10th May 2011

LATIN AMERICA
FOCUS
Is Peru’s boom about to be derailed?
• Peru’s medium-term growth prospects are amongst the best in the region. But in the near term
there is a mounting risk of overheating and tighter fiscal policy is needed to cool demand. In this
respect, the major risk posed by the emergence of Ollanta Humala in the Presidential election race
is not that he will pursue a Chavez-style takeover of the commanding heights of the economy, but
rather that lax fiscal policy will fuel a boom-bust cycle.
• Peru has had a golden decade in which it has outperformed its Latin American peers. Following the
lost decade of the 1980s, which was littered with sovereign defaults, Alberto Fujimori came to power
in 1990. He swiftly implemented savage reforms to tackle hyperinflation in what later became
known as ‘Fujishock’. Although he remains a controversial figure, his reforms laid the platform for
strong, investment-led, growth during the commodity price boom between 2003 and 2008. GDP
growth in Peru averaged 5.1% during the last decade, while regional growth averaged just 3.4%.
• Nevertheless, the increase in wealth has been slow to trickle down through the economy and poverty
has remained persistently high. This explains the revolt against the ‘continuity’ candidates in the first
round of the Presidential election. That has left what is, at first sight at least, an unappealing choice
between Mr. Fujimori’s daughter, Keiko, and the left wing Ollanta Humala, who has been linked in
the past to the Venezuelan President, Hugo Chavez. Indeed, the prospect of Mr. Humala triumphing
in the run-off on 5th June has sparked fears that Peru’s period of out-performance is about to come
to an abrupt end and the uncertainty has bred volatility in the markets.
• We suspect that those fears are probably overdone. Although a Humala victory may not be exactly
what the market was hoping for, it appears that the three key pillars of macroeconomic policy over
the past decade – the fiscal rule, inflation targeting and a floating exchange rate – will remain intact.
• Whoever triumphs, the near term priority for the new President must be to significantly tighten
fiscal policy to cool demand and prevent overheating. Thereafter, steps need to be taken to insulate
the non-commodity economy from so-called ‘Dutch disease’. Careful management of the exchange
rate to ensure a smooth and gradual appreciation should be complimented by supply-side reforms to
the labour market and tax system to maintain potential growth of 6% or so.
• Although it is not as clear-cut as the market appears to think, it does seem that the policies of Ms.
Fujimori are perhaps more likely to meet these challenges than those of Mr. Humala. In particular,
we fear that he would be more prone to fiscal populism than Ms. Fujimori. Accordingly, the key risk
of a Humala victory is perhaps not that he would undo the reforms of the previous twenty years,
but rather that, while growth would remain strong, the economy would be in for a bumpy ride.
David Rees
Tel: +44 (0)20 7811 3907
North America Europe Asia
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Chief International Economist Julian Jessop (julian.jessop@capitaleconomics.com)

Senior Emerging Markets Economist Neil Shearing (neil.shearing@capitaleconomics.com)
Emerging Markets Economist David Rees (david.rees@capitaleconomics.com)
Latin America Focus 1
Is Peru’s boom about to be derailed?
Peruvian politics is notoriously unpredictable.
With the second round of the race to succeed the
President Alan Garcia set to be photo finish
between Ollanta Humala and Keiko Fujimori, the
outcome is still unclear. But what does seem
certain is that, having topped the region’s growth
charts over the past ten years, prudent
macroeconomic policy is crucial to ensuring that
the opportunities presented by the current era a
abundance aren’t squandered and that the
economy continues to converge towards its richer
neighbours over the coming years. With the
election race entering the final furlongs, we take a
look at the key challenges facing the victor.
Fujishock, and awe
In order to understand what has underpinned the
recent strong performance of Peru’s economy, it is
important to first take a look backwards. The 1980s
was littered with defaults and great volatility in the
aftermath of the Latin American debt crisis which
was triggered by Mexico in 1982. During the
disastrous first tenure of the incumbent President,
Alan Garcia (1985-1990), the economy was
ravaged hyperinflation. Indeed, by the time Alberto
Fujimori came to power in July 1990, inflation was
close to 3,000% while GDP had contracted by a
cumulative 25% in three years.
economy’s supply potential, constrain the
excessive growth of domestic demand (and public
spending in particular) and reduce inflation. He
initially capped demand by cutting subsidies and
price controls, while he also changed the
exchange rate system. The multiple fixed exchange
rate system of the inti was abolished and replaced
by a unified exchange rate which then depreciated
sharply. (See Chart 1.)
Of course, the initial impact of these measures was
to cause prices to rise sharply and inflation topped
13,725% in August. (See Chart 2.) But the removal
of price controls and subsidies also meant that the
government no longer had to fund any shortfalls,
which it had done by monetising its deficit (a key
factor behind the inflation problem). What’s more,
an early form of a fiscal rule was introduced to
prevent current government expenditure from
exceeding current revenues. (This was later
enshrined in law in 1999 to limit the budget deficit
to 2% of GDP. It has subsequently been reduced
further to 1% of GDP.) As a result, inflation soon
began to fall and, once it has settled at lower rates,
a new currency (the nuevo sol, which is still used
today) was introduced in mid-1991.
CHART 2: CONSUMER PRICES (% Y/Y)

