Peru: Fragile uptick in capital markets

Peru was grabbing headlines in June and July on the back of two very different stories and ones that would seem to be mutually exclusive or at least unlikely. The country has been in the grip of social unrest—particularly in the remoter and less developed sierra and Amazon regions—with resultant political fall-out and substantive changes to the cabinet of President Alan García. At the same time, the stock market was recording blistering performance with rises of more than 100% year-to-date.

Peru hit world headlines in June when an Amazon town, populated mostly by indigenous people, was racked by violence which saw the official death toll hit 33, among which were reported to be 23 police officers. The resultant political crisis led the President to change his cabinet again, with the most significant head to roll that of the Prime Minister, Yehude Simon, who was replaced by Javier Velásquez.

Social unrest is a chronic condition with which Peruvians have learned to live, commentators say. In recent years, people have anticipated a trickle down effect from the country’s fast economic growth, but very little has actually been seen. That’s particularly the case in smaller towns and rural areas. People there feel left behind and resentful, Pedro Pablo Kuczynski, partner at the Rohatyn Group and a former Prime Minister, told Berlinguer.

Clumsy management of the situation with reluctance by the government to act and then a rush to make promises that could not be met exacerbated the situation, say analysts. Simon did not handle the situation as well as predecessors, thinks Richard Francis, sovereign analyst at Standard & Poor’s. Velásquez is likely to be more adept, he believes.

Despite the gravity of the situation, Kuczynski believes the unrest will not have a significant impact on large investment projects as international miners are used to working in countries with complex political backgrounds. Such companies are used to handling delicate political situations, in countries as volatile as Mongolia to Indonesia, agrees Francis.

Furthermore, there’s long been a divorce in Peru between politics and economic performance and it’s rare that social unrest adversely affects economic growth, adds Luis Benavente, head of the polling group at the University of Lima. Miners tend to be sanguine about unrest and the Peruvian government has given many demonstrations of political and juridical stability, which they consider more important, he says. Rather, concerns over unrest may have an impact in more cottage-style industries as local businessmen may feel reluctant to spend on expansion, reasons Kuczynski.

Economic drivers

The Peruvian economy, meanwhile, which had been on a tear, has slowed substantially. While GDP grew at a blistering 9.84% last year and at over 7.5% for the previous two years, the first half of this year was marked by a rapid deterioration with growth of just 0.9% on an annualised basis.

Even so, that looks impressive compared to most of the rest of the world, notes Benavente. The impact of the international crisis has been muted in Peru which, along with Panama, is going to provide the best performance in the region, he adds. Perhaps the most worrying feature is that the government has seen the tax take fall by some 20% in the last months, he notes.

Kuczynski partly attributes the severity of the economic slowdown to the running down of stocks and believes things will start to look up soon. Inventories have fallen to such low levels that companies will restock and Peru is likely to see much faster growth in the second half, he says. He predicts GDP of 3-4% in the second semester to give 2.5% to 3% growth for the year overall.

Driving the economy right now is a high level of consumer confidence in Peru’s B and C classes, thinks Kuczynski. There is still plenty of construction work, combining both informal and formal projects, and government funds for mortgages have helped sustain construction.

Peru also has the luxury of being able to afford a hefty fiscal stimulus to the economy after it squirreled much of its commodity gains away, in marked contrast to countries such as Venezuela, says Oscar Sanchez, senior economist at Scotia Bank in Toronto. The Garcia government was wise enough to prepay foreign debt and is now a net creditor to the rest of the world, Sanchez notes. This prudence helps explain why rating agencies moved the country up to investment grade last year, he notes.

Public investment is growing at more than 30% per year, compensating in part for the loss of foreign direct investment and drops in lending by foreign banks, Sanchez continues. The government is well able to afford a stimulus of just over $3bn in an economy of $140bn, he notes.

