Macroeconomic Strength and Industry Development in Peru March 2007 Authors: Wen-Ching Chuang, Fiona Kenyon, Dan Dan Jian, Fernando Prada and Ari Sznajder Abstract: In the last 50 years, Peru has experienced economic crises and booms related to international price volatility of its main exports: Natural resources with little added value. A sudden drop of these prices has usually caused a balance of payments crisis, pressures on debt service, higher fiscal deficit and in some cases, recession and slower economic production. International prices of raw materials are at their 10-year peak, but this situation is likely to end sooner or later. This paper explores medium and long-term strategies and policies to (1) strengthen Peru’s external debt management practices to reduce debt service and exchange rate risk; and (2) take advantage of the mining sector boom in order to diversify Peruvian export and production basis.

1. IntroductionPeru’s recent economic history is marked by periods of growth and volatility.

Hyperinflation of the 1980s was brought under control in the 1990s by the autocratic Fujimori regime. Yet exogenous shocks, such as the Asian and Brazilian financial crises, exposed the country’s vulnerabilities to forces beyond its control. Peru has one of the greatest mineral endowments in the world. However, the country has little control over the resulting industry and so has been unable to turn its natural wealth into broad economic prosperity. It has been helped in recent years by rising international commodity prices that have seen an increase in government revenues in the form of taxes and have aided its efforts to effectively manage its public debt.

Peru’s 2006 GDP growth reached 8%, up from 5.4% the previous year. Economic forecasts vary but are largely positive, ranging from another 8% to 6.8% for 2007. This growth can mostly be attributed to growth in the construction, manufacturing and silver sectors. While Peru’s economic growth has been driven by strong exports, it is beginning to reflect the economy’s diversification. There are hopes that a new free trade agreement with the USA will bolster such efforts1.

Concerns about Alan Garcia’s new government have to date been quelled by apparent policy continuity. Garcia has pledged to adhere to the monetary orthodoxy of his predecessor: a disciplined fiscal stance, an inflation-targeting regime and a managed float of the currency. He is also committed to maintaining such policies while trying to tackle endemic problems such as poverty.

Despite such positive advances, concerns remain about the long-term health of the economy. Standard & Poor's and Fitch both give Peru a sovereign risk rating (for long-term foreign-currency debt) of BB+, one level below investment grade. Moody's rates the country Ba3, three levels below investment grade2. This pessimistic view can be attributed to Peru’s narrow economic and export base that makes it extremely vulnerable to external shocks or decrease in demand. Mineral exports accounted for 62% of all exports in 2006, which clearly leaves the economy vulnerable to commodity price fluctuations.

We are concerned with the prospect of another international financial crisis and the potential for an unexpected drop in commodity price levels. Either or both of these events will leave the Peruvian economy exposed and vulnerable. We expect that the results of either scenario would be the slowing down of the mining industry and the increase of Peru’s debt burden. Both of these situations will severely damage the country’s economic health. To that end, we offer two broad strategies to Peruvian public managers and policymakers to reduce the country’s vulnerabilities to exogenous shocks. First, we suggest that Peru must remain vigilant in its management of its public debt. Its considerable success in this effort recently is to be commended but there is the fear that it will lead to managerial complacency. We question also whether its assumptions are correct- are assumptions of continued price stability correct? We preface this discussion with a review of Peruvian macroeconomic history from the Garcia period on, with a special focus on the effects of international financial crises. 1 “Peru finance: Is it investment grade?” The Economist Intelligence Unit. March 22, 2007. 2 Jennifer Hughes and Hal Weitzman. “Peru nears investment grade ratings” Financial Times, July 12 2005.

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Second we propose that Peru needs to protect its economy by pursuing an agenda of industrial diversification. It should focus on its comparative advantage- mining- by increasing its direct involvement in the industry, especially by providing better-skilled workers. Further to that, we argue that Peru should expand its manufacturing sector, especially in the areas of textiles. As well, we suggest that the country develop its agri-business investments to support farmers. All of this should be done with the intention of developing its regional trading relationships. 2. Peru Economic Crises and ManagementDeep Recession in the late 1980s (1986-1990)

The export of natural resources has long been one of Peru’s major economic strengths. With Peru’s democratization in 1980, which was seen as the foundation of future economic growth, Peruvians generally believed that prosperity would soon follow. However, the economic structure and political uncertainty of Peru presented a challenge to sustained economic growth. From mid 1970, in large part because of the dramatic drop in international commodity prices (figure 1), Peru faced inflation and financial crisis.

Figure 1: Long-term deterioration in raw materials prices

In mid-1985, in an attempt to reactivate the economy and save his own political career, President Alan Garcia adopted several policies that included setting strict price controls, raising wages, nationalizing commercial banks, overextending the credit of the Central Bank, cutting taxes, and limiting foreign debt repayment to 10 percent of export earnings.

Unsurprisingly, these policies caused a rapid but short-lived expansion. In 1986 the demand-led growth reached 8.5 percent and rose to nearly 7 percent in 1987.3 However, a severe recession began in 1988. Policies adopted by the Garcia administration led to production capacity restraints in many sectors, causing export earnings to fall and unemployment to rise. Central Bank reserves were negative by February 1988, and the growing fiscal deficit triggered the worst inflation Peru ever experienced4(Inflation for the year reached 1,700 percent according to official figures).

At the same time, Peru’s trade balance deteriorated considerably. Exports were affected by mining strikes and an artificially low exchange rate (due to exchange rate

3 “During the current economic crisis, export strategies should focus on industries that are targeted for growth”, Business America. 1989. 4 Ibid.