300 300
CHART 1: EXCHANGE RATE VS. US$
250 CPI rate average 250
7482% in 1990
0.0 0.0
200 200
0.5 0.5
Currency strengthens vs. US$ 150 150
1.0 1.0
1.5 1.5 100 100

2.0 2.0
50 50
2.5 2.5
0 0
3.0 3.0
1980 1984 1988 1992 1996 2000 2004 2008
3.5 3.5
4.0 4.0 Source – IMF
1989 1992 1995 1998 2001 2004 2007 2010
The economy was also opened up to the outside
Source – Thomson Datastream
world. Laws governing foreign direct investment
Mr. Fujimori quickly set about redressing the (FDI) were relaxed, while public firms were
economic problems with a raft of severe reforms privatised. The government also addressed the civil
known as ‘Fujishock’. These aimed to boost the unrest that had dogged Mr. Garcia’s tenure, paying

Latin America Focus 2

particular attention to the Shining Path corruption and human rights violations – offences
organisation. This boosted inflows of FDI, which for which he is still imprisoned. His successors,
more than doubled as a share of GDP. (See Table Alejandro Toledo (2001 – 2006) and the returning
1.) And, coupled with the increase in domestic Alan Garcia (2006 – present) put the finishing
savings that had resulted from efforts to reduce touches to the reform process by introducing
inflation and the fiscal deficit, investment began to inflation targeting in 2002 and signing free trade
rise as did the economy’s potential growth rate. agreements (FTAs) with the likes of the US, China
and EU. But it was undoubtedly Mr. Fujimori’s
TABLE 1: ECONOMIC INDICATORS reforms to the supply-side of the economy that had
Indicator 1980s 1990s 2000s laid the platform for future growth.
Real GDP Growth (%) 0.6 3.2 5.1
Nevertheless, increased supply potential will only
Exports (% GDP) 11.5 10.4 19.1
lead to an increase in output if it is matched by a
FDI Stock (% GDP) 4.4 9.6 22.7
similar pick-up in demand. Since commodities
GDP per Capita (US$) 1,390 1,950 3,020
account for around half of exports, that eventually
Inflation (%) 480 810 2.5
came via the commodity price boom of 2003 to
Source – IMF
2008. The economy’s terms of trade roughly
Banking crisis prompted tighter regulation doubled over the period which boosted incomes
It wasn’t all plain sailing though, and there was a by a cumulative $10bn or so (equivalent to about
wobble towards the end of the decade when a 9% of GDP). While some of that extra income was
banking crisis was triggered by the Asian Financial undoubtedly saved, we estimate that around
Crisis in 1997. By the time the crises had rippled three-quarters of it was spent which gave a
through to Peru in 1998, 70% of the financial significant boost to domestic demand.
system had become dollarised and short-term
This, along with the recent history of stable and
external debt had reached $3.7bn (equivalent to
prudent policymaking, ensured that the influx of
6.5% of GDP). The drop in commodity prices and
foreign direct investment (FDI) continued. (Again,
rise in risk appetite caused a ‘sudden stop’ in
see Table 1 above.) The stock of FDI increased
capital inflows, while the depreciation of the sol
from an average of 9.6% of GDP in the 1990s to
against the dollar pushed FX debt servicing costs
nearly 23% of GDP in the 2000s. The result was a
higher. The increase in non-performing loans and
rapid period of investment-led growth – GDP
squeeze on funding resulted in a credit crunch that
growth averaged 7% during the five year boom –
caused the economy to fall into recession and,
which was much stronger than elsewhere in the
with much of the financial system subsequently
region. (See Chart 3.)
nationalised, the recovery was sluggish.

