Peru market reforms to increase liquidity and trade

The Lima Stock Exchange (Bolsa de Valores de Lima, BVL) has had a difficult three years in 2013-15, but market players believe conditions are beginning to point to a recovery in 2016.

In terms of its importance to the wider economy, the BVL is comparable to bourses in other neighbouring countries. However, in recent years it has become somewhat less active and less liquid than its peers. The market capitalisation of listed Peruvian companies was worth 38.9% of GDP in 2014, according to the latest available comparable figures from the World Bank – ahead of Mexico (37.1%) and Colombia (38.8%) but behind Chile (90.4%). However, the BVL lagged behind in terms of the total value of shares traded: in 2014 this represented 1.8% of GDP, compared to Colombia (5.5%), Mexico (11%) and Chile (10.5%). Another way of describing the same phenomenon is to note that the BVL had the lowest stocks and shares turnover ratio – a measure calculated by dividing the total annual value of shares traded by the average market capitalisation. In 2014, Colombia (11.8), Chile (10.9) and Mexico (28.2) all had high turnover ratios, while Peru’s was the lowest (4.6).

Overall, the Peruvian financial system performed well in 2014 and 2015, despite a slowing economic growth rate. Two of its main components, banking and insurance, did best, while the stock exchange lagged behind. The Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP) followed a counter-cyclical monetary policy during the course of the year, gradually reducing banking system reserve ratios and using repo operations to inject liquidity. Partly because of this, financial system GDP continued double-digit growth throughout the year.

Bond Market

There is an active fixed-income market dealing in government and corporate bonds. Primary bond issuance in 2014 totalled $1.17bn, down from $1.75bn the year before. Despite this, the market sees activity rising in 2016, in light of growing interest by medium-sized and large companies and the need to cover the funding needs of Peru’s ambitious infrastructure investment programme. Peru’s freely convertible currency system means that both fixed and variable income markets can operate either in local currency – soles (PEN) or in foreign currencies such as the US dollar. Concern over excessive exposure to dollar-denominated debt at a time when the sol has been depreciating has led to a shift in the market, with more small and medium-sized companies now preferring to issue bonds in local currency.

Headwinds For Shares

In 2014 and 2015 the BVL was influenced by four main factors: weak global commodity prices; the relative slowdown of Peruvian economic growth; a weakening performance by the country’s main listed companies, which were impacted by the economic slowdown; and the fact that some securities were “over-punished” because of the negative turn in sentiment. The BVL General Index of share prices, (Índice General de la Bolsa de Valores de Lima, IGBVL) fell in year-on-year (y-o-y) terms during the first five months of 2014, enjoyed a small rally in June-September, but fell back into negative territory in the last quarter. The index closed 2014 at 14,794, down 6.1% on 2013.

During 2015, and broadly reflecting the same factors, the IGBVL was consistently down on year-earlier levels. For the first half of the year the index was down in a 10-20% range on year-earlier levels, but in the third quarter the drop intensified. At the end of September the IGBVL had slumped to 10,030, down by 38.2% on the comparable year-earlier point. The IGBVL lost 4945.73 points in 2015 to close the year at 9848.59. As a result, the stock exchange had its third consecutive year of falling share prices in 2015. The last positive calendar year for the IGBVL was 2012, when it expanded by 5.9%.

By sector, the index has traditionally been dominated by financial companies and these continue to do comparatively well (compared to the average for the BVL as a whole), as do companies in the consumer and retail sectors and those in manufacturing. Companies in services have performed less well. Mining companies were the sector most impacted by the end of the commodities boom, and their performance remained poor in 2015.

Lack Of Liquidity

Other metrics have confirmed that the stock exchange has been facing a challenging period. Market capitalisation dwindled from $102.6bn in 2012 to just under $60bn in September 2015. While the number of shares listed on the BVL has increased over the last five years, to 298 by the end of September 2015, the total value of shares traded has been trending down steadily, from a peak of over $500m a month in 2011 and 2012, to $318.2m in 2014, and to less than half that – $129.5m – in the first nine months of 2015. This confirms a picture of an increasingly illiquid exchange, where significant trading is limited to only a minority of shares.

Roberto Flores, head of strategy and economic research at brokerage Inteligo, told OBG that after enjoying boom years in 2007-08, the Lima stock exchange has suffered setbacks and has lost dynamism for a variety of reasons, including the ebbing of the commodity boom and lower investor appetites for emerging markets. “An important factor was the lack of further reforms, both in the wider economy and in the capital markets. This led to the situation we are seeing today, where the BVL is very vulnerable. But the situation is reversible and a series of reforms have been initiated, including the elimination of capital gains tax, a reduction in trading commissions, an increased role for market makers, and other long-term reforms. The aim is to get more companies to list on the BVL, and not just to list, but also to float a significant number of shares,” he said.