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controls), and overall imports increased largely due to rising demand for essential goods such as foodstuffs and petroleum products.

With the severe recession, trade deficit, fiscal deficit, and lack of foreign exchange reserves, Peru was in a desperate situation in the late 1980s. From 1988 to 1990, the nominal GDP in US dollar at PPP (Purchasing power parity) of Peru dropped $14.2 billion. In 1990, the Fujimori administration started reforms that managed to avert total disaster. Fujimori Reforms in 1990

The Fujimori administration pursued several strategies to promote free market reform. First, they removed the control of price and interest rates and liberalized market mechanisms. Second, they eliminated the restrictions on capital flow, and with the cooperation of the IMF and World Bank successfully increased foreign investment. Third, they promoted significant privatizations in mining, electricity and telecommunications. Fourth, they adopted fiscal and monetary austerity. Fifth, they liberalized international trade and reduced of customs tariffs. Sixth, they restructured foreign debt. Seventh, they put financial institutions under stricter supervision.

These macroeconomic policies soon contributed to rapid economic growth in Peru, and inflation remained low. Privatization had the beneficial effect of increasing government revenue and stabilizing Peru’s international reserve levels. Liberalization also led to increased foreign direct investment and exports. This led to a stable and well-behaved exchange rate, and the Peruvian government gained the capacity to reduce the fiscal deficit and pay down its debts. In addition, the monetary austerity imposed by the government and its international advisors helped the government control inflation. After Fujimori’s reforms, a stronger and more stable macroeconomic performance emerged. However, Peru’s successful experiment was not only based on its macroeconomic policies. Dancourt (1999) points out that one could also contend that the influx of capital in the first half of the 1990s, which was associated with historically low foreign interest rates, has been a decisive factor in the movement toward stability of prices and expansion of the aggregate product that typified Latin America.

Although the dramatic market reforms of the early 1990s produced growth, Peru remained exposed to political and exogenous shocks. In Fujimori’s second term (1995-2000), the institution of reforms slowed, and the administration turned to more populist spending policies. In addition, a pre-electoral expenditure boost coupled with falling revenues caused the non-financial public-sector (NFPS) deficit to increase by 3.4% of GDP in 2000, following two years of recession.5 The slow pace of reform came along side the severe El Nino and the international financial crisis from 1997 to 2000. The economy stagnated. The crises described below demonstrate the inherent vulnerability of the Peruvian economy to unexpected global market volatility. The Cost of Past Financial Crises

The impact of the late 90s crises lasted until 2001. During the Asian crisis, Peru’s growth in terms of GDP dropped from 6.7% in 1997 to -0.5% in 1998. In 2000, the GDP increased 3.1% because of the pre-election effect (increased government spending), but dropped to 0.2% in 2001, showing that the impact of the international financial crises still

5 Country Profile- Peru 2006. Economist Intelligence Unit.

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remained. As for total foreign reserves, they decreased around US$ 2624 million from 1997 to 2000. Peru’s inward direct investment declined $600 million after the Asian financial crisis, but the lowest point was in 2000, with the total amount of $830 million. However, this dramatic decrease was not only because of the international financial crises, but also the political uncertainty related to Fujimori’s corruption and the presidential election.

Table 1: The Impact of the Crises from 1997-2001 on the Peruvian Economy

Crisis Asian Crisis Russian /Brazilian Crisis

Period 1997 1998 1999 2000 2001 Growth of GDP (annual variation in %)

6.7 -0.5 0.9 3.1 0.2

Poverty Rate % 42.7 42.4 47.5 48.4 54 Total Foreign Reserve (including Gold) $US million

11,254 9,832 9,001 8,630 8,928

Inward direct investment $US million

2250 1650 1950 830 1150

Sources: EIU country profile Impact on Capital Markets

The Asian financial crisis of 1997 caused a global shock with effects lasting two years. According to the IMF, by the time the Asian crisis broke out, Peru’s private sector had regained significant access to international capital markets. During 1997, gross debt inflows reached US$1.7 billion, of which U.S$1.5 billion was in the form of loans. The effect of the Asian crisis on short-term capital flows appears to have worked primarily through banks’ external credit lines. Total short-term inflows rose from US$290 million in the third quarter of 1997 to US$1.2 billion in the fourth quarter of 1997, but dropped to US$360 million in the first quarter of 1998. In addition, there was an immediate influence on medium and long-term private capital flows (privatization not included), when the net flow fell to US$222 million in the fourth quarter of 1997, from US$ 475 million in the previous quarter. Most of the decline was in FDI.

On the debt side, Peru’s EMBI (Emerging Market Bond Index) began to rise sharply from the average of 345 basis points (1 bp=0.01%) to 604 bp as of mid November 1997. (Figure 2)

Compared to the Asian financial crisis, the impact of the Russian and Brazilian crises in 1998 and 1999 had a more sizable impact on Peru. Or rather, the impact of the Asian financial crisis remained, and the Russian/Brazilian crisis deepened volatility. In 1998, Peru experienced a sharp change in capital from a net inflow of US$ 355 million in the first quarter to a net outflow of US$ 1.3 billion in the fourth quarter, as banks and enterprises’ credit lines went into significant decline. A huge reduction in the short-term external credit of Peruvian banks continued. From 1998 to 1999, the amount of credit available fell by almost US$ 2 billion. During this period, the economic growth slowed

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due to the contraction of capital flow and increase of the cost of market access. Some researchers have also attributed this slow growth to the effect of El Nino.

