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AmericasMay 6 2007

Peru edges towards

Peru is the new darling of investors and has recently enjoyed a handful of rating upgrades. Its policy of promoting growth while keeping inflation under control is slowly paying off, reports John Rumsey.
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The global commodities boom is to thank for kindling growth in Peru. Gross domestic product (GDP) increased by 7.67% in 2006, reaching $71bn. And it continues to head upwards, hitting 9.2% in January this year. Better still, there are no signs of over-heating, with inflation very subdued at 1.1% last year.

Other Latin countries enjoying the commodity boom, such as Venezuela and Argentina, have similar rates of growth, but inflation is taking off. It reached 16% in Venezuela last year and 9.8% in Argentina.

Peru’s slow-but-steady monetary and fiscal policies are paying off. Standard & Poor’s raised its rating to BB+ last November. This is partly because of a diversifying economy and falling debt levels, says Jane Eddy, managing director, corporate and government ratings Latin America at S&P. Although a further upward movement in the next 12 to 18 months would be atypical: “Peru consistently surprises on the upside,” she says.

Foreign debt upgraded

Moody’s Investors Service (Ba2) and Fitch Ratings (BB+) signalled their optimism by upgrading their outlook on Peru’s foreign debt in March. An investment grade rating widens the pool of investors with consequent effects on yield, notes Ms Eddy.

Undeniably Peru, in common with other Latin economies, is still too dependent on mining. Mining accounts for half of exports and more than 34% of foreign investment. That said, the country has benefited not just from price increases in its commodities, but volume increases too, says Julio Velarde Flores, president of the Central Reserve Bank. The volume of exports was up by close to 15% in both 2004 and 2005, he says.

And, unlike copper-reliant Chile, Peru has a diversified commodities base, he adds. Peru is the top producer in silver, ranks second or third in tin, lead and copper, and is a significant producer of other minerals. Its key commodity prices are likely to be stable this year, with a 5% fall over the 2008/09 period, Mr Velarde predicts.

Safety net

Even if commodities fall, other sectors are starting to pick up the slack, he says. The most exciting of these are construction, where growth hit 15% in 2006, and consumer goods, which were up by 10.6%.

The central bank has been building up its reserves to ensure that, should commodities fall faster than anticipated, the landing will not be a hard one, says Mr Velarde.

The country accumulated $1.8bn in the first two months of the year, bringing total reserves to $18.5bn. This cushions against volatility and means the bank can act as the lender of last resort if there is a currency crisis, which looks unlikely. Analysts see the sol depreciating by some 1.5% this year, says Mr Velarde, adding that the central bank does not make its own predictions.

On the fiscal front, Peru has a very low tax base, that crimps its flexibility, says S&P’s Ms Eddy.

That is being addressed, counters Juan Miguel Cayo, vice-minister of the economy. Peru is moving to bring the tax take up to 17% of GDP over two years from the current level of 15%, he says. That’s very different to Venezuela, where the government has announced that it will eliminate its 14% VAT levy over time.

To achieve the 2% increase in tax revenues to GDP, the Peruvian government has pruned tax exemptions, which saw Amazonian areas free from many taxes. The imposition of tax fuel on that region – with some exceptions for cities that are reachable only by air or river – will be a significant driver, Mr Cayo says. The government is also eliminating the tax exemption on capital gains taxes.

Peru is altering the tax code to make it pro-contributor and pro-investor, says Mr Cayo. It is being simplified for small and medium-sized enterprises among others, he adds. And to diversify the economy further and bring in investment, the government is extending a tax rebate on VAT on projects of more than $5m where there is a pre-operational phase of more than two years.

Finally, the government is cutting tariffs to encourage a more competitive environment. The measures are widespread and not directed at industries as “we don’t want to pick winners”, Mr Cayo says.

He sees the optimal figure for tax collection to GDP as 18%, although for now there are no plans to capture that extra 1%. But it is not the quantity but quality of spending that is key, he insists. Peru still has a long way to go to improve the quality of public expenditures, he says. To help get there, the government is simplifying social spending programmes.

Peru spends $1bn each year on such schemes, but “they have a very low impact because they are so atomised”, says Mr Cayo. There are more than 80 schemes, many of which are not well co-ordinated or focused, he adds.

The government is seeking to merge these programmes, select a head to direct and co-ordinate an overall strategy, says Mr Cayo. “We will promote an approach that emphasises basics from supplying food and clean water to education.” He also plans cutting administrative costs from 20% to less than 10%.

Monetary policy

Mr Velarde is in the happy position of having a very low inflation rate. Even so, he is vigilant. His main worry is that with domestic demand rising, production will be unable to keep up, causing an upward trend in inflation.

There are no signs of that yet. The benchmark 4.5% interest rate could move up this year, says Mr Velarde, pointing out that most analysts predict an increase of 25 basis points.

The combination of high GDP growth, a restructured framework of legislation for banking and low rates have led to rapid growth in lending, albeit from a low base. Lending increased by 14% in both 2005 and 2006.

Ms Eddy notes that the banks’ ability to manage rapid growth in their lending portfolios and the concentration on dollar lending is a possible cause for long-term concern. “We are conscious of our vulnerability in lending in dollars,” Mr Velarde says, but points out that banks have a reserve requirement of 30% for dollar lending and 6% for local currency lending. That has contributed to a marked shift to lending in soles, he notes. In 1998/99, 91% of loans were in dollars; that number has fallen to 59%.

Market response

An investment backwater in the 1990s, Peru’s markets have been responsive to the gush of positive news. Key indices of the Bolsa de Valores de Lima rose by about 200% last year. That’s not a figure that could or should be repeated this year, says Mr Velarde.

Observers still worry about political stability. President Alan García’s defeat of populist Ollanta Humala in elections last year was seen as the best result between two unattractive candidates. Mr García has gone on to pursue market-friendly policies that have reassured the market. Even so, Mr Humala, after a post-election slump, has made an unlikely comeback thanks to various mistakes by Mr García’s natural rival, Lourdes Flores, says Ms Eddy. That’s not worrying for now, as the danger of a political upset looks remote with the president’s approval ratings well over 50%, but it is worth keeping an eye on.

Bond yields have also been retreating. Twenty-year bonds were yielding 8.25% two years ago. Now they stand at 6.3%, says Mr Velarde.

That will allow the government to keep pushing forward its debt restructuring, says Mr Cayo. In the next 12 months, the government envisages issuing a further $2bn in local currency debt, much of which will be improving the profile of outstanding debt, he says. The country aims to pay off its remaining $900m in Brady and $1.8bn in Paris Club debt by year-end. That should bring the much-hoped-for upgrade closer still.

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