negatively affect the agriculture, fishing, trade and transport services.

However, even if the economy will require some recovery time from factors beyond the government’s control, the long-term outlook remains encouraging, with Peru set to remain among the region’s best performers in a number of areas.