Nonetheless, every cloud has a silver lining and CHART 3: CONTRIBUTIONS TO GDP GROWTH (%-PTS)
the crisis was the trigger for significant reform of 14 GFCF 14
12 Net Exports 12
the banking sector. Banks were forced to hold Private Consumption
10 10
Government
reserves far in excess of those mandated by the 8 8
6 6
Basel agreement, while liquid assets equivalent to
4 4
at least 8% of sol-denominated short-term debt and 2 2
0 0
20% of FX short-term debt were required. -2 -2
-4 -4
Solid framework for growth -6 -6
The following year, however, Mr. Fujimori was 2004 2005 2006 2007 2008 2009 2010

forced out power in November 2000 under a Sources – Thomson Datastream, CE

cloud after accusations of election rigging,

Latin America Focus 3

In the first instance, the increase in demand simply
soaked up the increase in supply that had been
generated by the previous reforms. As a result,
there was a period of strong growth without
inflation. And once capacity pressures began to
build policymakers were able to tighten
macroeconomic policy. The public sector ran
substantial fiscal surpluses while monetary policy –
through both interest rates and other means such
as bank reserve requirements – was also tightened.
Finally, having managed a gradual appreciation of
the exchange rate, the central bank allowed it to
appreciate more rapidly in 2008 to take the edge
off of import prices. As a result, unlike in previous
cycles, inflation was, on the whole, managed well
and it wasn’t until the sharp spike in global food
and energy prices that the CPI rate rose far above
the central bank’s 1-3% target range in mid-2008.
Brief dip into recession
Of course, the commodity price boom eventually
proved to be a bubble which burst. Just like in
1998, there was another ‘sudden stop’ in capital
low of 1.25% while a fiscal stimulus equivalent to
2 % of GDP was also unleashed, primarily focused
on infrastructure spending which boosted the
construction sector. The result was a sharp v-
shaped recovery which ensured that the economy
actually grew by 0.9% in 2009 and then by 8.7%
in 2010. (See Chart 4.)
Election race heating up...
Accordingly, the new President will take over a
healthy economy when he or she enters office in
July. The most pressing question is who will it be?
The failure of the previous regimes to eliminate
poverty can explain the rejection of the ‘continuity’
candidates in the first round of the election.
Although poverty has fallen in recent years, Peru
still lags behind Brazil – and even Venezuela – in
this regard. (See Chart 5.) Given that Peru has
outperformed both economies in recent years,
there has been a backlash against the politicians
who simply promised more of the same.
CHART 5: POPULATION LIVING IN POVERTY (% OF TOTAL)

inflows as the global economy slid into recession. 70 70

Nevertheless, the prior reforms and prudent 60 60

management of the economy ensured that there 50 50

was little lasting impact on the economy and that 40 40

the recovery was much quicker. 30

Peru
30

20 20
Venezuela
CHART 4: GDP (% Y/Y) 10 10
Brazil
0 0
12 12
CE
Forecast 97 98 99 00 01 02 03 04 05 06 07 08 09
10 10
Source – World Bank
8 8

6 6
That has left what is, at first sight at least, an
unappealing choice between Keiko Fujimori, the
4 4
daughter of the imprisoned former President, and
2 2
the left-wing Ollanta Humala, who has been
0 0
linked to Venezuela’s Hugo Chavez. The markets
00 01 02 03 04 05 06 07 08 09 10 11 12
have been jolted by the emergence of the latter for
Sources – Thomson Datastream, CE
fears that he will undo the reforms of the past
The rapid rebound in commodity prices since their twenty years or so – equity markets in particular
trough in 2008 has obviously given growth a leg- have experienced a rollercoaster ride (down by as
up. But the bigger picture is that policymakers had much as 16% at one point). But we suspect that
plenty of room for manoeuvre to loosen policy Mr. Humala has been stigmatised by comments
when the global crisis hit. The central bank was that he made during the 2006 Presidential election
able to slash interest rates by 525bps to an historic race, when he talked of nationalising private

Latin America Focus 4

mining firms. This time around he has gone to
great lengths to convince the electorate – and the
market – that his policies are more moderate this
time around. In this respect there are some
parallels to Brazil’s experience during the election
of President Lula in 2002 (perhaps that is no
coincidence given that Mr. Humala has enlisted
the help of Lula’s former campaign manager).
While the markets appear to be concerned that Mr.
Humala will radically alter the current path of the
economy, we doubt that things will get that bad.
For a start, Mr. Humala is not guaranteed victory.
The latest polls have been split between Ms.
Fujimori and Mr. Humala. What’s more, even if he
does triumph, he will have to build a workable
coalition in the divided Congress. And in any case,
the most important point is that Mr. Humala has
repeatedly expressed a desire to redistribute Peru’s
significant commodity wealth, he has also been
careful to reiterate that he would do so while
respecting the current economic framework.
So far as redistributing wealth in concerned, any
attempt to create equality and calm the angst of the
poor – who account for the majority of the
population – is surely a good thing from the
perspective of the medium-term stability of the
economy (recent events in the Middle East
reinforce this point).
By contrast, the free-market policies of Ms.
Fujimori pose less of an obvious threat to foreign
investors. This has certainly been reflected in the
market reaction to any sign that she is mounting a
strong challenge to win the second round.
... as is the economy
Even though the economy has recovered quickly
from the global crisis, there are still challenges
facing policymakers. In the near term, the main
obstacle for the new government will be steering
the economy through the current era of
abundance. With interest rates in the developed
world set to remain very low for an extended
period of time, capital will continue flowing to
emerging markets in search of higher returns. High
commodity prices coupled with Peru’s relatively
good growth prospects mean that it has been a
major destination for foreign capital and, assuming
that the recent volatility surrounding Mr. Humala’s
emergence settles down, money should continue
flowing into the country.
Clearly, inflows of cash to capital constrained
economies with large investment needs are
positive for the likes of Peru. But they also create
challenges for policymakers. In the first instance,
they must be careful to ensure that the right kinds
of capital – for example long-term investments
rather than short-term speculative inflows of ‘hot
money’ – are attracted, while also protecting the
export sector from the subsequent exchange rate
appreciation. What’s more, they must also ensure
that the capital is channeled into investments
which will boost the productive capacity of the
economy rather than simply fuel increases in asset
prices. Failure to do this will leave the economy
vulnerable to a sudden withdrawal of external
funding and a potential balance of payments crisis,
while ‘hot money’ could also inflate bubbles.
Bubbling up?
So far at least, policymakers appear to have done a
decent job. Growth is still being driven by
investment while there is little evidence of
bubbles. But that is not to say that one will not
inflate. Accordingly, it is a good idea to monitor
those areas which seem most at risk from a bubble.
An obvious candidate for a bubble is bank lending.
As we have already noted, prior reforms meant that
the banking sector entered the recession in good
shape. Although credit growth slowed on an
annual basis, it only temporarily dipped into single
digit growth and has since recovered strongly.
Credit expanded by over 20% y/y in February. (See
Chart 6, overleaf.)
There does not appear to be a credit bubble yet –
the banks are well capitalised, new lending has
been made largely in sols and default rates remain
very low. But even so, that does not mean that a
credit bubble will not inflate further down the line
Latin America Focus 5
on the back of easy funding from abroad. Despite CHART 7: IGBVL EQUITY MARKET
the succession of interest rate hikes and increases
24000 24000
in reserve requirements, lending has continued to
22000 22000
accelerate and is heading back towards its pre-
20000 20000
recession levels and we will continue to monitor
the situation in our regular Latin America Banking 18000 18000

Heat Map. 16000 16000

14000 14000
CHART 6: BANK LENDING
12000 12000
70 70 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11
Total Credit
60 60
Nuevo Sol Credit Source – Bloomberg
50 FX Credit 50
40 40 What’s more, with the Peruvian bourse about to be
30 30 merged with the markets in neighbouring Chile
20 20
and Colombia in order to boost their liquidity (and
10 10
0 0
thus tradability). As a result, there is a risk that the
-10 -10 equity market could surge into bubble territory
2000 2002 2004 2006 2008 2010 later this year – especially if the markets are
Sources – BCRP, Thomson Datastream, CE eventually convinced that Mr. Humala will be
broadly market friendly.
Another potential area for a bubble is real estate,
which is, in part at least, a counterpart to a credit Guard against complacency
bubble. A lack of official data on the housing Nonetheless, even if policymakers manage to
market makes this difficult to analyse in much successfully prevent bubbles from inflating, they
depth. But the construction sector has been a key must still ensure that the economy does not
driver of growth and while this appears to have overheat. Following last year’s strong recovery
been predominately due to infrastructure works from recession the economy is already operating
and business-related building, anecdotal evidence above potential. And with GDP set to expand by at
indicates that there has been a boom in house least another 7% this year on the back of booming
building (and prices) too. Indeed, some reports domestic demand, capacity pressures look set to
suggest that house prices in some areas of Lima intensify. (See Chart 8.)
have more than tripled since 2006 which appears
frothy to say the least. CHART 8: OUTPUT GAP (% POTENTIAL GDP)

0.8 0.8
No spare capacity
A final area to watch is the equity market.
0.6 0.6
Admittedly, concerns that Mr. Humala will go on a
0.4 0.4
Venezuelan-style destruction of the economy 0.2 0.2
caused equities to tumble after the first round of 0.0 0.0
the election. At one point the IGBVL equity market -0.2 -0.2
was down by 16% after Mr. Humala’s first round -0.4 Excess capacity -0.4
victory, before rebounding as Ms. Fujimori gained -0.6 -0.6

ground in the polls. (See Chart 7.) Either way, the Peru Brazil Chile Colombia Mexico

fundamentals of equities remain good – the Source – Capital Economics

economy’s prospects are good, commodity prices
Meanwhile, inflation has already risen above the
are still high and the end of QE2 is unlikely to
central bank’s 1-3% target range. So far the pick-
diminish capital flows to emerging markets (see
up has been driven almost entirely by food and
our latest Capital Markets Analyst for more details).

Latin America Focus 6

energy prices, and the lagged effect of the recent
spike in commodity prices will probably push the
CPI rate even further above target range in Q4 this
year. (See Chart 9, overleaf.) The good news is
that, assuming that commodity prices now flatten
off, or begin to fall as we expect, then the food and
commodity exporters. If that is the case then
growth may become decidedly unbalanced, much
like it has done in Brazil (so-called Dutch Disease
– more on this later). (See Chart 10.)
CHART 10: DEVIATION OF THE REAL EXCHANGE RATE FROM 10

energy components should fall back sharply in the YEAR AVERAGE (%)
first half of next year. 70 60.1 70
60 60

CHART 9: GLOBAL SOFT COMMODITY PRICES & FOOD CPI 50 50

40 40
80 GSCI Agri + Live. (Adv. 6m, % y/y, LHS) 12 30 30
16.7 16.4
60 Food CPI (% y/y, RHS) 10 20 20
6.9
8 10 1.3 10
40 -16.4
6 0 0
20
-10 -10
4
0 -20 -20
2
-20 Brazil Colombia Chile Peru Mexico Argentina
0
-40 Potential path of food inflation if -2 Source – Thomson Datastream
soft commodity prices stay flat
-60 -4
00 01 02 03 04 05 06 07 08 09 10 11 12 Ultimately, we still expect commodity prices to fall
back towards the end of this year and into 2012.
Source – Thomson Datastream
That should ensure that the economy has a soft
However, the bad news is that the slowdown in landing (we expect GDP growth of around 5% in
food and energy inflation will probably be 2012) while any bubbles would be pricked before
partially offset by a rise in core prices as capacity they fully inflate. But in the meantime interest rates
constraints start to bite. We expect inflation to will probably continue to rise. We expect the
average 3.5% this year and 3.0% in 2012. BCRP, which has already hiked rates by 275bps in
this tightening cycle, to raise the base rate to at
Tighten policy to avoid a disorderly mess
least 5.5% by year-end and to continue intervening
As a result, for as long as commodity prices remain
in the currency market. (See Chart 11.)
elevated and capital continues to flow into Peru, it
is clear that policy needs to be tightened. But that CHART 11: INTEREST RATES (%)
process is not straightforward since aggressive
7 7
interest rates hikes would only serve to attract CE
Forecast
6 6
further inflows of ‘hot money’, add to upward
5 5
pressure on the exchange rate and provide
4 4
additional fuel to red hot domestic demand –
3 3
something of a vicious circle.
2 2

Admittedly, sterilised FX purchases by the central 1 1

bank have effectively fixed the nominal exchange 0 0

2004 2005 2006 2007 2008 2009 2010 2011 2012
rate – that is to say, so long as commodity prices
Sources – Thomson Datastream, CE
remain elevated the nuevo sol will not be allowed
to appreciate by much beyond a line in the sand Fiscal policy most effective tool
somewhere between 2.70-2.75/$. But accelerating However, in a global environment of loose
inflation means that the real exchange rate will monetary policy, fiscal policy holds the key to
probably appreciate more sharply later this year preventing overheating in Peru. Ahead of the
and squeeze the competitiveness of the non- Presidential election, fiscal policy has remained