Fernando Manrique, head of equities at pension fund Prima AFP, agreed with this analysis, telling OBG, “When Peru was booming we missed the opportunity to reform and diversify the stock market. The pension funds have money to invest; the problem now is that it is an illiquid market – we need more new products.”

Manrique is optimistic about the future, however. He believes that innovations like the introduction of short-selling, arbitrage, securities lending and – as a desired consequence of those three, along with the spot market – trading in derivatives could also help boost the overall level of transactions.

Juan José García Chau, researcher of think tank Contribuyentes Por Respeto, told OBG that the Lima stock exchange had been a victim of its own success. During the boom years foreign investors piled into the market, contributing to the strengthening of the national currency and capturing particularly high US dollar returns. Concerned by the effects this was having on exchange rate volatility, in 2009 the government introduced a 5% capital gains tax on stock market transactions. “The net result is that when the global economic context became less favourable, the volume of transactions on the Lima stock exchange collapsed. Right now, on some days there have been as few as 300 transactions. Lima has become an illiquid exchange,” said García.

Threat Of A Downgrade

In August 2015 these negative trends came to a head as the BVL faced a potential downgrade from emerging market to frontier market status. New York-based Morgan Stanley Capital International (MSCI), a publisher of a range of global capital market indices, mooted the downgrade. MSCI operates with three main capital market classifications – namely, developed, emerging and frontier markets. The countries and stocks in each category are selected on the basis of a number of criteria, including liquidity and overall turnover.

MSCI said it was considering demoting Peru from the emerging markets to the frontier markets group. The main reason for doing so was that the BVL had sharply falling turnover levels.

“Currently, only three securities from the MSCI Peru equity universe meet the relevant investability requirements applicable to emerging markets,” MSCI’s press release stated. While the individual securities were not directly named in the statement, some of the most important companies on the Lima market include mining stocks Southern Copper and Buenaventura, and financial groups Credicorp and Intergroup Financial Services. The MSCI Peru index has a weighting of only 0.4% in the overall emerging markets group, which is dominated by China (24.1%) and South Korea (14.1%). The other Latin American countries in this grouping are Brazil (7.4%), Mexico (4.5%), Chile (1.2%) and Colombia (0.6%).

If Peru were to be moved to the frontier markets group, the number of BVL-traded securities that would qualify under the less-demanding criteria for inclusion in that group would grow to 16, and its weighting in the new group would rise to 12.8%, second only to that of Kuwait (19%), and above that of the only other Latin American country in the frontier class, Argentina, with a weighting of 9.4%. MSCI said it would also consider moving one of the BVL’s top listed stocks, Phoenix-based mining company Southern Copper, to its US index.

MSCI said that it wanted first to hear feedback on the suggested reclassification from all major players and index users. Christian Laub, the head of the exchange, meanwhile warned that reclassification could trigger a capital outflow of between $1.5bn and $5bn. “If they tell us we’re a frontier market, it will take us between seven and 10 years to become an emerging market again,” he told press in August 2015. “That’s why the situation is serious.”

In the 10 days following the initial MSCI announcement on August 14, the BVL select index fell by 12.4%, with the less-liquid general index down by 8.3%. Although that period –the third quarter of 2015 – coincided with a sharp downturn of global markets led by China, a good part of the Lima fall was attributed to worries over the effects of reclassification.

Reform Initiated

Both the BVL and the government sought to make the case for remaining in the emerging markets group. Officials said they were looking at changes that would increase capitalisation and liquidity. These included new rules to facilitate short-selling and automated trading, and to ease restrictions on market makers, along with the streamlining of taxation and the development of links with other stock exchanges in the Pacific Alliance group of countries (Chile, Mexico and Colombia). Some brokers, however, believed that the threat of a downgrade might in the end act as a positive catalyst to speed up capital market reforms.

Peru is a member of the Integrated Latin American Stock Market (Mercado Integrado Latinoamericano (MILA), a reciprocal agreement with the bourses of Chile, Colombia and Mexico to move towards shared listings and common trading platforms. Enzo Defilippi, Peru’s deputy minister of economy, told local press, “We are going to show them Peru should not be included in the list of frontier markets, because it is a strong and licit economy, and because its stock exchange should be in the list of emerging markets like its peers in the Pacific Alliance.” Alonso Segura, the minister of economy and finance, who travelled to New York along with BVL president Christian Laub to make Peru’s case to MSCI, made similar comments, noting that a Peruvian downgrade would be a setback not just for the country but for MILA as a whole.

