Peru's fiscal policy and increased investment spark economic growth

Across a range of metrics Peru has emerged as one of the best performing economies in Latin America. The country possesses strong fundamentals, combining robust growth, a falling fiscal deficit, rising export revenue and a credit rating second only to that of Chile. Nevertheless, challenges remain in terms of ensuring sustainable development. The country has undoubtedly benefitted from its openness to private enterprise and foreign investment, along with its prudent fiscal policy. However, recent growth has been driven primarily by an uptick in mining investment and international commodity prices, with Peru’s 4.1% growth in 2018 falling below that experienced from 2005 to 2013, when annual growth averaged more than 6.5%.

“Between 2005 and 2013 we grew exceedingly fast, although that was an exceptional period,” Guillermo Arbe, head of economic studies at Scotiabank Perú, the local subsidiary of the Canada-based multinational financial institution, told OBG. “However, given the country’s solid macroeconomic balance, the resources it has to invest and the low levels of penetration in many segments, Peru’s growth potential is higher than what it is currently achieving.”

The government of President Martín Vizcarra Cornejo, who was sworn in on March 23, 2018, has focused its efforts on combatting corruption. Meanwhile, Peru’s independent judiciary has taken robust action against politicians implicated in the corruption scandals related to the Brazilian construction giant Odebrecht. However, the new administration has been somewhat slower in carrying out necessary economic reforms. Nonetheless, in early 2019 the government unveiled a new policy programme aimed at boosting the country’s competitiveness.

Performance

Peru’s economy grew by 4.1% in 2018, according to the IMF, appearing to mark a rebound following the sluggish growth that came in the wake of the 2014 fall in global commodity prices. Meanwhile, private investment was up 4.4% after posting negative growth between 2014 and 2016 and growing by 0.2% in 2017, according to the economics analysis firm BBVA Research. Public investment also rose from negative figures to 8.4% in 2018, with credit ratings agency Fitch attributing this improved public investment figure in part to the resolution of a series of delayed infrastructure projects, which in turn are set to support economic development over the coming years. Domestic demand also performed well, rising 3.9%, up from 1.6% in 2017. Both private and public consumption posted solid improvements, up 3.8% and 2%, respectively, compared to 2.5% and 0.5% increases in 2017.

Structure

According to the National Institute of Statistics and Informatics (Instituto Nacional de Estadística e Informática, INEI), the two major drivers of GDP growth in 2018 were mining and manufacturing, contributing 12.4% and 13.3% of the total, respectively. The Peruvian economy has had a relatively similar structure for the last decade, though the relative contribution of both these sectors has declined somewhat, from a high of 14.2% for mining and 16.4% for manufacturing in 2008.

Nevertheless, the total value of these industries increased by around a third in constant 2007 prices over this period; the value of mining rose from PEN49.6bn ($15bn) to PEN66.5bn ($20.1bn), and manufacturing from PEN57.3bn ($17.3bn) to PEN71bn ($21.5bn). Both the contribution of mining to GDP and the total value of its output dropped slightly in comparison to 2017. This can be largely attributed to lower international metal prices and a dip in extraction brought about by temporary geotechnical issues (see Mining chapter).

A new wave of investment in the mining sector is, however, expected to boost both output and its overall contribution to GDP. Investment in the industry rose 26% in 2018 to $5bn, according to BBVA Research, with this figure set to rise to over $6bn in 2019. This increase is expected to bolster overall economic development, with a particular impact on the country’s already expanding manufacturing sector. This is due to the strong forward and backward linkages between the Peruvian mining sector and other areas of the domestic economy; manufacturing consumes 44% of the goods and services produced by the mining industry, while transport and storage services account for 16% and the hydrocarbons industry 13%.

Another significant contributor to GDP was the trade and maintenance of motor vehicles, which contributed 10.4% in 2018. Construction accounted for 5.9%, while transport and storage contributed 5.6%, followed by business services (4.9%), telecommunications (4.5%) and financial services (4.5%).

Meanwhile, manufacturing enjoyed its highest annual growth rate since 2011, expanding by 6.2% in 2018, up from 0.2% in 2017, according to the National Society of Industries (Sociedad Nacional de Industrias, SNI). Primary manufacturing grew by 12.7%, while non-primary manufacturing rose 3.9%. This expansion was driven in particular by the fish processing and preservation industry, which grew by 70.4% as a result of a high catch rate and increased international demand for seafood products. The second-fastest-growing segment of manufacturing was electrical equipment manufacturing, at 28.5%, followed by metal products (11.1%) and furniture manufacturing (8%) (see Industry & Retail chapter).