Latin America Focus 7

too loose and the authorities have been slow to What’s more, the country’s demographics are also
withdraw the large stimulus in 2009. Admittedly, favorable. The UN expects the population to
the public sector as a whole ran a small primary increase by around one-third from about 30
budget surplus last year. But the IMF calculates million people in 2010 to something like 40
that, given the sharp rebound in both GDP growth million people by 2050. (See Chart 13.) Not only
and commodity prices, the public sector actually does this mean that the economy should have a
ran a structural primary budget deficit of around ready supply of labour over the coming years, but
1% of GDP. it also means that the public finances won’t run
into the costly process of supporting an ageing
As such, the best course of action would be for the
population (as is the case in the developed world).
new President to implement a significant fiscal
tightening. Not only would closing the structural CHART 13: POPULATION (MN)
deficit reduce aggregate demand, but it would also
45 45
UN Projections
allow real interest rates to remain low, thus making 40 40
Peru less attractive to speculative investors. To this 35 35
30 30
extent, one of the major concerns regarding Mr.
25 25
Humala is that he is perhaps less likely to 20 20
significantly tighten fiscal policy than Ms. Fujimori, 15 15
10 10
meaning there is a greater risk of overheating if he
5 5
does eventually become President. Indeed, it 0 0
seems that the threat from Mr. Humala is not that 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

he will embark on a Chavez-style command and Source – UN

control economic model, but that he will
Better manage commodity wealth
exacerbate boom-bust growth cycles.
Looking further ahead, the key challenge facing
Bright medium-term policymakers over the medium-term is to manage
Irrespective of this, we still believe that the the country’s commodity income. Given that Peru
medium-term outlook for Peru is, on the whole, has such large commodity reserves, and that they
very good. First and foremost, it is the poorest of account for half of all exports, natural resources
the major economies in Latin America. (See Chart will continue to be a significant part of the
12.) As a result, in the presence of good economy for some time. There are two main risks
policymaking there is scope for further ‘catch-up’ associated with this. First, the economy will
growth as the economy converges towards its continue to be vulnerable to swings in global
peers – and indeed the developed world. commodity prices and thus boom-bust cycles.
Neighbouring Chile perhaps offers the best
CHART 12: GDP PER CAPITA (US$BN)
solution to this problem, where excess commodity
50,000 50,000 revenues are saved in the sovereign wealth fund
45,000 45,000
40,000 40,000
ready to be mobilised when commodity prices fall
35,000 35,000 to smooth the deterioration of the terms of trade
30,000 30,000
25,000 25,000
and growth.
20,000 20,000
15,000 15,000 The second risk is that continued upward pressure
10,000 10,000 on the real exchange rate from commodity export
5,000 5,000
0 0 revenues and capital inflows will damage the
US Chl. Brz. Ven. Mex. Arg. Col. Per. competitiveness of the manufacturing sector.
Source – IMF Moreover, capital and labour may be directed to
the resources sector and away from manufacturing,

Latin America Focus 8

 where productivity and employment growth tends
to be highest. This is the phenomenon known as
‘Dutch disease’. The result tends to be that the
non-commodity sectors are hollowed out, making
the economy more dependent upon imports.
The question, then, is what needs to be done to
ensure that the non-commodity sector can flourish
while the commodities sector is booming? The
answer lies in creating a dynamic and flexible non-
resources sector, which is able to accommodate a
stronger exchange rate. At the macro level
policymakers can continue to intervene in the
currency market in the short term to ensure that the
appreciation of the sol continues to be gradual.
That should give firms time to adjust. But such an
approach is ultimately unsustainable and it is
imperative that the government to makes key
supply-side reforms. There are three main areas to
address in this regard.
The first is infrastructure. Good infrastructure can
greatly reduce the time and cost of transporting
goods to markets which, in turn, helps to keep
their overall price down. The Peruvian government
has made great leaps in this sense with an increase
in paved roads, amount of railway track in use and
investment in sea and air ports. However, given
that the economy has come from such a basic
starting point, there is still room for further
improvement on this front and more measures to
integrate the rural areas are also needed.
The second area for reform is the labour market. In
an ideal world firms would be able to hire and cut
employees as and when they are needed in order
to ensure that each worker is operating at their
maximum level of productivity. Of course, there
tend to be certain safety nets for employees and in
some countries it can be difficult to reduce the
number of workers which can have adverse effects
on unit labour costs. In general, the World Bank’s
‘Doing Business 2011’ report indicates that Peru
stacks up well in comparison to its neighbours.
Wages are low by regional standards and there
appears to be a fair amount of flexibility within the
regulations.
Finally, measures should be taken to improve the
general business environment. Not only would this
help local entrepreneurs, but it would also attract
foreign firms into the non-resources sector. The
latter may then translate into technology and
knowledge transfer and help the economy to
diversify away from commodity exports. In
general, Peru stacks up well in the ‘Doing Business
2011’ report. It moved up 10 places to be placed
36 out of 183 economies (and second only to
Mexico within Latin America), with large
improvements in the scores for starting a business
and trading across borders since last year. (See
Table 2.)
The main areas for improvement include the
amount of time that it takes to obtain construction

