Economic growth in commodity-dependent Peru is unlikely to surpass 5% in 2017, prompting the Kuczynski government to devise a plan to boost the economy that focuses on investment in infrastructure and improved productivity. 

Alfredo Thorne

As with most highly commodity-dependent emerging countries, Peru’s economy was pushed into a deceleration phase by the drop in global commodity prices that began in 2012. Real gross domestic product (GDP), having averaged 5.7% between 2001 and 2011, slowed to 4.2% in the first three quarters of 2016.

Although this was still high by emerging market standards, the drop in GDP did highlight Peru’s dependency on its commodities output. Of this 4.2%, 2 percentage points were attributable to copper exports, and government and private expenditure added 1 and 1.2 percentage points, respectively.

Recently, the global commodities outlook has improved, in light of expectations that US president-elect Donald Trump will opt to push spending on infrastructure. However, this may be insufficient to maintain Peru’s long-term growth above 5%.

Diversifying economic base

Against this backdrop, Peru’s new administration, led by president Pedro Pablo Kuczynski, has set the goal of priming new engines of growth in order to diversify the country’s economic base. While national reliance on commodities and, in particular, minerals will remain an important source of growth, new ones are required, giving a more flexible economic structure, and one that is better able to absorb shocks.

The new administration intends to promote the development of new mining projects through the easing of social tensions and cutting down the amount of red tape involved. Even with the international copper price at the current low of $2.5 per pound, Peru’s all-in cash costs average only $1.3 per pound. Mining remains a highly profitable activity and is expected to continue to boost overall growth. Other minerals markets, while less strong, remain among the most profitable among emerging economies.

The government has identified two new engines of growth that will help the economy to achieve greater diversity and balance going forward: investment in infrastructure and productivity growth. It is necessary that Peru engages in a new phase of structural reform in order to induce this transformation. The last time that a Peruvian government committed to such long-term reform was in the 1990s, which resulted in strong growth in the following decade.

This type of extensive reform typically demands increased government expenditure. At the time the current administration came to office, in August 2016, the public-sector deficit had widened to 3.5% of GDP – the largest level since 2001, therefore the first policy decision that the new government took was to anchor expectations by committing to a fiscal convergence programme.

Reducing the deficit

The government passed legislation committing to a gradual reduction in the overall fiscal deficit, to 1% by 2021 (the end of Mr Kuczynski’s term of office), while keeping the overall gross GDP-to-debt ratio below 30%. This policy has generated sufficient fiscal space to engage in structural reform.

Peru has lagged behind other countries in terms of infrastructural development, as indicated by the World Economic Forum’s Infrastructure Index. However, investment in infrastructure has a high rate of return and capital investment could be the principal driver of overall growth. Being a commodity-dependent economy, private capital investment is also dependent upon mining.

In the first three quarters of 2016, this investment component fell by 44% year on year, dragging down the overall private investment figure; moreover, private investment growth has been negative over the past 13 quarters. A refocusing on investment in infrastructure and, in particular, on public-private partnerships (PPPs) should boost private investment and make capital investment a source of long-term growth.

In early December 2016, using the special powers granted by Congress, the government published new legislation simplifying public works, including taxation on public works and a restructuring of Proinversión, the infrastructure investment agency.

The aim of this exercise was to cut down on the amount of red tape involved in the approval process for public works, and thereby accelerate approval times. It is intended that Proinversión be redirected to specialise in PPPs, following the successful examples of Canada, Australia and New Zealand. It is the intention of the present administration to boost private investment and co-finance $70bn of new projects over the course of its mandate.

The challenge of boosting growth of total-factor productivity (TFP) is greater, but holds the key to increasing overall growth. Although TFP, together with capital investment, accounted for more than two-thirds of the rapid growth experienced by the Peruvian economy between 2001 and 2011, it turned negative in 2016.