As for net medium-term and long-term private flows, they contracted significantly in the third quarter of 1998 to US$180 million, from an average of US$550 million in the previous two quarters. However, in the second quarter of 1999, it returned to US$ 830 million, which is the long term average in the past.

The Russian crisis had much larger impact on Peru’s Brady bond,6 than did the Asian Crisis, with spreads peaking at 1061 basis points. The difference between the minimum and maximum EMBI for Peru during 1998 was 684 bp (while during the Asian crisis, the difference was 285 bp with a peak of 604 bp). According to the IMF, this range is higher than in Panama (489 bp), but significantly lower than in Mexico (807 bp), Argentina (1100 bp), Ecuador (1800 bp), and Venezuela (2300 bp).

Figure 1. EMBI Spread Peru vs. Global from 1997-2004. Source: Latin Focus

Asian Financial Crisis

Russian and Brazilian Crises

6 Brady bonds are long-term obligations of emerging markets nations, which are generally secured with government bonds. Brady Bonds are among the highest-volume and most liquid bond issues of the emerging markets.

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Figure 2. Peru’s GDP growth from 1991-2030 Forecasts. Source: EIU country index

Figure 3. Peru’s Inward Direct Investment from 1992-2011 forecasts. Source: EIU Macroeconomic Policy After the Crises

For the Peruvian government, several challenges followed these crises, namely a high unemployment rate, unstable capital inflows and small GDP growth. According to the Multiannual Macroeconomic Framework of Peru, the Peruvian government adopted a policy of fiscal prudence as well as an inflation rate targeting policy similar to industrial economies’. In order to maintain monetary stability and promote investment, the

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Peruvian government kept the inflation rate within 1.5-3.0 percent7. Second, they reduced external vulnerability through the limiting of the account deficit to a ceiling of 3 percent of GDP, preserving an adequate level of net international reserves, implementing policies concerning the management of the government’s financial assets and liabilities, and strengthening the financial system. As for the development of the domestic capital market, the Peruvian government set a goal to increase the issuance of long-term securities denominated in domestic currency. They also swapped the bonds denominated in US dollars to domestic currency in order to decrease debt service and the extent of dollarization. By doing so, the foreign debt and financial deficit of Peru will decrease gradually, and, it is hoped, the economy will grow in a stable way. Also, EIU forecasts that the inward flow of capital will remain constant at about $2000 million until 2010. Observations

As we can see from these crises, economic stability in Peru is dramatically affected by international market volatility. Peru’s exposure to market movements can be explained in large part to the make-up of its economy. Most importantly, Peru 1) Has an export-oriented economy, 2) a high foreign debt percentage, and 3) a weak fiscal system.

According to the officials in the Central Reserve Bank of Peru, a chief current concern is a possible ‘hard landing’ of the U.S. economy and domestic political radicalism or populism. In addition, the future challenge faced by Peru is how to minimize its exposure to international commodity prices; the drop of which may be the cause of the next substantial financial crisis. 3. Future Macroeconomic Policy: Improve debt management to reduce debt service in the future

During an economic boom, economic agents tend to engage in risky behavior in the belief that the fundamentals that drive the prosperity will continue indefinitely. In the case of Peru during the 60s to 80s, several administrations started big public investment projects, expanded the welfare system without proper financing, controlled prices, subsidized economic sectors and production, and in general, expanded the public expenditure, fiscal deficit and external debt. While international prices are high and the balance of payments is in surplus, tax revenues and public enterprises cash flows augment accordingly. Similarly, the temptation to spend more increases, and the favorable economic situation does not permit to analyze and balance adequately the risks involved.

One of the most perverse policies during such periods of economic expansion is that of the government taking on more external debt to finance oversized investment projects or to finance increased current expenditures levels while assuming similar future cash flows. In general, international capital markets, as well as international financial institutions and bilateral donors, were eager to lend to developing countries at favorable rates, and Peru increased its ratio debt/GNP during the 60s, 70s and 80s. The main trigger of financial crises has been the inability to fulfill international obligations—measured by the amount of interest and principal arrears during the last 30 years (Figure 4). Not

7 Citation from the meeting of Central Reserve Bank of Peru on March 2nd.

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surprisingly, the periods of increasing debt and arrears coincide with the financial crises during the 70s and the 80s, as well as the reduction of the overall GDP.

A recent Inter-American Development Bank (IADB) report indicates that external debt in Latin America, without adequate risk management, may generate a financial crisis through three channels: (i) an increment of the fiscal deficit and the need to finance this at conditions that worsen as this gap widens; (ii) volatility of the exchange rate, that have a direct impact over the countries’ financial capacity and it is usually associated with imbalances in the balance of payment (BOP) and the fact that Latin American countries cannot access easily to domestic-currency denominated loans or bonds; and (iii) interest rate risk, when developed countries change abruptly their monetary policy affecting the conditions at what developing countries take loans.8 The report also indicates that the last two channels—which often correspond to external shocks to the Latin American economies—explains more adequately the link between external debt and the occurrence of a financial crisis. Figure 4. Debt/GNP and cumulative debt arrears

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Total debt (EDT)/GNP (%) Debt arrears (US$ billion) Source: World Bank, Global Development Finance 2007. In the case of Peru, these three factors have come together to generate a financial crisis during the last three decades. We have suggested earlier in this paper that in the Peruvian economy a link exists between international prices of its main exports, the situation of the

8 Borensztein, Eduardo, Eduardo Levy and Ugo Panizza (coordinators), Living with debt: How to limit the risks of sovereign debt, Washington D.C., Inter-American Development Bank, 2007.