Standard & Poor’s is predicting GDP growth of 3% this year and 4.5% in 2010 although both were subject to downward revision as this magazine went to press. The economy is tied tightly into commodity prices and Peru is very tied into the global economy, says Francis. The fiscal stimulus should start to pick up speed in the second half, as was the pattern last year when public spending was ramped up 40%, he notes. Moreover, public spending won’t be wasted as it is urgently needed to update Peru’s antiquated infrastructure, he notes.

Francis agrees that the government has ample scope for borrowing and points to recent issuance. A July sovereign issue saw the government selling $1bn in notes at a 6.95% yield or a 344 basis point spread over the US Treasury equivalent, he notes.

Mining bounce

A key component of economic growth and determination of the direction of the stock exchange comes from the mining sector. In the last quarter of last year and the first few months of this year, mining companies were compelled to mothball projects as prices of Peru’s key commodities crashed.

That hesitancy on the part of mining firms is now being reversed. Although the news is mixed, there are clearly signs of a pick up and some of the largest mining projects in Peru are being resumed. Kuczynski estimates that two thirds of the projects are likely to go ahead.

These include the largest investments by China in the country, Chinalco’s Toromocho copper project with an estimated capital expenditure of $2.15bn and Minmetals’ copper project Galeno. Furthermore, Southern Copper announced in June that it will resume construction at its Tia Maria and Toquepala mines in Peru after prices rebounded this year, the firm’s CEO Oscar Gonzalez Rocha announced.

Not all the news stemming from the sector is good and firms from developed countries have been particularly cautious. Rio Tinto has mothballed two large projects in Peru while Anglo American has put a project on hold, too. However, the projects that are being delayed would have been questionable were it not for the price boom seen in commodities and Rio Tinto is heavily indebted while Anglo American is preoccupied with a proposed merger with Xstrata.

The stock market reflects the performance of commodity prices and mining stocks and is driven to a large extent by what happens in China, says Kuczynski. To a lesser extent, it is moved by the amount of money local pension funds have to invest. Assets have been growing rapidly as the labour force formalises, he says.

Further support to Peruvian markets has been lent by a general thirst for emerging market assets and a reduction in risk perception, Sanchez notes. It is not just the equity market that has bounced back however. Spreads on sovereign bonds and volatility in the FX rate have both trended lower. Spreads came down to 250 basis points (bps) from 300bps at the start of July and 400bps in April, he notes.

Furthermore, the Central Bank has been able to control the level of the sol, a key issue in Peru where significant lending is still carried out in the greenback, Sanchez notes. Since February, inflation has fallen fast allowing the Central Bank to implement aggressive reductions in interest rates. Rates have come down to an all-time low of 2% after six months of consecutive cuts.

The strong performance out of the market to date is unlikely to last, more because of a steadying in the price of commodities than thanks to political problems. Kuczynski, for one, is cautious on performance for the rest of the year. The Chinese have been buying commodities because of fears of inflation in copper and zinc. That has driven up the stocks of the middle-sized mining companies, which are prevalent on the Lima exchange, he says. He believes that inflation will not materialise in the next few months, lessening China’s appetite.

Gains in the stock market are likely to be a little disappointing in the second half, agrees Sanchez. Commodity prices and stocks have substantially re-valued and while he does not expect commodity prices to fall, there is likely to be flatter performance, he believes. The stock market is distorted too by a lack of liquidity, he points out.

For now, the stock exchange is dancing more to the tune of commodity prices than political concerns. That is not surprising as García’s term only runs out in July 2011. However, politics will come to seem more important next year. Previous elections have been marked by bitter contests between right and left and radical political platforms.

Ollanta Humala, who lost the run-off to García in 2006, is still in the wings. Kuczynski believes he does not stand a good chance of election with recent polls giving him just 22% of intentions. “The only chance for him is if the Centre and Right knife each other and ineffective, old candidates show up,” he says. But García is not widely liked either, with polls showing popularity levels in the high 20s and low 30s. One wildcard is congresswoman Keiko Fujimori, daughter of the former Alberto President, a likely candidate for the presidency who obtained the highest vote nationwide when she stood for Congress.

With stable commodity prices and an ever more uncertain political outlook, investors need to exercise caution in chasing a Peru story whose best moment may have passed.

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