Formalising employment

There are several policy options that could boost TFP, but greater formalisation is the most effective policy tool for the Peruvian economy as it currently stands; at present, two out of every three workers are employed in the informal economy and are consequently without access to social services.

The Instituto Nacional de Estadística e Informática, the national statistics institute, estimates that a worker in the informal economy has one-third the productivity level of a worker in the formal economy, and a commensurate salary level. By extension, it is apparent that the most effective way in which to induce higher productivity is by promoting formalisation of the economy.

Unfortunately, informality has been under-researched and few economies have successfully made rapid progress towards formalisation (a notable recent exception being Turkey). The Kuczynski administration intends to promote formalisation by reducing its cost, boosting credit and removing the tax on salaries from formal employment. The government’s target is to increase the formal workforce to 45% of the overall total, from 25% at present, by the end of its term of office.

Previous tax legislation discouraged formalisation by making it an overly expensive process. A very small firm would pay almost no taxes; a medium-sized firm would pay a 1.5% tax on gross sales (translating into a 30% tax on profit); and a large firm would pay 28% tax on profit and 6.8% tax on dividends distributed. This meant that, when a small firm grew, it faced a very steep increase in its effective tax rate.

The new tax legislation has made this transition more gradual, with a very small firm now paying 0.625% of gross sales on account of profit taxes, a medium-sized firm paying a 10% tax on profits, and a larger firm paying a 29.5% tax on profits and a 5% tax on dividends distributed.

Profits redefined

Moreover, the Peruvian tax administration office has simplified the formula for calculating the profits for small and medium-sized enterprises (SMEs), by defining it as the difference between the value of their sales and that of their inputs. Only firms with gross annual sales in excess of $2m are required to submit their full financial statements.

The government also intends to gradually reduce value-added tax (VAT) from its current rate of 18%. Initially, the government asked Congress to reduce this rate to 15% over a three-year period, but Congress would only approve a reduction of 1 percentage point.

In an economy with the high level of informality that Peru has at present, VAT tax ends up being a tax on gross sales. As VAT is a 'chain' tax, where firms pay tax on the difference between the value of their sales and that of their inputs, and SMEs have informal contracts with their suppliers, these companies pay taxes on their sales without getting credit on their inputs.

To complement this push towards greater formalisation, therefore, the government is instilling a credit revolution, making credit accessible to SMEs in a way in which it hasn’t been previously. The special powers accorded it by Congress have allowed the current administration to pass a factoring reform, allowing firms to sell their invoices in a centralised market managed by the Lima Stock Exchange; in effect, a form of commercial paper market.

Capital gains on these invoices are taxed at the lower rate of 5% that is applicable to all other financial instruments, and highly liquid capital could even be regarded as tax-exempt. In addition, the government is using Cofide, its development bank, to make credit accessible to SMEs, by Cofide taking the first loss on commercial bank loans granted to SMEs.

Reforming social services

The final instrument that the government has at its disposal in its effort to increase formalisation is to remove tax on formal employment. The government has convened an international commission of experts to help design a reform of the social services, including healthcare, pensions and labour termination costs.

The objective of this is twofold: to reduce the public sector contribution to workers’ payrolls, and to improve the quality of social services. Currently, the former reach 30% to 40%, and the government target is for them to reach below 20%.

By reducing the difference between the cost of employing a formal worker and that of employing an informal worker, the government intends to increase labour mobility within the working population. At present, the probability of an informal worker migrating to formal employment is only 8%, while the probability of movement in the opposite direction is 15%.

Improving the quality of social services should also help the push towards greater formalisation. Although Peru currently has a contributory, subsidised health service, only 40% of the population has access to health coverage. Pension coverage is even lower: out of a labour force of 15 million, only 4 million have access to pensions. Only 3 million workers have access to some form of provision against unemployment.

Although the challenges are significant, the government is confident that the measures it is putting in place can lay the ground for Peru’s next rapid growth phase – another big step on the road to true modernity.

Alfredo E Thorne is Peru's minister of economy and finance


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter