Peru Central Bank Still Easing as Political Risks Rise

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Peru’s central bank meets today and is expected to cut rates 25 bp to 2.75%.  Yet political risk remains high even as the economy suffers from the ripple effects of the corruption scandals in the construction sector. 

POLITICAL OUTLOOK

President Kuczynski faces the prospect of another no confidence motion.  The Popular Force (PF) has just signed on to the motion made by the New Peru and Broad Front parties to launch a new impeachment motion due to new evidence.  Led by Keiko Fujimori, PF no longer has a majority in parliament and so must rely on other opposition parties for support.

Kuczynski remains under pressure.  His approval rating fell to 17% from 22% last month, while those in favor of him resigning rose to 63% from 55%.  62% said Kuczynski has been deeply compromised by recent testimony by former Odebrecht representative Jorge Barata.  Barata said under questioning by Brazilian prosecutors that his company had financed the electoral campaigns of Kuczynski and three of his predecessors.

Other politicians have been implicated too.  Barata said Odebrecht donated millions of dollars to the campaigns of at least six Peru politicians between 2006-2013, including opposition leader Keiko Fujimori.  Her popularity fell to 24% from 29% previously.  On the other hand, support rose for Veronika Mendoza (24% from 18%), Kenji Fujimori (34% from 33%), Julio Guzman (30% from 26%), and Alfredo Barnechea (29% from 21%).

Congress voted not to impeach President Kuczynski in December.  The vote was 78-19 with 21 abstentions.  After the failed vote, PF expelled Kenji Fujimori (Keiko’s brother) and two of his allies, while seven more resigned.  These ten had abstained from the vote, ostensibly in exchange for a pardon for his father and former President Alberto Fujimori, who is now a free man.

Municipal and regional elections will be held in October.  Parliamentary and presidential elections are scheduled for mid-2021, but could be brought forward.  2016 runner -up Keiko Fujimori is likely to run for president again.  An independent bid from Kenji also seems likely after his split from PF.  Mendoza of the left-wing NP came in third in the first round of the 2016 presidential vote, and so she too may run again.

Peru scores well in the World Bank’s Ease of Doing Business rankings (58 out of 190).  The best components are getting credit and registering property, while the worst are paying taxes and starting a business.  Peru does slightly worse in Transparency International’s Corruption Perceptions Index (96 out of 180) and tied with Brazil, Colombia, Indonesia, Panama, Thailand, and Zambia.

ECONOMIC OUTLOOK

The economy is slowing.  GDP growth is forecast by the IMF at 3.8% in 2018, up from 2.5% in 2017.  GDP rose 2.2% y/y in Q4, the slowest rate since Q1 2015.  The ongoing corruption scandal in the construction sector has halted projects worth billions of dollars.  Given this hit to infrastructure spending, we see downside risks to the growth forecast.  Indeed, some estimate that the impact shaved as much as 1.5 percentage points off GDP growth last year, and that it could shave off another percentage point this year.

Price pressures remain low, with CPI inflation at 1.2% y/y in February.  This is the lowest since May 2010 and close to the bottom of the 1-3% target range.  Core inflation is also at a cycle low of 2% y/y, and WPI inflation just moved back into positive territory (0.6% y/y) after three straight months of deflationary readings.  This argues for loose monetary policy.

The central bank meets today and is expected to cut rates 25 bp to 2.75%.  The bank has been cutting rates every other month, which points to a 25 bp cut to 2.75% after it stood pat in February.  After today, the next policy meetings are April 12, May 10, June 7, and July 12.  We see another 25 bp cut at the May meeting, but what happens in H2 will be data dependent as the bank is seen nearing the end of the easing cycle.

The fiscal outlook is worsening despite rising commodity prices.  The nominal budget deficit widened to an estimated -3.1% of GDP in 2017, and is expected to rise further to -3.4% in 2018 before narrowing to -3.0% in 2019.  Much will depend on metals prices, as copper and gold account for a large part of the government’s revenues.

The external accounts are deteriorating.  The current account was an estimated -1.3% of GDP in 2017, the smallest annual deficit since 2009.  The IMF expects the deficit to widen to -1.6% of GDP in 2018.  Higher commodity prices should help exports, but this will be offset by stronger imports as growth picks up.

Foreign reserves remain near record highs.  Gross reserves were $63.7 bln in February, down slightly from the all-time high of $64.4 bln in January.  They cover nearly 15 months of imports and are about 9 times the stock of short-term external debt.  As such, external vulnerabilities are extremely low.

INVESTMENT OUTLOOK

The sol continues to underperform.  In 2017, PEN rose 4% vs. USD and was ahead of only the worst EM performer ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), PHP (-0.5%), and COP (+0.5%).  So far in 2018, PEN is -0.5% and is ahead of only the worst performers ARS (-8.5%), PHP (-4%), INR (-2%), IDR (-1.5%), and TRY (-1%).  Our EM FX model shows the sol to have VERY STRONG fundamentals, and so this underperformance should ebb.

Peruvian equities are outperforming after a solid 2017.  In 2017, MSCI Peru was up 33% vs.  34% for MSCI EM.  So far this year, MSCI Peru is up 8% YTD and compares to 3.5% YTD for MSCI EM.  This outperformance should ebb, as our EM Equity model has Peru at an UNDERWEIGHT position.

Peruvian bonds have outperformed.  The yield on 10-year local currency government bonds is -37 bp YTD.  This is behind only the best EM performers Egypt (-112 bp), Brazil (-78 bp), Russia (-53 bp), and South Africa (-47 bp).  With inflation likely to remain low and the central bank in dovish mode, we think Peruvian bonds will continue to underperform.

Our own sovereign ratings model shows Peru’s implied rating steady at BBB+/Baa1/BBB+.  As a major copper exporter, the fall in prices fed through into weaker fundamentals.  However, the outlook has improved and actual ratings of BBB+/A3/BBB+ appear to be largely on target.