Latin America’s shining star

Originally published in the November 2008 issue

In the midst of a regional slowdown prompted by unprecedented turmoil in global capital markets, Peru stands out among its Latin American neighbours as a beacon of solid, indeed soaring, economic growth. Despite the headwinds facing emerging markets everywhere, Peru’s economy continues to grow.

To be precise, real GDP growth accelerated 10.3% in the first half of the year on the back of 9% growth in 2007. A recently released monthly GDP indicator showed that there had been no let-up through August, with growth continuing at a 9.9% pace through the first eight months of this year. This is impressive considering that average GDP growth in the region will be around 4.5% this year.

Peru should continue to substantially outperform its Latin American neighbours in the near term. But a moderation in the rate of growth is in the offing. For an economy with huge exposure to both commodity price volatility (commodities represent 77% of Peru’s exports) and weaker foreign demand (exports represent nearly 30% of Peru’s GDP, one-fifth of which are shipped to the US) the optimism about Peru’s prospects may seem paradoxical. After all, if the past is any guide, we should expect Peru to flounder during the current bout of weak global/US growth and commodity price volatility.

But Peru, which has been rated investment grade by Standard & Poor’s since July, is not the same country it was a decade ago. The sweeping structural changes that Peru underwent during the past decade, including halving its poverty rate, boosting export volumes to four-times the level of 1998,increasing the diversity of its export mix, reducing its external debt stock, and enabling an accumulation of savings in its private pension system have reduced vulnerabilities to external shocks.

While the political ghosts of Peru’s past continue to haunt the current government, the risk of political instability is, at least for the moment, quite low. Thus, while Peru’s explosive economic growth will surely moderate in the coming year, the country is poised to maintain its ‘star’ status.

Given its natural resources and the composition of its exports, Peru was a beneficiary of the unprecedented appreciation in commodity prices in recent years. This, along with its double digit rate of domestic demand growth has earned Peru the moniker of “Boomtown”. Domestic demand growth of 12+% in the first half of the year has been fueled by high levels of public spending and the expansion of credit to the private sector. In particular, the construction sector has grown at a rate of more than 15% this year and is partially responsible for the surge in foreign direct investment to Peru. The mining sector has also attracted a good deal of foreign investment.

Throughout this expansionary period, Peru has maintained conservative fiscal and spending policies and, importantly, effectively managed its debt profile to become a net creditor. Peru has gross public external debt of around US$18 billion, while the Central Bank’s accumulated FX reserves are currently around US$35 billion, equivalent to 27% of GDP. Beyond that, Peru’s government this week reiterated its commitment to posting a public sector surplus that exceeds 2% of GDP in 2008 but revised down its forecast for 2009 to 1.1% of GDP.

On the external side, Peru accumulated a trade surplus of more than US$8 billion in 2006 and 2007 and is expected to end this year with a surplus of around US$5.5 billion. This year’s 45% fall in the price of base metals (which represents close to 60% of Peruvian exports) and the sharp deterioration in the trade balance will contributeto a dramatic reversal in the current account, from a 1.4% of GDP surplus in 2007 to an expected deficit of 3.2% in 2008. Herein lies one of the pertinent risks to the rosy scenario for 2009.

Resilient but not immune
The nascent slowdown in Peru is likely to materialise in the fourth quarter of 2008, as the current account deteriorates, credit expansion slows and the risks to inflation – until now restricted to food and fuel – tilt to the upside. The extent to which these weaknesses are contained will depend to a certain extent on actions taken by the government and Central Bank. Until recently, most of the inflationary pressures in Peru have stemmed from higher international prices of food and energy, while demand pressures on prices have been contained. But the rapid pace of domestic demand growth in the first half of the year (in spite of policy measures taken during the past 18 months) and rising inflation expectations have meant that the current inflation rate of 6.3% could increase. While most economists expect inflation to remain elevated above 6% through the end of this year, the Central Bank’s forecast is for inflation to moderate. The official forecast has inflation falling below the top of the Central Bank’s 1-3% target band by the end of 2009.

As in other Latin American countries, however, the inflation picture is complicated. On the one hand, lower food and oil prices abroad and an expected deceleration in domestic demand should have a disinflationary impact later this year and in 2009. At the same time, a weaker nominal exchange rate will put pressure on consumer prices, fueling inflation. An additional risk for Peru stems from an expected slowdown in foreign direct investment to the mining sector, which is currently the most important source of current account financing. In the first half of the year, FDI is running at a healthy pace of US$4.3 billion (versus US$5.3 billion for all of 2007). However, given the current uncertainty in international markets, FDI inflows are expected to fall in 2009-2010.

Set to Outperform
Given the conditions in global financial markets, Peru’s resilience thus far is impressive. As a result of its prudent fiscal and monetary policies and structural reforms, the country is poised to not only withstand additional market turmoil but to continue to outperform similarly situated emerging markets.


Heather Bergman is from Société Générale Asset Management’s Strategy and Economic Research team. She is based in Los Angeles