Assessment Pending

At the end of September 2015, having listened to initial representations, MSCI said Peru would remain in the emerging markets category pending further assessment of the BVL’s performance in the period running up to June 2016. This fell short of the 30-month assessment period sought by Peru, and MSCI warned that “failure by the Peruvian authorities and the stock exchange to reverse the declining trend in liquidity… may lead to MSCI’s decision to reclassify the MSCI Peru Index to Frontier Markets in June 2016”. Carlos Rojas, a managing partner at Andino Asset Management in Lima, commented to Bloomberg, “Nine months is a short time span. Now it is up to the local regulators, the stock exchange, and the Finance Ministry to do the hard and intense work needed to create liquidity in the market.” However, BVL president Laub clarified that the exchange was not being asked to wholly transform its performance in nine months, telling local press what MSCI wanted to see was “a beginning of a change in the negative trend we have been experiencing”.

Rafael Gómez de la Torre, head of information at BVL, told OBG that a wide range of initiatives were under way to make the exchange more dynamic and boost traded volumes. Government has lifted the capital gain tax for most relevant stocks starting Jan 1, 2016. The exchange was moving to authorise short-selling, in the belief that increasing the available trading options, not only in a rising market but also in a falling one, would attract more players and have a long-term positive effect. As a further diversification strategy, the BVL was looking at introducing US-style real estate investment trusts, following Mexico’s example, where they have been introduced and are known as fideicomisos de inversión y bienes raíces. The BVL was also looking into the introduction of computer-based automatic trading, in the belief that this too might stimulate transaction volumes.

Market Makers

BVL has stressed the importance of boosting the role of market makers. Until recently market makers such as brokers or other funds offered trading in certain shares only at particular times of day or week. The aim now is to ensure that market makers can offer buy or sell positions continually throughout trading hours. There has also been an effort to simplify the tax treatment of market-making activities (trading on behalf of clients).

Laub has said that if blue-chip local stocks such as Intercorp Financial Services, Alicorp, and others such as Ferreycorp, Graña y Montero and Cementos Pacasmayo can be added to the MSCI Peru index, then the aim will be to ensure that they each have appropriate market makers. “If I want to buy or sell something, then the market maker can give me a price. There will be a buy-sell spread, but the more liquid we can make those shares, the narrower the spread will be, and that will attract people who currently aren’t trading on the BVL because they are worried about it being illiquid,” Laub told Semana Económica.

Pension Funds

Peru’s private pension funds are important players on the country’s capital markets. Luis Valdivieso Montano, executive president of the pension fund association (Administradoras de Fondos de Pensiones, AFPs) and a former minister of finance, told OBG that the funds now have around $40bn of capital under management. They are investing around $4bn a year, of which just under 60%, or $2.4bn, goes to Peruvian capital markets, and leverages further funds, since the AFPs always take a minority stake in new ventures. “We have contributed a lot to deepening Peruvian capital markets,” Valdivieso said. “The stock market is now beginning to diversify, and we are talking about it green lighting investments in derivatives and alternatives. We are also investing more in infrastructure, which now represents 11% of our total portfolio.”

Under current regulations the AFPs must invest at least 58% of their funds in Peru, which means they have a 42% limit in overseas investments. Valdivieso said his association is a strong supporter of tax and procedural simplification on the stock exchange to boost transaction volumes and avoid the potential MSCI downgrade to frontier market status. He values stock exchange collaboration with Pacific Alliance countries through MILA and said that the long-term aim should be to make private pensions portable across all MILA countries.

Outlook

While analysts do not see any quick return to the stock market boom that developed during the peak of the commodity cycle, there is a degree of confidence that the next few years will see a process of stabilisation and recovery. In part this is because the GDP growth rate is expected to pick up moderately in 2016. In addition, many believe that metals prices are stabilising and that in one or two years they too will begin a moderate recovery. In such a scenario, and partly because of new mining projects in the pipeline, coupled with Peru’s competitive cost structure, company margins will begin to improve again, re-awakening investor interest in the stock exchange.

Enrique Corredor, a partner in Brazilian investment bank BTG Pactual, is one of those who holds a positive view of capital markets’ outlook in Peru. Corredor told the Peruvian newspaper El Comercio in October 2015 that although there are a number of risks, macro-economic conditions are set to improve and, encouraged by the strength of the US dollar relative to Latin American currencies, investment interest in the region is likely to return. He is expecting merger and acquisition interest in Latin America and Peru to increase by as much as 50% in 2016 relative to 2015, with particular interest in retail, food, health and infrastructure sectors. He said the country’s open economy and the desire to push forward with the MILA will have a positive impact going forward.