Open for Business

Beginning in the 1990s Peru underwent a series of pro-market reforms intended to boost entrepreneurship and open the economy to international investment. These reforms, coupled with the prudent management of government finances, supported sustained growth since 1993 – punctuated only by a minor recession in 1998 caused by the Asian financial crisis and a severe El Niño. As of May 2019 Peru had a creditworthiness second only to Chile in Latin America, with an “A3” rating from Moody’s, “BBB+” from Standard & Poor’s and “BBB+” from Fitch. In its March 2019 report on Peru, Fitch stated that the country’s credit rating reflects its robust public and external balance of payments, and its credible, consistently applied fiscal and monetary policies, stating that these have “entrenched macroeconomic and financial stability”.

Similarly, according to the World Bank’s April 2019 country report, Peru was able to weather the 2014-17 drop in international commodity prices through a combination of increased mining production and “prudent fiscal policy management in terms of monetary and exchange policies”. This allowed the country to “endure the decline in fiscal income without drastically adjusting spending”.

Strong Fundamentals

Economic stability has been supported not only by the government’s ongoing reform agenda, but also by the steadfastness of the Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP). Foreign exchange reserves – which increased sharply in the years following the liberalisation of the economy – before stabilising between 2016 and 2018. Since then, the country’s international reserves have increased, rising from a total value of PEN202.6bn ($61.3bn) at the end of 2018 to PEN212.7bn ($64.4bn) in April 2019.

In addition, inflation has been reduced over recent years, remaining within the BCRP’s target band of 2% plus or minus 1% since August 2017 and was solidly below 2% until October 2018, according to INEI. While the rate gradually increased to reach 2.5% in March 2019, the BCRP forecast in the same month that this would likely stabilise to 2.3% over the short term. The BCRP affirmed its commitment to retain an expansionary monetary policy, a benchmark interest rate of 2.75% and a real interest rate of around 0.4%. This approach undertaken by the central bank has been relatively positively received by domestic and regional players.

Furthermore, because industry players currently expect the country to continue to grow below its potential for the coming years, a sudden rise in inflationary pressures appears unlikely. Given this, in their March 2019 report the Peruvian Banking Association stated that it was “reasonable” for the BCRP to maintain its expansionary position, as long as inflation remains within the target range and economic activity remains below its potential. However, writing in April 2019, BBVA Research stated that the BCRP could marginally increase interest rates during the second or third quarter of 2019.

Although the country’s public debt-to-GDP ratio has increased from a 18.1% in the first quarter of 2014 to 25.7% at of the close of 2018, it remains one of the lowest in Latin America. In addition, the country has been able to reduce its exposure to currency volatility by increasing the portion of its debt stock denominated in Peruvian nuevo sol. According to Fitch, this ratio reached 66% in 2018, with the government targeting 80% by 2022. To support its efforts to repay dollar-denominated debt using its own national currency, the Ministry of Economy and Finance (Ministerio de Economía y Finanzas, MEF) has sought to attract more international investors to develop its local bond curve.

In July 2017 Peru sold its first-ever tranche of domestic currency-denominated bonds that was be cleared and settled by Belgium-based financial institution Euroclear. Demand was more than three times that of what was sold and raised $3bn. This enabled foreign buyers to more easily participate in the trade, with around 70% of the deal sold to non-resident investors. This issuance was followed in November 2018 with a new PEN10.3bn ($3.1bn) 10-year sovereign bond, the largest local currency note ever issued in an emerging market, according to the MEF. These efforts appear to be paying off; the BCRP reported in March 2019 that the share of Peru’s local bond curve held by foreign investors had reached 51%, up from 46% in December 2018. However, according to Scotiabank, around $3bn of offshore capital flowed into the country’s sovereign bond market in the first quarter of 2018 alone, leading to an appreciation of the domestic currency against the dollar. As a result, the BCRP began to buy US dollars in March 2018 after nearly 14 months of not intervening in the foreign exchange market.

Investment

Rising private investment has served as one of the major drivers of growth in the Peruvian economy in recent years. Private sector investment grew by 4.7% in 2018, up from 0.2% in 2017, according to the MEF, and is projected to rise by 7.5% in 2019, driven by major new infrastructure projects and the development and expansion of mining facilities. BBVA Research agrees that this trend is set to continue over the medium term, but projected in April 2019 that the annual expansion in private investment was likely to reach 6.5%.

