The Abundance Divide
Mar 14, 2006
Gray Newman (New York)
At first glance, it is hard to imagine what more you could ask for than the kind of economic performance seen in Peru in recent years. Inflation has collapsed and hovered around 1.5% during most of 2005 even as the economy posted its best real GDP growth, up 6.7%, in eight years. Although positive terms of trade have certainly helped, domestic demand has also posted a strong rebound, up 5.7% last year. (For more details see “Peru: All About Growth” in today’s GEF). The enviable mix of robust growth and low inflation has helped the authorities strengthen a developing local capital market, reduce external debt, and build up reserves while running the largest current account surplus in more than a quarter of a century. And the prospects for a free trade agreement with the US could bring more good growth.
The positive news from Peru’s economy, however, runs up against a much more troubling political landscape. The current administration currently manages only a 15% approval rating, and that represents a two and half year high. The president’s rating is only slightly higher, near 17%, according to the most recent opinion polls. The race ahead of the presidential election, set for April 9, has seen some 20 candidates in the running. In the past four months, trying to determine who is the front-runner and who are the contenders for a second round if needed on May 7 has been a never-ending task, with gyrating polls as candidates swap places as voter intentions fluctuate. As of the latest poll released on Sunday, March 12, the latest two leading candidates were in a dead heat. Why the stark contrast between what by most accounts has been a stellar record on the macro economic front and what appears to be a largely dysfunctional political system? I suspect that part of the problem lies in the fact that Peru remains very much a tale of two economies: a coastal economy that has benefited from export linkages stands in contrast with the southern highlands, la Sierra Sur, which have seen limited benefits from the recent Peru miracle. Peru is still living an “abundance divide” which has contributed to its volatile political situation. And that I believe may pose the greatest challenge to the next administration regardless of who is elected. The failure to address the “abundance divide” represents the greatest threat, from my perspective, to Peru. I expect that whoever is elected to take office this year will find relatively high commodity prices and hence should benefit from ample fiscal resources. Indeed, Luis Arcentales is forecasting that Peru is likely not only to beat its goal of having a budget deficit of no more than 1% of GDP, but that the balance could even tilt slightly on the side of a surplus. Many Peru watchers, and most of the local investors I met with in Lima in early March, believe that the ascension of one candidate or another may spook the markets. That is certainly possible. But I suspect that at the end of 2006 the most likely scenario is that regardless of who heads the next administration, he or she will be faced with abundance on the fiscal and growth front. And that poses its own set of risks. I am concerned that the markets will simply not be there to discipline fiscal slippage or poor policies that could hamper an improvement in long-term or potential GDP. That is why it is all the more important that the new administration wisely uses today’s abundance not only to take steps to broaden Peru’s tax base, improve dispute resolution and contract enforcement, but also to channel public investment to tackle Peru’s “abundance divide.” I am a big believer in the power of low inflation to produce lower real yields and in turn help create a new credit culture that can benefit the region’s burgeoning working class. There is compelling evidence to suggest that the deeper the degree of financial development in a country, the greater the benefits of economic growth in helping to raise the incomes of the poor. But in the case of Peru, the income divide remains so wide that I suspect the next administration will not only be charged with keeping Peru on the right path to boost overall economic growth, but will also have to redouble efforts to tackle a poverty rate still hovering around 48% of the population. Relying on the mix of good growth, low inflation and an expanding credit market is likely to be insufficient to produce a stable outcome. For years, one of the most common exercises used in emerging markets has been to run a debt sustainability model. In 2002, for example, there was a heated debate over whether Brazil’s debt was sustainable, with many market participants concluding that it was not. The entire exercise seems a bit dated today when the catch phrase in the external debt markets is one of “scarcity value” as country after country in the region is engaging in external debt buybacks. I would propose in the case of Peru, however, that another model may be in order: something that we could call a “political governability” model. While I suspect that we may see gyrations in investor sentiment in the weeks leading up to the April 9 presidential election and the likely second round on May 7, I am more worried about the calm that I suspect will return after the new administration takes office. It may seem difficult today to imagine calm, particularly given how tense relations have been between the business community and some of the candidates. But I suspect that calm will return as the next administration does little to upset the kind of abundance that Peru has been enjoying of late. And that is the moment, in my view, of greatest risk. If investors fall back into the complacent state we saw during most of the past year and the new administration fails to tackle Peru’s income disparities, I am afraid that the political and social backlash will rear its head once again. Bottom line Some Peru watchers appear to view the current political turmoil as some kind of folkloric electoral element worthy of curiosity at the most. Instead I would argue that the volatility of recent months is a reflection of Peru’s most important challenge: how to tackle the “abundance divide.” Inequalities of income distribution have long been one of the most difficult challenges facing economic growth and development in Latin America. In some countries, economic growth has been robust enough and the benefits to a growing working class have been strong enough to reduce the risks of political ungovernability. In Peru’s case, however, the challenge facing the next administration is clear: not to be lulled into inaction given the abundance of the moment.
