Interview with President of the Central Reserve Bank of Peru, Julio Velarde

Peru proved surprisingly resilient during the commodity slowdown and economic growth is now picking up speed; what has driven this performance?

Julio Velarde: GDP growth in Peru accelerated from 1.9% in 2015Q1 to 4.4% in the third quarter of 2016, driven mainly by the expansion of the mining sector, which grew 16% in 2015 and 23.5% as of September 2016. As a result, the mining sector contributed 1.3% to growth in 2015 and we expect this contribution to reach 0.7% in 2016. In the last two years, new projects, such as Toromocho and Las Bambas, contributed to expand copper production from 1.3 million tonnes in 2014 to 2.3 million tonnes in 2016.

In addition, consumption, which accounts for 64% of GDP, grew 3.4% in 2015, and we expect it to reach 3.5% in 2016, supported by a resilient labour market and easing credit conditions. During this period, monetary policy remained expansionary, as real interest rate remained below its estimated natural level of 2%, and consumer credit grew at 12% in 2015 and around 8% this year, above the pace of expansion of nominal GDP. Employment continues to grow, particularly in the service sector, at a pace of 4.6% during the last year, contributing to sustained labour income (which during the last quarter expanded by 5.8 % in annual terms).

"Employment continues to grow, particularly in the service sector…"

For the next two years, we expect the economy to continue gaining momentum and growing above 4%, driven by a faster expansion of private and public investment, which we expect to benefit both from the rebound in mining prices and higher investor confidence.

Is the worst of the commodity slowdown now behind Peru?

JV: Our baseline scenario considers a recovery of Peru’s terms of trade of 3.9% in 2017, consistent with a more balanced global market for minerals. In the case of copper, we expected the demand from China to remain strong, as investment in infrastructure and real estate are likely to continue to grow.

During the last few years Peru’s economy benefited from huge new mining projects coming online; are you worried about the gap in the pipeline for similar projects over the next few years?

JV: We expect investment in mining to continue growing in the coming years, although at a slower pace. For the next two years, we expect 27 new mining projects, representing an investment of around $6billion. As social unrest associated with mining projects dissipates, we see a faster rebound in mining investments as a likely scenario. If the latter is to materialise, it is critical to promote stronger relationships between mining companies and the communities in the area where the projects are developed. This will boost investment in the sector and secure a recovery in business confidence.

Peru has strong growth potential in other areas besides mining. We expect infrastructure development through PPPs to reach over $13billion in the coming five years; and new irrigation projects, which will expand agricultural lands for export production by more than 150 thousand hectares, will provide additional momentum.

To what extent has Peru managed to diversify its economy away from mining and how far do you see this trend of diversification continuing?

JV: We have experienced an important push towards diversification of productive and export sectors away from mining. Non-traditional exports have been increasing in the last 10 years, with 638 new products in the export basket. Furthermore, our trade partners increased from 173 in 2004 to 184 in 2014, while the number of export companies increased by 2,799 in the same period. We expect this trend to continue, especially in an environment where resources experience a reallocation between sectors, as traditional exports, such as mining, become less profitable.

For instance, the structure of Peruvian exports as of today shows that one-third comes from industrial products (namely textiles, wood and furniture, chemicals, and agricultural and seafood products, including vegetables, fruit, cereals, shellfish, and frozen fish). In comparison, industrial goods accounted for only 25% of total exports in 2005.

This trend is also consistent with an increasing diversification of Peru’s industrial exports. From 2005 to 2015, the number of industrial items climbed from 4,000 to 4,445. Likewise, the number of export destinations for these goods increased from 148 to 157 over the same period. In contrast, the number of export destinations for commodity products declined from 29 in 2005 to 26 in 2015; and the number of commodity items remained below one hundred

The composition of the workforce by industry also reflects the diversification of the economy. Recent figures show that the percentage of mining workers remains at nearly 1% of the overall labour force (between 2004 and 2014), whereas the share of construction workers skyrocketed (from 3.7% to 6.5%) and employment in service activities increased from 21.9% to 24.4% over the same period. Moreover, the share of mining in GDP has declined in real terms from 15.8% in 2005 to 12.4% in 2015.

We also expect the process to continue in the future through the passing of new legislation for facilitating activities such as aquaculture, forestry, and agriculture, together with a greater emphasis on R&D. The new legislation for aquaculture defines three levels: subsistence, micro and small enterprises, and medium and large enterprises. Additionally, the authorities have introduced a new framework for governing forestry and wildlife activities; and incentives (such as tax exemptions, higher depreciation, and a special labour regime) are now in place to promote the development of private plantations. Finally, new legislation establishes tax benefits up to 175% for R&D expenditure (or 1,335 tax units, currently equivalent to $1.7million) developed by firms in association with local researchers.

Despite many attempts, Peru has been unable to reduce its infrastructure deficit; are you optimistic that this government will have more success?

JV: The government has shown a strong commitment to bridge the infrastructure deficit. It has recently announced the reduction of the current gaps in basic infrastructure, such as for water and electricity supply, as one its top priorities; and it has introduced a reform of the public investment system. The latter’s main objective is to expedite the process for completing feasibility studies and securing a timely entitlement of the areas were operations will take place. It also seeks to ensure that the objectives of public investment are consistent with the government’s priorities. Along these lines, the new authorities have announced a plan to “unblock” infrastructure projects for $18.8billion.

In our view, the impact of a surge in public investment can be significant due to the high multiplier effects this type of spending has on aggregate demand. Our growth forecast for 2017 (4.3%) include an important increase in investment flows from these projects.

However, there is still uncertainty about the actual timing and magnitude of the flows that the “unblocking” process could promote.

Peru has low levels of sovereign debt, should the country increase its borrowing?

JV: Peru has one of the lowest levels of public debt in the region. This is a major strength in any economy, and for a small open commodity-producer economy like Peru, it is of paramount importance, given the volatility of our terms of trade and the pro-cyclicality of international capital flows.

The net debt (currently 9% of GDP) will likely reach 13.6% of GDP by the end of 2018 due to a boost in public investment. However, at the same time, the government has announced a smooth path for reducing the budget deficit as a percentage of GDP, from 3% in 2016 to 1% in 2021. This will ensure that public debt will remain below the limit of 30% of GDP established by the Fiscal Responsibility Law. The authorities are aware that Peru needs to spend more in infrastructure and education. In the short run, the government can obtain resources for these purposes from the private sector using PPPs actively. In the longer term, as the economy grows and the formal sector expands, higher permanent tax revenues will be available to finance these needs.