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balance of payments, the fiscal deficit and the capacity to repay financial obligations.9 Although the Peruvian Government has improved the macroeconomic framework, there is a growing discussion that the current international situation is not sustainable; therefore, we need to start thinking of alternative measures to avoid the next financial crisis. Figure 5 shows the evolution of the trade balance during the last 35 years, and how favorable its situation has been in the last five years. Figure 5. Trade balance 1970 – 2006

Source: National Institute of Statistics. Elaborated by Apoyo Consultoria.

The inflows of external currency due to this export boom have generated some concerns about the likelihood of a “Dutch disease”. However, the real exchange rate has remained stable for the last five years. In addition, the Central Bank have sterilized the supply of extra dollars—at a rate of US$110 million per week in the last year—and the non-tradable sector has been growing in line with the tradable sector—if it had not, the likelihood of Dutch disease would have been higher.

Peru has learnt its lessons the hard way, so we can affirm that the situation and the likelihood of a financial crisis is not as high as in previous decades. The last four administrations (Alberto Fujimori, Valentin Paniagua, Alejandro Toledo and Alan Garcia) have implemented policies coping with the external and domestic economic vulnerabilities: • Multi-annual macroeconomic framework (MMM). This instrument permits the

Central Bank to estimate the future trends of macroeconomic variables (inflation, 9 Nevertheless, other factors have also impacted and accelerated financial crises. During the 80s, for example, the Fenomeno del Niño hit twice; and the increment of financial flows during the 90s generated a process of deindustrialization that affected the capacity to export value added products—when the Asian and Brazilian Crises hit Peru, it experienced a problem of external liquidity that was partially solved with the amount of international reserves and contingency lines from the IMF.

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exports, interest rates, among others) and determines the financing needs for the following periods, as well as the compatible domestic and external debt levels. The MMM is also compatible with the macroeconomic targets stated in the IMF letters of intention, which focus on the level of fiscal deficit and inflation. Therefore, these binding instruments seek to prevent an un-financed expansion of government expenditures that might cause inflation.

• National system of Public Investment (SNIP). In the past, Peru initiated big infrastructure projects with no adequate evaluation of their cost-benefits and they often surpassed the financial capacity of the public sector. The SNIP is an attempt to rationalize the decision-making to start projects that involve public resources, requiring pre-investment studies and the design of alternatives. Moreover, every public investment project is evaluated not only by the regional governments but also by the central government, which ultimately approves them. Although it might delay some investment decisions, it prevents the incentives to take on external debt to finance oversized projects, as well as helps to prevent corruption.

• Independent Central Bank. The Peruvian Central Bank used to finance government expenditures when access to financial markets was limited or when the trade balance was unfavorable. However, its only instruments were printing more domestic money or injecting international reserves into the economy—i.e. increasing money supply—, which helped in the short term but generated several hyperinflation episodes during the 80s. Nowadays, the Central Bank can only increase or reduce the money supply through market channels as long as it is compatible with the inflation target. Moreover, the Congress ratifies its independent board, which is independent from the intervention of the central government.

• Accumulation of international reserves. The export boom, the record of tax revenues and central government savings, the augment of investment and pension funds, and the increment of deposits in the banking system have caused an all-time record accumulation of international reserves. Nowadays, international reserves represent almost 10 months of total imports of goods and services, while in previous decades it represented no more than six months. This situation has raised concerns about the real capacity of the economy to absorb these resources, but also concerns about politicians’ temptation to utilize government savings. Lately, the opportunity cost of maintaining such level of international reserves has been widely discussed, usually with a focus on instruments that yield lower returns than, for example, investing in

the domestic stock exchange. However, the Central Bank has been able to exert its independence and avoid any political interference.

• Improved debt management. Peru has taken advantage of the current international situation—low interest rates, strong economy and favorable international ratings for its economy. Therefore, it has increasingly preferred to rely on international capital markets by issuing bonds

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Figure 6. External government debt by creditor type (US$ million)

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(Figure 6), especially after the agreement with the Paris Club of official creditors in 1996. On the other hand, the government has been making an extra effort to change the currency debt composition to avoid the exchange rate risk to the economy. From 2000, where the proportion of domestic currency denominated debt was less than 5%, it has soared to almost 18%. The plan, outlined in a recent Ministry of Economics report, expects to raise this level to 40%.10

There is room to improve these efforts to minimize the risk of a financial crises caused by a sudden drop of international prices or an unfavorable international context. We propose two main policies: First, reduce the impact of debt service through the issuing of sovereign bonds to smooth the debt service profile; and second, to acquire more insurance for the “bad times” through the creation of a trust fund managed by an independent board.

Figure 7 shows that the current debt service profile concentrates most of the payments in the next ten years at around US$ 1.8 billion per year—the total Peruvian budget is around US$ 10 billion on annual average, including debt service. With increasing tax revenues and central government deposits on international securities (as part of the international reserves), fulfilling the international financial commitments does not seem to be a hard task. While this may be true, several assumptions are being made that must be explored. Figure 7. Debt service 2006 – 2040 (US$ billion)

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Source: Ministry of Economics and Finance First, tax revenues have soared because of extra cash flows from mining companies and the economic boom related to the favorable external conditions (including high international export prices). Second, it has been relatively cheap under these conditions to

10 Ministry of Economics and Finance, Annual Program of public debt management, Lima, 2007. Available in http://www.mef.gob.pe

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sell sovereign bonds in international capital markets and it has also been easy to introduce new financial instruments such as domestic currency denominated bonds. Third, most of the debt reduction has been a direct cause of swapping expensive private sector loans for sovereign bonds.

