Does commodity rebound mean recovery for Peru?

Peru is approaching 2018 with some confidence that the worst of an economic downturn fraught with internal and external challenges is finally over.

First battered by the end of the commodities supercycle, the country was then hit by the local fallout from the regional graft scandal caused by Brazilian construction company Odebrecht (which reached the very highest levels of the country’s political and business elite). Finally, abnormal flooding devastated its northern coast.

After less than a year in power, president Pedro Pablo Kuczynski reacted by instigating a wide-reaching cabinet reshuffle. This gave his reform agenda some new momentum just as recovering commodities prices helped the business and investment cycle rebound.

Early reforms pay off

Despite its recent troubles, Peru still enjoys the favour of the international community and good access to the international markets, having built a track record of sustained economic growth and fiscal discipline since the deep reforms of the early 1990s.

The country still has plenty of unexplored potential to lure investors seeking opportunities in a region that has struggled in the aftermath of the commodity boom. In the infrastructure sector alone, Peru faces a monster investment gap of an estimated $160bn. This translates into dozens of projects waiting to leave the drawing board to be developed by domestic and international companies.

Yet extremely poor governance remains a major challenge across the board, as the Odebrecht scandal underlined. Even the state’s deep pockets cannot help if national, regional and local authorities struggle, as they often do, to spend their annual budget for lack of human resources and competences. If the worst, at least economically, is really behind the country, expectations are high that Mr Kuczynski will focus on reforms and try to find some political room to address governance issues once and for all.

On the rebound

“The economy is turning around,” says Pablo Secada, former chief economist at the Peruvian Economy Institute (IPE) and CEO of consultancy firm Opportunity Investments. “Private investment started falling in 2014, when the mining cycle came to an end, but even when mining investment stopped falling, investment in other sectors kept retreating because SMEs postponed their investment plans.

“That cycle touched bottom in the second quarter of 2017, when the economy began to bounce back driven by external factors such as the growing prices of mining commodities, but also recovering exports volumes in traditional sectors such as textiles. Business confidence has also bounced back, hinting at a definitive recovery in private investment in 2018.”

After the global financial crisis, Peru led Latin America’s 'Southern Cone' in growth as booming commodity prices boosted investment in its mining sector. Peru is the world’s second largest producer of copper, the world’s third largest producer of zinc and silver, and the sixth largest of gold, with mining products making up 60% of total exports. The government tried to capitalise on that unprecedented push by setting in motion infrastructure developments across the board to raise millions of Peruvians out of poverty and unleash the country’s economic potential.

As the commodity cycle cooled off, economic growth sharply fell in 2014 and any attempted recovery was frustrated by weak external conditions, but also by the Odebrecht scandal, which sent shockwaves throughout the local political and business communities. Most notably, it saw former president Ollanta Humala and his wife taken into custody (pending a final verdict on money-laundering charges related to their dealings with the Brazilian company and Venezuela); implicated another former president, Alejandro Toledo, who is now living as a fugitive in the US; and did not spare Mr Kuczynski, who has denied any wrongdoing and is protected by political immunity as long as he is president.

Brighter horizon

The devastation left behind by the flooding that hit Peru’s northern coastal areas put additional pressure to the authorities and economy. Overall, public and private investment combined fell to less than 21% of GDP in the first three quarters of 2017, the lowest level since 2009, according to figures from the central bank.

“There have been challenges, particularly at the beginning of the year, but things are improving and we expect growth to gain momentum towards the end of 2017, reaching its potential in 2018, primarily on the back of higher public and private spending, as well as accommodating financial conditions,” says Fernando Bravo, a Peru-born managing director at Goldman Sachs’s investment banking division. Goldman Sachs expects annual growth in Peru to stand at 2.8% in 2017, then accelerate to 4% in 2018, from 4% in 2016.

With an emerging consensus that the worst might be behind the economy, the business environment – which appeared particularly depressed once the Odebrecht scandal hit – is also improving.

“With the new cabinet and more constructive policy environment, we are starting to see increased [economic] activity, and despite all the uncertainties, we do see very strong interest from investors across asset classes and sectors to invest in Peru,” says Mr Bravo. “They still see the country as one of the strongest among the main Latin American economies, both from a macroeconomic and structural reforms perspective, but also in terms of investment opportunities.”

Peru’s overall FDI amounted to $6.9bn in 2016, down from $8.3bn the previous year, but considerably higher than the $4.4bn recorded in 2014, according to figures from Unctad. Central bank figures show FDI flows remained weak in the first half of 2017, when they did not exceed $2.6bn. 

Despite the recent headaches, the country’s economic fundamentals are solid and its public finances relatively sound, although the fiscal deficit is growing and estimated at 3% and 3.5% in 2017 and 2018, respectively, from 2.6% in 2016, which already represented the highest level in 15 years, according to figures from the IMF. On the other hand, public debt is expected to be 30% of GDP at the end of 2017, according to the IMF.

Major bond offering

Yield-thirsty financial investors still hold Peru in high esteem. State-owned oil company Petreperu pulled off the largest corporate offering in the country’s history in June 2017, when it placed two bonds worth a total $2bn fetching a 4.75% yields on a 15-year tranche, and 5.625% on another 30-year tranche. These are competitive yields for an issuer such as Petroperu and underline the market’s propensity for Peruvian commodities.

At the same time, national investment promotion agency ProInversión signed three public-private partnerships (PPPs) in 2017, including a $95m project for the development of a waterway network in the Amazonian region of the country with a consortium led by Chinese-owned Sinohydro, as well as a $278.4m transmission line running between Mantaro, Marcona, Socayaba and Montalvo, which was awarded to Colombian utility company ISA.

Beyond an apparently recovering investment sentiment, the Odebrecht scandal, as well as the hiccups in the reconstruction programme caused by flooding, highlighted Peru’s long-standing governance challenges. Its governability is currently at stake at a national level, with Congress dominated by a pugnacious opposition led by Keiko Fujimori, the daughter of former president Alberto Fujimori, who is in jail serving a maximum 25-year sentence for human rights violations.

“In the context of this administration, Congress is controlled by the opposition, and that poses some challenges to getting things done,” says Mr Bravo. “However, particularly since the cabinet reshuffle in mid-year, there is a bit more dialogue, and it’s going to be important for the government to gain some more consensus with concrete achievements. Historically, Peru has done very well from a macroeconomic perspective, but there is room for growth in terms of strengthening different institutions. That’s why, in addition to launching projects, it is important to launch structural reforms such as the formalisation of the economy and labour reforms.”

Peru’s institutional strength ranked 106th out of the 137 countries surveyed in the latest Global Competitiveness Report by the World Economic Forum.

Joining the club

One of the main objectives of Peru on its way to upgrading its institutions, is becoming a member of the OECD, a matter that Mr Kuczynski has defined as a state issue. The government is signing up to a series of international conventions on its way to OECD membership, such as the 'Multilateral Convention on Mutual Administration Assistance in Tax Matters', which it endorsed in October.

At the same time, local regulatory frameworks and institutions are being strengthened. With regard to infrastructure investment alone, the government upgraded the legislation on PPPs (see page 8) and restructured investment promotion agency ProInversión (see page 7).

But the challenge ahead goes way beyond these measures. Peru needs major reforms in any sector, from the labour market to the judiciary, health and education. Only when it becomes a modern, functioning state will its investment potential finally be unleashed.