While there is broad agreement that such private activity is set to rise, industry players have cautioned that it will not necessarily do so exponentially. “Although the pace of growth of private investment is increasing, it is not expanding fast enough to trigger a virtuous cycle like before,” Guillermo Arbe, chief economist at Scotiabank Perú, told OBG.

Meanwhile, public investment grew 8.4% in 2018, up from -2.3% the previous year. The change of regional and municipal administrations on January 1, 2019, following the local elections of October 2018, is, however, expected to exert a downward pressure on public spending, though the projected impact of these changes differs between analysts.

The MEF forecast that this activity would grow by 4.5% over 2019, while BBVA Research forecast it would drop to 0.2% before rising 10.3% in 2020. These figures may be bolstered further through the provision of additional public funds in the run-up to the XVIII Pan American Games, which will take place in the country’s capital in July and August 2019. In addition, the government’s ongoing Reconstruction with Changes programme, which is intended to improve resilience to natural disasters and climatic events, could also bolster spending.

Reform Agenda

While the MEF forecast in April 2019 that growth would remain at around 4.8% per annum for the period 2020-22, the IMF has projected a growth rate of 4% in 2020 and BBVA Research has forecast a rate of 3.7% in the same year. Nevertheless, both the government and observers agree that the country requires structural reforms to improve its performance and ensure high, sustainable economic expansion over the medium and longer term. For example, according to figures published by the International Trade Centre, Peru had around $12.6bn in untapped export potential in 2018.

“Peru has not undertaken enough reforms and there remains a lack of efficiency in our economy,” Rodrigo Acha, assistant economic analysis manager at the American Chamber of Commerce in Lima, told OBG. “We have essentially benefitted from a rise in the number of greenfield mining projects, which have enabled us to double mining production.”

While the Peruvian economy has steadily improved its business environment and openness to international investment since the early 1990s, the implementation of complementary reforms has been somewhat slower. According to Fitch, without changes to significantly improve the country’s infrastructure and greater flexibility in its labour market Peru is unlikely to achieve sustained growth higher than between 3.5% and 4%.

As part of an attempt to overcome these challenges, the government of President Vizcarra launched the National Competitiveness and Productivity Policy (Política Nacional de Competitividad y Productividad, PNCP) in January 2019. The programme highlights three areas that need to undergo reform and greater investment in order to boost the countries productive capacity and ensure sustainable development, namely physical capital, human capital, and the efficiency of markets and institutions. The PNCP envisions achieving improvements in all these areas by coordinating activity between the public and private sectors, along with academic institutions and civil society.

Infrastructure

According to the report initiating the PNCP programme, $160bn of investment will be needed through to 2025 to develop physical infrastructure on a par with countries such as Japan, Singapore and Thailand. Around 70% of this figure is required for transport, energy and telecommunications. In order to address this deficit, the government plans to increase state investment and initiate new public-private partnerships (PPPs) to expand and upgrade infrastructure. According to the “Global Competitiveness Report 2018” published by the World Economic Forum (WEF), Peru ranked 90 out of 140 countries for infrastructure, with a notably low ranking in terms of quality of roads (108th) and road connectivity (96th).

While closing this infrastructure gap presents a considerable challenge, the government has been proactive in attempting to address the issue. In early 2018 it announced a plan to instigate a range of new hard infrastructure projects with a total value of $11bn. The country has a well-developed state organisation for the promotion of private investment in public services, namely ProInversión. The body has been particularly proactive in the promotion of the PPP model. The agency has a portfolio of 58 projects totalling $10.3bn for 2019-21, with a third related to transport and telecommunications, followed by sanitation (20%), energy and mines (13%), health care (12%), irrigation (11%), real estate (6%), education (4%), and tourism and culture (1%).

However, the PNCP has highlighted that a lack of funds is not the primary issue, but rather the slow execution of approved projects, with 61% of planned infrastructure projects not going ahead in 2017. This record of slow implementation was further exacerbated in 2018 in the fallout from the Odebrecht scandal, which delayed work on the Southern Peru Gas Pipeline and the third phase of the Chavimochic irrigation scheme.

Education

The country also aims to harness human capital accumulation to achieving sustainable and equitable growth and future-proof its labour market. Peru performs well across a range of education indices, with a net primary school enrolment rate of 96.6% and 82.5% in secondary education, according to UNESCO. According to the World Bank’s “The Human Capital Project 2018” report, Peru has an adjusted equivalent of 8.3 years of schooling, which placed it ahead of Brazil (7.6 years), but behind Colombia (8.5 years), Ecuador (8.9 years) and Chile (9.6 years). Furthermore, the country ranked poorly in the WEF index for the extent of staff training (124th), digital skills among the population (111th), critical thinking in teaching (80th) and the skill set of graduates (95th). Nevertheless, the government is making efforts to improve skills levels in Peru, allocating PEN30.6bn ($9.3bn) to education in 2018, an 11% increase on the previous year (see Education chapter). Furthermore, in January 2019 the Bicentennial National Pact in Education was signed to affirm continued investment in improved education and skills training for workers.