TABLE 2: “DOING BUSINESS 2011” LATIN AMERICA RANKING (OUT OF 32, WORLD RANKING IN BRACKETS)

Ease of Starting Construction Registering Getting Protecting Paying Trading Enforcing Closing a
Doing a Permits Property Credit Investors Taxes Across Contracts Business
Business Business Borders
Mexico 1 (35) 12 6 13 7 12 15 9 8 1
Peru 2 (36) 8 21 2 2 3 11 7 18 17
Colombia 3 (39) 14 9 6 10 1 19 17 25 5
Chile 4 (43) 10 13 3 13 5 3 12 4 15
Argentina 22 (115) 24 32 18 10 20 23 24 1 12
Uruguay 24 (124) 23 29 29 7 18 26 29 15 8
Brazil 26 (127) 20 24 19 18 15 25 23 11 21
Ecuador 27 (130) 28 17 8 18 25 10 28 13 22
Bolivia 29 (149) 30 22 25 25 25 31 27 24 9
Venezuela 32 (172) 25 20 12 32 31 32 32 6 27
Source – World Bank

Latin America Focus 9

permits. Meanwhile, more needs to be done to
enforce contracts while the red-tape surrounding
closing a business could be reduced. (Again, see
Table 2.)
It seems that all of these things are very achievable
and that Peru should be able to attract increasing
amounts of investment into the non-commodities
economy. That is especially the case now that, in
addition to the current deal with the US, Free
Trade Agreements with both China and the EU are
about to come into effect. If that proves to be the
case we see little reason why the economy cannot
maintain potential growth of around 6% per
annum over the medium-term. Clearly, this will
not be enough to propel Peru into the league of the
world’s top twenty largest economies – its
population is simply too small. But it may be
sufficient for the economy to become larger than
neighbouring Chile over the next ten years or so.
(See Chart 14.)
CHART 14: CHILE & PERU NOMINAL GDP (US$BN)
450
CE Forecasts
400
350 Chile
300
Peru
250
200
150
100
50
0 0
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020
Sources – IMF, CE
Summary
In summary, then, a succession of crises over the
last thirty years has pushed Peru down the road of
reforms. While painful at the time, reforms to
monetary policy, fiscal policy and the banking
sector helped to ensure that, while much of the
global economy was in meltdown, the recession in
Peru was both brief and shallow. But even though
the economy has outperformed its peers in recent
years, the growing wealth has been slow to trickle
down through the economy. Persistent poverty has
triggered a rejection of the continuity candidates in
the Presidential election and so the run-off on 5th
June will be contested by Ollanta Humala and
Keiko Fujimori.
Whoever wins, the key challenge for the new
regime in the near term will be to prevent the
economy from overheating and asset price bubbles
from inflating. Monetary policy will continue to
tighten but, ultimately, tighter fiscal policy is
required. Thereafter, supply side reforms, are
needed to prevent ‘Dutch disease’ from hollowing
out the non-commodities economy. In this respect,
Ms. Fujimori is probably more likely to get the job
done than Mr. Humala. Indeed, although we
suspect that fears that he will drive a Venezuelan-
style re-shaping of the economy are overdone, his
social programs would probably come at the
expense of looser fiscal policy meaning that the
bigger threat would be that there would be a return
to boom-bust growth. In this situation the economy
should still grow at an average rate of 6% per year
over the medium-term. But periods of stellar
growth would probably be punctuated by sporadic
recessions.
450
400
350
300
250
200
150
100
50
Latin America Focus 10