On the other hand, some recent developments have increased the pressure to increase government expenditures—which are perfectly financed under the current conditions. First, the government has increased the budget through additional provisions in order to finance what has been called an “investment shock”. Second, this program has not been totally effective because most of the public investment projects have not surpassed the SNIP standards—which have caused several attempts to reduce its influence from the Congress. Third, the external sector has started to grow at lower rates since January 2007.11 The Central Government is still in primary surplus—before debt service—but these developments create some clouds over the horizon.

As we have learnt before, the potential inability to service debt has consequences that are felt before a developing country actually defaults—the increment of sovereign risk that makes additional debt more expensive, for example. Therefore, Peru should take advantage of the current international conditions and be more aggressive at reducing future debt service. The first strategy is to issue more sovereign bonds in the international markets with the support of multilateral institutions, in order to increase the array of financial instruments available (for example, domestic currency bonds, bonds with longer maturity, among others) and reduce the perceived risks. The idea, as is recent actions have shown, is to obtain conditions that allow Peru to achieve investment grade ratings—only Chile and Mexico have investment grade in Latin America. However, the Peruvian government could issue more bonds in the international markets signaling that it is not taking additional debt but reducing future payments—this strategy have been successful so far.

The second strategy, which is not as important in comparison to the first one, consists on negotiating better agreements with bilateral donors, which still represent 35% of the total external debt. Although these loans usually enjoy concessional conditions, a great part of them represent past debt related to projects not currently functioning—for example, the debt with the Japanese government. In general, it is possible to negotiate better terms with bilateral donors in order to redirect resources to the social sectors. In addition, the Peruvian Government could start negotiating future agreements, such as future swap commitments in the case of a shortage of funds in the future12 or simply exchanging debt for social or environmental investment.

There are several advantages when focusing on debt service, especially in the case of a small country that is still developing its capital markets. Figure 8 shows the change on the yield curve from June 2005 to 2006, showing that small interventions can lead to great benefits. In that period, the Peruvian government was able to double the period of its sovereign bond issues from 10 years to 20 years without a significant increment on the

11 The Minister of Trade and Tourism, during a meeting with the IEDP 2007 team, presented evidence that almost 35% of the recent export growth is caused directly by the price effect, as opposed as the increment on the goods production and productivity. 12 One possible idea here is to create clauses in future negotiations that secure future disbursements on social programs if it is the case that a potential financial crisis threatens social expenditures. In any case, such instruments have to be designed in coordination with donors.

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interest rate—only 4 points at the end of the period, even though the interest rates for short term debt increased by 50 points due to the increment of the reference interest rates in the United States and the relative augment of country risk. Of course, the current yield curve also generates opportunities to the private sector to obtain more long-term financing. Figure 8. Peru’s bond yield curve (June 2005 – June 2006)

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Source: Ministry of Economics and Finance However, any new bond issue to reduce future payments should assume that the government would be firm on its commitment to save these resources or utilize them to prepay debt at better conditions instead of using those resources to augment fiscal expenditures. If the second case is true, investors will incorporate this information and require a higher interest rate in the future. Therefore, the central government should provide strong signals to international investors: The Peruvian Government should create a trust fund to secure part of the current international reserves. By securing, for example, one or two US$ billion (or the equivalent in other currencies depending on the risk evaluation) as a form of insurance in case of future economic distress, the present administration will renew its commitment with macroeconomic stability and sustainable government expenditures. On the other hand, it is also sending a signal that the government will not inject these resources to an already liquid economy, which might cause a currency appreciation and harm to the tradable sector.

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Both of these measures have a common objective. Peru should be able to obtain investment grade in the next two years and provide more powerful signals that its economy is strong enough to attract foreign investment at favorable conditions. In conclusion, by minimizing the likelihood of cause a financial crisis through debt problems, Peru is committing to continue a responsible macroeconomic management.

4. Industry Diversification

Table 2: Exports 1990-2006

EXPORTS 1990 - 2006Statistics

Growth Adjusted Average Std Dev for Risk

1. Traditional products 15.45% 18.76% 0.824

Fishing 13.57% 28.79% 0.471 Agricultural 17.67% 58.36% 0.303 Mineral 17.02% 19.97% 0.852 Petroleum and derivatives 18.49% 41.33% 0.447

2. Non-traditional products 11.60% 11.86% 0.978

Agriculture and livestock 16.20% 11.91% 1.361 Fishing 11.32% 22.88% 0.495 Textile 9.87% 13.28% 0.743 Timbers and papers, and its manufactures 23.99% 19.61% 1.224 Chemical 13.68% 15.69% 0.872 Non-metallic minerals 15.10% 12.52% 1.205 Basic metal industries and jewelry 11.48% 26.57% 0.432 Fabricated metal products and machinery 12.70% 32.20% 0.394 Other non-traditional products 27.95% 73.44% 0.381

3. Other exports 11.47% 17.16% 0.669

4. TOTAL EXPORTS 14.23% 16.02% 0.888 IN PERCENT OF TOTAL (%)

Source: Central Bank of Peru

By reviewing Table 2, we can see that with the exception of timbers and papers and other non-traditional products, the fastest growing industries are agriculture, minerals and petroleum and derivatives. However, these commodities also are the riskiest- they have very high standard deviations, which points to the variability of prices and market volatility that periodically shakes the economy. Moreover, when growth rates are adjusted for risk only three commodities for export appear to be desirable: non-traditional agriculture and livestock, timbers and papers and non-metallic minerals. This indicates that Peru is heavily reliant on industries that are subject to frequent peaks and troughs. This makes the economy very vulnerable.