Institutions

The Peruvian government is also seeking to significantly improve the efficiency of state institutions. Administrative bottlenecks create barriers to the implementation of hard infrastructure and human capital formation, while also negatively impacting upon the country’s broader economic competitiveness. While Peru was ranked 90th overall in terms of institutions in the WEF’s 2018 index, it ranked 128th for the burden of government regulation, 136th in terms of the efficiency of the legal framework in settling disputes and 129th for the impact of organised crime.

“We are a country with a deeply ingrained culture of paperwork, where everything needs 10 signatures,” Arbe told OBG. “This means that everyone who signs something needs to trust the other nine people, and that trust is not always there.” However, the government is pursuing an ongoing effort under the National Strategy of Government Open Data 2017-21 to digitise state services and procedures.

While Peru has historically faced major challenges in terms of corruption, ascending to the highest levels of the state, it also had one of the most robust judicial responses to the Odebrecht scandal in the region. Furthermore, the administration of President Vizcarra announced a raft of policies in August 2018 intended to take on corruption.

These proposals included greater transparency and accountability in the appointment of the judiciary, improved regulations on political party financing and the immediate re-election of politicians to the same position they previously held at the end of a five-year term. These reforms were supported in a nation-wide referendum in December 2018. However, while these efforts are welcome, greater progress will be needed to streamline the administration of licences and business activities and eliminate graft at lower levels of government in order to overcome these challenges.

Labour Market

The PNCP reform agenda also includes plans to reform the labour market to make it both more inclusive and more flexible. According to the latest figures from INEI, 72.5% of the economically active population and 46.5% of salaried workers were employed in the informal sector. Exclusion from formal employment is exacerbated by overly complex regulatory frameworks for different sectors of the workforce, coupled with restrictive laws governing the dismissal of workers and high taxation, according to the PNCP report.

Indeed, Peru ranked 128 out of 140 countries in the WEF’s “Global Competitiveness Report 2018” in terms of its hiring and firing practices, while its overall competitiveness ranking stood at 63. This high level of informality within the Peruvian labour force also has a negative impact on government revenue. In order to address this challenge, the government of President Vizcarra is pursuing reforms to make it easier for firms to fire workers, while also improving legal provisions to enable part-time and remote work to increase flexibility.

“We need to change our labour laws so they are closer to international norms,” Arbe told OBG. In addition, he added that the country should work to improve the digitalisation of administrative services and taxation for businesses and workers in order to tackle informal employment.

Outlook

While Peru faces a range of challenges, it has nonetheless made considerable progress across numerous areas in 2018 and possesses strong underlying fundamentals. Growth levels are healthy, supported by rising private and public investment, and the public finances are robust. It has improved its debt-to-GDP ratio and entered international capital markets, and its efforts to repay dollar-denominated debt using its own national currency have been successful. Furthermore, the country has shown a consistent openness to international trade and investment, and holds strong credit ratings.

Despite persistent issues with corruption, Peru possesses an independent central bank and a respected, well-functioning investment authority. Furthermore, it showed regional leadership in its handing of the Odebrecht scandal and has since implemented a range of anti-corruption legislation. Fitch has forecast GDP growth of 3.7% in 2019 and in 2020, underpinned by major infrastructure projects and rising exports. In particular, increased investment in the productive capacities of the mining sector appears set to support economic expansion.

While the economy is steadily improving, higher growth rates and more rapid structural transformation will be needed to achieve poverty reduction and development objectives. The country still faces major bottlenecks in terms of productivity and competitiveness, and continued expansion remains highly sensitive to international commodity prices – particularly of copper – highlighting the need for economic diversification. A range of exogenous factors could similarly imperil the pace of growth, including the trade war between China and the US, and the possibility of further monetary tightening on the part of the US Federal Reserve. Importantly, in the context of fiscal consolidation (see analysis), the country has a sizeable infrastructure gap, limitations in human capital and inefficiencies among governmental institutions. Myriad efforts are, however, under way to address these obstacles and promote more sustainable growth, and investors and economists alike will be tracking the results closely.