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All About Growth
Mar 14, 2006
Luis Arcentales (New York)
After posting its best growth performance since 1997, the Peruvian economy seems poised to benefit from yet another year of abundance. Last year’s scorecard leaves no doubt as to the underlying strength of Peru’s growth backdrop. Peru’s heavy exposure to primary goods exports has made it a chief beneficiary of the ongoing commodity boom: fueled by record mineral shipments, exports soared 37% last year generating the first current account surplus since the mid-1980s. Meanwhile, the public sector posted its smallest deficit (0.4% of GDP) in eight years partly thanks to record mining-related income taxes, which were nearly five times higher than their 2000-2004 average. Indeed, even by regional standards Peru’s current expansion is nothing to be sniffed at: since annual GDP growth turned positive in 3Q01, Peru has been the most rapidly growing major economy in Latin America. And all the good growth has come hand in hand with muted inflationary pressures. With global and domestic tailwinds likely to blow in Peru’s direction again this year, Peru’s expansion is set to carry on unscathed. As a consequence, we are revising upward our GDP forecast for this year to 5.8% from 4.5% previously while hiking our 2007 estimate to 4.7% from 4.4%. Although our new call for 5.8% growth this year might seem conservative given the economy’s strong momentum in recent months, it carries an important message: with the boost to growth from net exports set to diminish over the course of the year, healthy domestic-demand led growth should take center stage in sustaining Peru’s solid economic rebound. Sustaining rapid GDP growth rates, however, is far from Peru’s greatest challenge. As Gray Newman suggests on his note “Peru: The Abundance Divide” (in today’s GEF) the country’s policymakers must address the needs of the many Peruvians who have missed out on the current growth upswing. The ongoing abundance, thus, provides a distinct window of opportunity for the next administration to tackle the challenge of easing the country’s worrisome income divide. The export machine The performance of the export sector has been nothing short of spectacular. As a chief beneficiary of booming commodity markets – commodities including gold, copper and zinc accounted for three quarters of total exports in 2005 – exports nearly doubled over the past two years. But far from just a terms-of-trade story, Peruvian exporters have also reaped the rewards of past investments – particularly in mining and hydrocarbons – as higher volumes accounted for fully 40% of growth over the same period. And non-traditional exports have mirrored the uptrend in commodity shipments. The combination of strong global demand, higher investment product diversification and the temporary trade benefits under the Andean Trade Promotion and Drug Eradication Act (ATPDEA). The prospects of the ratification of the free-trade agreement with the US, moreover, would have the dual advantage of making many of the benefits under ATPDEA permanent and potentially give a further boost to export-related investment. With a strong global picture in 2006, Peru’s external sector is poised to benefit. To be sure, the best in terms of exports volume and price gains is likely behind us. Yet with prices for key exports such as gold, copper and zinc hovering near record levels, there is room for prices to decline and still be above last year’s levels. Adding record profits in mining, the generally upbeat sentiment in the business community and the potential for a US free-trade agreement and, once again, export performance could surprise most Peru watchers. Indeed, despite our expectation for a strong jump in imports fueled by accelerating domestic demand, we are looking for a trade surplus in 2006 of $5.3 billion, nearly unchanged from last year’s level. Our upbeat outlook is not without risks. Potential delays in the approval of the US-Peru free trade agreement beyond year end – when the ATPDEA expires – could hurt confidence and investment plans, thus having negative implications beyond the ending of the current beneficial tariff structure. And there could be continued volatility in the period leading up to July 28 when the new administration takes office if the favored candidate of the business community is unsuccessful. But the jitters could prove to be temporary. Indeed, at the present, consumer confidence appears to be reaching new highs even as confidence in the current administration remains weak. Domestic demand on the spotlight Domestic demand should take the spotlight this year. The improving domestic demand story might come as a surprise to many who often view Peru as no more than a commodity play. But whether one looks at the drivers of private and public consumption or investment, the fundamentals are pointing in the direction of stronger growth. The combination of rising jobs, confidence and credit is underpinning healthy consumer growth. Not surprisingly given the strength and increasingly broad-based upswing in the economy, urban job growth is accelerating. Another tailwind for consumers has come from the explosive growth in credit. Real growth in consumer and mortgage loans reached 20% and 14% respectively last year. Importantly for the sustainability of loan growth, expanding credit has come hand in hand with an improvement in the profitability and overall health of the banking system. To be fair, Peru remains a very underbanked country by regional standards but the trend towards further financial deepening seems now well established. Echoing the optimism on the consumer front, business sentiment is riding high. Recent survey results speak for themselves: fully 44% of participants awaited higher sales as the year came to an end, with only 14% expecting a contraction. Meanwhile, 30% of businesses expected higher purchase orders – the highest level in at least a year. Noise related to the upcoming presidential election was likely behind some of the deterioration in the near term assessment of the economy. However, the best news for the investment outlook is that nearly half of all businesses surveyed by the central bank expect better days ahead, with only 6% holding a pessimistic view. Combine upbeat business sentiment, record mining profits, the strong commodity cycle and rising mortgage credit and the case for strength in investment is a compelling one. The most recent January trade report shows demand for capital goods imports at record levels. Looking ahead, surveys paint a particularly upbeat picture on investment prospects, mainly in mining but also in manufacturing. On the construction front the first signs from 2006 are encouraging with cement shipments soaring 18%, which reflects buoyant demand for housing and commercial property. Lastly, the abundance on the fiscal front cannot be underestimated: delays in several public projects mean that they have been pushed to 2006. Moreover, with public coffers awash with cash, local governments have been unable to spend fast enough, which points to generous public outlays this election year (municipal elections will take place later in the year). Bottom line Peru’s five-year long expansion at first glance looks powerful. As the boost to growth from the trade front begins to abate, the drivers of domestic demand are in place to take center stage in sustaining a brisk pace of growth. And in line with the region’s improving fundamental picture, Peru appears in better shape to deal with the risk of a global slowdown. Our upbeat assessment for Peru’s economic prospects, however, masks the risk from the country’s chief challenge, namely Peru’s income divide. As long as the benefits of another year of impressive growth performance fail to lift the living standards of the 48% of Peruvians living in poverty, today’s abundance is unlikely to help generate the social and political stability needed for sustainable long-term growth. And that should concern all who are watching Peru and Latin America.
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