In addition to a well-designed debt management mechanism, industry diversification is also imperative for Peru to reduce the potential risks fluctuating

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international commodity prices and external shocks. We advise that Peru concentrate on developing the sophistication and depth of its most important industries, namely, mining, agriculture, fisheries and tourism. In this section, we analyze the advantages and challenges Peru may face in developing these and complementary industries to diversify its industrial structure. We advocate Peru should aggressively develop mining-related processing and manufacturing industries as well as promote the development of other sectors such as non-traditional agriculture and tourism.

Mining and Mining-related Industries

Peru is currently the world’s fifth largest producer of gold and silver and the second-largest silver producer (first in South America). It also produces a large share of the world’s zinc and lead supplies. The mining sector has been the fastest growing in the Peruvian economy largely due to the privatization project pursued by the Fujimori government in the 1990s and continued by his successors. Additionally, the government has aggressively marketed the availability of untapped concessions to be bid upon. Most of the recent gains have been in gold, the output of which has grown considerably from 10 tons in 1990 to 174.6 tons in 2004. Growth has been driven by the large mining concerns at Minera Yanacocha, owned by the American firm, Newmont Mining, and a local company, CompaÒÌa de Minas Buenaventura, and at Pierina, owned by the Canadian firm, Barrick. The Pierina mine, opened for business in May 1999, has the world’s lowest production cost, at US$45/oz. Yanacocha, which now produces 40% of Peru’s gold, has the largest reserves. It helped to make gold Peru’s largest single export earner in 1998-2003, overtaken by copper in 2004 as copper prices rose13. In addition to gold, Peru also has 15% of the world’s copper reserves and production has experienced strong growth since the mid-1990s. As with gold mining, most of copper operations are foreign-run, for instance, the Antamina copper and zinc mine. This mine, based in the Andes, is estimated to have the largest unexploited reserves of copper and zinc in the world. Between 2001, when the mine opened, and 2002, total national copper production increased 70%. It was also the single largest boost to the Peruvian economy in that year. Other recent significant investment is at Las Bambas. In August 2004, Xstrata Copper, a Swiss-based firm won that mine’s concession with a bid of $121 million, which was three times the base amount estimated by ProInversion14, the state investment agency. The economic benefits from this investment stand to be huge. Annual investment over the initial three-year exploration stage is projected at US$40m. The construction phase will take a further three years at an estimated cost of US$2bn. Once the extractive phase commences, the government estimates that the mine will boost overall mining exports by up to 30% annually and add 1 percentage point to real annual GDP growth. While the mining industry is very profitable for investors, its benefits are not necessarily widely felt by Peruvians. The industry’s role as a job generator is limited at best, as it imports its workforce. According to Peru Project, the industry directly and indirectly

13 Country Report –Peru 2006. EUI. 14 From meeting with ProInversion, in Lima Peru, March 2007.

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employs about 255,000 people in total15. While mining products make up the largest share of exports, at 48%, their direct contribution to GDP is only 11% and its share in tax collection is only 13%, which is reflective of the commerce-friendly tax policies enacted to attract investment from abroad. Furthermore, the industry is highly concentrated in the hands of large multinational firms who are first and foremost loyal to their shareholders and seek to maximize profits. Indeed, the Peruvian mining industry is divided amongst three groups: large firms that have 51% of the market, medium-sized firms and mines that make up 43% of production and small mining operations that contribute 4% of production. The largest group is made up of about seven large firms; the second group around 45 and the third many firms16. However, there is room for increased domestic participation in this burgeoning field. According to the Peru Project’s report, Development Strategies for the 21st Century: the case of Peru, the mining industry encourages the development of other forms of economic activity, for instance, agriculture, highway construction and transportation.

Peruvian industry remains vulnerable to exogenous price shocks, especially because it has positioned itself largely as the supplier of primary goods and has yet to successfully produce secondary products that have greater value.

Much of Peru’s recent success can be in part attributed to the regulatory changes made alongside the privatization efforts of the 1990s. Taxations schemes were designed to encourage foreign direct investment. More importantly, the government has made commitments to regulatory stability in tax, exchange rate and administration. These pledges are formalized in contracts between the Ministry of Energy and Mines and the firm awarded concessions to mine17.

Recent discussion about market restructuring or the redistribution of industry gains has focused on the renegotiation of contracts. Regional leaders in Cusco advocate increased political decentralization that will in turn allow them to negotiate directly with the firms operating mines in their region18. The legality of this is uncertain and the central government, while receptive to some decentralization, uninterested in handing over key negotiating responsibilities.

However, the desire of communities burdened with large industrial developments to better participate in its rewards is understandable. An option to secure more financial benefits would be to tax companies more. In 2006 there was a lot of debate regarding the application of a windfall tax to capture some of the extraordinary gains. However, this idea was poorly received by industry and so was never implemented. As a compromise, a voluntary fund structure was established into which firms operating may donate money to

15 Francisco Sagasti, coordinator. Development Strategies for the 21st century: the case of Peru. Editorial Apoyo: Lima Peru. November 2000, pg. 87. 16 ibid, pg. 87. 17 Sagasti, 88. 18 Antamina mine representatives stressed their long-term contract and cooperation with the Peruvian central government. They also suggested local/regional governments should concentrate on efficient public spending.

