Many investors are concerned about the risks to growth and the potential for higher inflation in Peru following two recent shocks: severe floods stemming from the coastal El Niño and allegations of corruption related to the Brazilian construction conglomerate Odebrecht. Both raise hurdles for the government’s infrastructure push, which is at the heart of President Pedro Pablo Kuczynski’s plan to revive domestic demand and promote growth (see chart below).
In the short term, we think GDP growth should drop closer to the 3% range from the consensus forecast of 3.5%–4.0% six months ago. Yet, even as headwinds increase, we continue to believe that the government’s overall strategy will lead to a new period of dynamism in the Peruvian economy over the medium term. Solid planning, sound fundamentals and improving terms of trade should help significantly, and Peru continues to have many levers at its disposal to achieve its policy objectives.
Peru’s solid economic agenda and ample tools
Under a special 90-day legislative window granted by parliament last year,President Kuczynski’s government enacted 112 reform decrees that provide asolid framework to support its economic agenda. They include measures tofacilitate infrastructure projects and a revised fiscal law that will allowthe government to pursue slower consolidation and still be bound by a30%-of-GDP public debt limit.
In 2017, the execution of public works and an additional fiscal thrust willprovide important support to the economy. The government recently launcheda fiscal stimulus of close to 1% of GDP. Reconstruction efforts followingthe torrential rains will likely require additional resources (possiblyleading to a wider deficit), and government investment will also be animportant supplement to non-mining private investment, which is expected togrow for the first time in four years. Growth in private consumption shouldfollow, albeit with a lag given the softness in the job market.
Exports should contribute positively to growth this year as the tradebalance reverts to a surplus. The improving terms of trade is an importanttailwind to domestic fundamentals and will likely lead to a smaller currentaccount deficit of about 2.6% of GDP in 2017, more than fully financed byforeign direct investment.
Central bank policy: rate cut possible
Better coordination between fiscal and monetary policies is also likely toserve Peru’s economic agenda well. The Banco Central de Reserva del Peru(BCRP) recently lowered its estimates for growth and raised them for outputgaps in both 2017 and 2018, creating room for more stimulative monetarypolicy. To this end, the BCRP has been lowering reserve requirements, andas long as core inflation remains behaved after the recent shocks, webelieve the BCRP will lower the policy rate.
To anchor inflation, the central bank may allow the sol (PEN) to appreciateoutside of its recent trading range. PEN fundamentals remain strong, andthe currency has lagged improvements in the terms of trade (see chart below). Thecountry’s solid foreign currency reserve position at 32% of GDP should givethe BCRP further confidence.
The central bank is still seeking to control volatility in the currencyamid strong inflows, which may increase further under Peru’s recent taxamnesty law. Continued intervention from the BCRP serves to mitigatevolatility and discourage speculative inflows; it thus also helps keep thePEN below its intrinsic fair value while providing investors withattractive volatility-adjusted yield against other Latin Americancurrencies.
We think Peru’s investment case remains a strong one within emerging marketfixed income. The currency, in particular, remains undervalued, in ourview, and therefore we favor overweighting the currency and investing inlocal currency bonds rather than more fully valued international bonds.
With the steep yield curve in Peru, we think local duration is alsoattractive. Even though damage from the recent floods may drive inflationhigher in the near term, our longer-term expectation is for inflation tosettle in a band around the central bank’s 2% target.