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be used for social purposes within the community. Antamina mine is the first to voluntarily contribute, with a $60 million investment in the past year.

While this is a virtuous solution, its informality and voluntary nature make it vulnerable to economic downturns or general greed. If the government believes that mining companies ought to contribute directly to communities’ economic health, then a formal mechanism must be established. This might take the form of an increased tax on revenues to be collected by the central government. Alternatively, it might come in the form of a stabilization fund19 that will guard against market swings in prices. Contributions made by mining firms to publicly managed funds could then be used by public managers in years when prices decrease to offset the economic hardships felt by reliant communities.

In addition to developing better income redistribution mechanisms, the Peruvian government must pursue complementary industry development. Rather than simply exporting the raw materials produced by mines to then be manufactured into more valuable goods overseas, Peru should develop the capacity to do that manufacturing itself. Currently, Peru has a healthy jewelry industry, but it mainly serves the tourist market and is not widely exported overseas.

We heard from officials at ProInversion that Peru has failed at these efforts before, namely in the semi-conductor market. This points to the risks inherent in entering an already developed industry. In order to compete, actors must be sure that their product meets world standards and that it can be produced at a competitive price. This is difficult to do when trying to develop the expertise and know-how necessary to produce. Furthermore, it is very difficult to remain at the cutting edge. The experience of Peru has been that it developed the ability to produce copper-based secondary goods that then became obsolete.

In order to avoid a repeat of the copper experience, Peru must tackle the underlying knowledge gap. Beyond improving the quality and reach of its public school system, this might also include a structured apprenticeship program with industries deemed strategically important. This will provide students the opportunity to become well trained and exposed to the latest methods used in the fields of their choice. It will also further strengthen the ties between local communities and foreign owned and operated firms. It will then also act as an effective knowledge transfer that will contribute to the domestic development of complimentary practices to the mining industry, such as refinement, electronics production, etc.

Such a strategy ought to involve the central government as a facilitator. A by-product of training schemes and industry development may be increased joint ventures between private industry and government. This will allow for the dissemination of technology and expert knowledge and the movement toward greater redistribution of economic gains and community involvement. Furthermore, it may insulate both industry and government from the effects of exogenous shocks. Both parties will have a stake in

19 Sagasti, 88.

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protecting their investments and are both reliant on the other’s contribution to the JV for their success. For instance, the state may contribute favourable tax conditions and subsidize labour in exchange for training and a community investment fund. Both contributions make the JV more successful and so lessen the likelihood of one partner exiting the partnership when economic conditions deteriorate.

Finally, the government ought to bolster the participation of small and medium mines that are largely domestically owned. These firms are the most vulnerable to exogenous shocks as they lack the deep financial pockets of large multinationals. Furthermore, they lack the same financial and administrative capacity that can directly affect their productivity and efficiency levels and ability to improve their technological standards20. Second, medium and small mines often make use of out-dated technologies and have less rigorous environmental standards. Both these factors affect profitability, particularly as environmental standards and strengthened and better enforced. Moreover, the spillover effects are two-pronged. First, the sustainability of the resource being exploited is affected. Second, the viability of other industries, such as non-traditional agriculture and ecotourism is also threatened. Therefore, taming the negative behaviors of smaller sized mining companies and ensuring a harmonious economic development environment is also important to the economy as a whole21.

Agriculture, Manufacturing and Non-traditional exports

Developing the non-traditional agriculture sector for export is another important diversification strategy. Agricultural and livestock accounted for more than 8% of Peru’s GDP in 2006, and its exports have increased 26.4% from 2004 to 2005 and 20.1% from 2005 to 200622. Largely due to the Andean Trade Promotion and Drug Eradication Act (ATPDEA), Peru has enjoyed market access to the U.S, its biggest trading partner. This trade agreement was expanded in April 2006 and has been confirmed by the Peruvian Congress. The favorable weather and increased U.S. demand for some products, such as asparagus and avocados, has given Peru an advantage in exporting agro-products. Referring to Table 2, we can see that no-traditional agriculture and livestock has been growing on average about 11% since 1990 and has a relatively low standard deviation of 11% and so distinguishes itself as a sound investment choice and an area that should be greater developed in the future.

Public infrastructure development, which connects the inner highland area with coastal ports, is crucial for promoting agricultural exports from Peru’s rural area. In 2005, construction alone constituted nearly 5% of the Peruvian GDP23. However, most investment has been focusing on mining infrastructure construction. In order to develop the agro-sector and its export capacity, the Peruvian government should focus spending

20 Sagasti, 89. 21 Mining NGO, APRODEH, mentioned that the development of secondary processing industry has caused harm to environment. However, when asked whether local residents would accept these factories given this negative impact, the speaker said usually local communities were too poor to reject these rare development opportunities. 22 Country Report- Peru 2006, Economic Intelligence Unit. 23 Country Report- Peru 2006, Economic Intelligence Unit.

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on infrastructure that can be used by a myriad of industries. Such development ought to include extensive road and highway system. This is another opportunity for joint ventures between industry and government that may allow for cost sharing.24

Meanwhile, the Peruvian government can also play a significant role in helping farmers get market information that can help them make the best decisions about what to grow to meet market demands. Projects such as “Poverty Reduction and Alleviation” (PRA) initiated by Chemonics/USAID has been helping farmers identify market demands and facilitating the meeting of the supply and demand sides. Furthermore, it concentrates solely on industries that exhibit high short-term gains. It then helps educate producers on how to best serve identified markets. Amongst its non-traditional agriculture products are asparagus, avocado, artichoke, and organic cacao. This project has been successful and the will soon be adopted by the Peruvian government25. When the government takes over, it is important to maintain the efficiency and transparency of the current structure.

Manufacturing in general and textiles in particular is another area where Peru has potential. From 2004 to 2006, Peru’s exports of textiles increased more than 15% and accounted for 30% of Peru’s non-traditional exports26. Unlike the mining industry, which requires large capital investment and can only absorb limited quantities of labor and thus directly benefits a limited portion of the population, the manufacturing industry, especially those in non-primary industries, requires relatively less capital and can generate more wide-spread economic benefits. Mostly in the form of small and medium enterprises (SMEs), the textile industry can provide local entrepreneurs with opportunities to learn and practice business and managerial skills. These SMEs can become training schools for the population of skilled workers, who can also benefit other industries such as the resources processing industry.

Though Peru may not be able to compete with other major manufacturing exporting powers such as China and India, it still can get a slice of the worldwide manufacturing industry pie, given that the price of labor is relatively low and it has tariff-free market access to leading economies such as the U.S. However, these are all necessary but not sufficient conditions. Other than cheap labor and market access, stable industry policies and a friendly business environment are crucial, which are largely initiated and cultivated by government policies. Therefore, the Peruvian government should promote and encourage the development of non-primary industries, as well as having a strategic plan to identify its comparative advantage in the world market. The next step is Peru moving up the value chain to higher margin and higher value added activities. Peru has distinct textile raw materials and special indigenous designs. As a result, it is possible and important for it to develop its distinctive textile products that differentiate from textiles from China and India. Its alpaca production can be more

24 In our meeting with the Minister of Transport on March 1, the Minister indicated that the lack of financing is one of the factors that challenge infrastructure development. Also, she mentioned some of the building standards were too high and were not realistic for normal commercial use. She talked about the “Rural Roads program”, in which the building of infrastructure is financed by the central government, while the maintenance is covered by local governments or private institutions. 25 Learned from our meeting with Chemonics/ USAID on Feb 27. 26 Country Report- Peru 2006, Economic Intelligence Unit.

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lucrative if producers are better able to meet consumer demands, particularly in regards to style and design. Tourism

Tourism has been boosted due to a more stable domestic environment, and growing global trends in travel. In order to expand and develop its tourism sector, Peru needs to diversify its tourist activities and destinations. At present, most tourism has been attracted to mainly capital Lima and Cusco. Macchu Picchu and its surrounding Inca archaeological sites remain the most popular destinations. There has been limited development of tourism infrastructure in the northern Amazon area and the north-middle jungle areas. As other promising industries that Peru needs to develop, more value should be added into tourism services. For instance, tourism-related services and infrastructure should be developed to facilitate traveling. High-end hotel and logistical services should also be promoted so as to meet the demands of luxurious tourists from the developed countries, especially Japan and other East Asia areas. Moreover, the creation, design and promotion of tourism branding have become more and more important. For the popular tourism destinations such as the city of Cusco and Macchu Picchu, having a marketable brand and effective marketing strategy is extremely important for Peru to exploit its tourism resources more efficiently and effectively. Much as with textiles, Peruvian handicrafts produced to be sold to tourists, ought to be accredited or officially recognized by some body that overseas product quality. By effectively trade marking Peruvian made goods, Peru can increase the value of its original arts and crafts. 5. Conclusion In conclusion, Peru is currently well placed to make positive changes to its business and economic operations that will benefit both industry and society. By carefully handling its external debt and conservatively managing its spending during this boom time it will be able to avoid the mistakes of the past. Furthermore, by joining forces with both small and large producers in the areas of mining, agriculture, textiles and tourism, the government will be able to diversify the country’s economic base and income distribution, thereby reducing its vulnerability to external economic forces.

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References “Assessing the Determinants and Prospects for the Pace of Market Access by Countries Emerging from Crisis—Country Cases”. International Monetary Fund. www.imf.org. September 2001. Borensztein, Eduardo, Eduardo Levy and Ugo Panizza (coordinators), Living with debt: How to limit the risks of sovereign debt, Washington D.C., Inter-American Development Bank, 2007. Country Profile- Peru 2006. Economist Intelligence Unit. Dancourt, Oscar.“Structural Reforms and Macroeconomic Policy in Peru, 1990-1996”, After Neoliberalism What Next for Latin America?, (ed. Lance Taylor), The University of Michigan Press: 1999. pp. 161-188. Francisco Sagasti, coordinator. Development Strategies for the 21st century: the case of Peru. Editorial Apoyo: Lima Peru. November 2000, pg. 87. IMF, “Debt-Related Vulnerabilities and Financial Crises—An Application of the Balance Sheet Approach to Emerging Market Countries”, International Monetary Fund. www.imf.org. July 2004. Jennifer Hughes and Hal Weitzman. “Peru nears investment grade ratings” Financial Times, July 12 2005. Ministry of Economics and Finance, Annual Program of public debt management, Lima, 2007. Available in http://www.mef.gob.pe “Peru: during the current economic crisis, export strategies should focus on industries that are targeted for growth -Business Outlook Abroad”, Business America. April 24, 1989. <http://64.233.167.104/search?q=cache:KWYswdjrwYgJ:findarticles.com/p/articles/mi_m1052/is_n8_v110/ai_7606557+peru+economic+crisis&hl=en&ct=clnk&cd=8&gl=us> “Peru finance: Is it investment grade?” The Economist Intelligence Unit. March 22, 2007.

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