Publish in Perspectives - Monday, May 23, 2016
Pedro Pablo Kuczynski and his running mate, former economy minister Mercedes Aráoz, at a campaign stop. (Photo: PPK)
Investor outlook for Peru and Chile differ.
BY FRANCO UCCELLI
In Peru, there is no easy choice between two market-friendly candidates. Not much difference is seen between Keiko Fujimori and Pedro Pablo Kuczynski (PPK) in terms of their economic policy biases and proposals, but for many the choice between the two candidates will not be easy. While Fujimori has tried to portray herself as the candidate of the poor and PPK as the candidate of the rich, such distinction is described as being politically motivated, with most people seeing only minor differences between the two right-of-center candidates. That said, from a business standpoint, and given that there is no consecutive reelection in Peru and PPK’s advanced age, the ideal outcome would be a PPK victory this time around, followed by a good government that preserves support for the current pro-market economic model, and a Fujimori victory five years later, extending the implementation of the prevailing model for at least 10 more years and hence preventing the emergence of any strong anti-market sentiment. PPK is considered much less political that Fujimori, whose party is viewed by many as more disciplined and cohesive and thus more likely to better control Peru’s social fiber, particularly as it will have a majority in congress (73 of 130 seats). Both Fujimori and PPK’s economic teams are widely regarded as very competent and professional, and much more technical than political in nature.
Fiscal approach may differ, but broad discipline is generally assured. Fujimori and PPK’s approach to fiscal policy is likely to be somewhat different, with Fujimori expected to focus on higher taxes and lower deficits (relative to PPK), and PPK expected to focus on lower taxes and higher deficits (relative to Fujimori). That said, both Fujimori and PPK are seen as likely to relax the current fiscal stance, but there is no clarity on how much. Although a possible increase in the fiscal deficit to 3 percent of GDP through 2019, followed by gradual declines thereafter, has been advocated by PPK’s camp, no official pronouncement on the matter has come from the Fujimori camp. However, with fiscal revenues totaling only around 20 percent of GDP in Peru, compared to 25 percent in the other Pacific Alliance countries (Chile, Colombia, and Mexico), locals believe raising the tax burden should be a top priority of the next government.
Only subtle changes to monetary policy, if any, may be in the cards. Monetary policy is widely expected to stay broadly unchanged, with a high probability that senior officials currently at the helm of the central bank (BCRP) will stay in their posts. This would guarantee monetary and FX policy continuity and eliminate policy uncertainty in the near term, a credit positive. Some of the subtle changes to the current monetary policy framework may include managing FX risk through bank capitalization rather than reserve requirements, making BCRP board terms overlap rather than coincide with presidential terms, and increasing the operational autonomy of the central bank.
Near-term external financing needs are fully covered. The government has pre-financed its 2016 and 2017 external needs, so only some local issuance is yet to be done. Since proceeds have to be earmarked to specific projects, new issuance is not a priority for the outgoing government. That said, the goal to “solarize” the public debt remains in place, so liability management operations are always an option. Moreover, the government would like to deepen local market liquidity, as most domestic investors only buy and hold debt instruments.
Agrarian bonds are a sensitive, but not macro relevant, issue. The controversial agrarian bonds are not seen as a macro relevant issue, but rather only as a sensitive issue for some. The government has yet to issue a decree specifying the mechanism for them to be repaid, but the intent to do so is seemingly there. This will likely follow a decision regarding the proper exchange rate to use to determine their fair value.
CHILE: CONFIDENCE SHOCK NEEDED
In Chile, growth has likely hit bottom, but the pace of recovery is rather uncertain.
While growth has been growing below potential for some time, it is finally expected to pick up in the near term, as the macro adjustment to the recent terms of trade shock has by now been fully internalized. The key lingering risks to stronger growth are a protracted recovery in consumer and business confidence levels, which remain quite low and have undermined investment appetite, and assorted external factors (such as China weakness, US electoral/political noise, and Fed policy indecision), which have combined to generate protracted uncertainty. Growth potential was estimated by an external committee at 3.6 percent last year, but, given current commodity prices and low domestic confidence levels, it is probably only in the 3.0 percent-3.5 percent range. In general, the Chilean economy has probably already hit bottom, but there are mixed views on the pace of recovery. Stronger regional growth would give a significant boost to the Chilean economy.
Confidence shock is much needed, but it may have to wait until after the next election cycle. Recent opinion polls confirm that both the government’s approval rating and overall domestic confidence levels are quite low. While some pundits believe this a transitory phenomenon, others (perhaps most) believe the negative sentiment will likely endure at least until after the next presidential and congressional elections, which are scheduled for November 2017, when a “better” government will be formed. The leading pre-candidates (primaries are not scheduled until July 2017) are two former presidents, Ricardo Lagos (center-left) and Sebastian Piñera (center-right), both of whom are viewed as very viable pro-market alternatives, and therefore likely to be welcomed by the market.
Rate hikes are unlikely in the near term, or are they? Most local pundits believe the BCCh is unlikely to hike rates in the near term, as inflation is slowly declining and is expected to gradually converge to the official 3 percent (+/-1 percent) target over the next 24 months (i.e. the monetary policy horizon). Moreover, growth remains below potential and the recovery needs to firm up before rate hikes become a more viable policy option. The reference rate is currently negative in real terms, but is actually positive (also in real terms) if measured against medium-term inflation expectations. Alternatively, some policy makers believe the reference rate is still below its medium term equilibrium level, which they estimate at 4 percent, and hence further hikes may be likely in the near. While in theory this may indeed be true, the timing of such hikes remains suspect at best, with most people believing they may not take place until sometime next year.
The government’s reform agenda has focused on tax, education, constitutional, and labor issues. The Bachelet administration’s reform agenda is viewed by many as being anti-business, but the government has vehemently insisted that it is far from it and that such view is skewed by political considerations and not an adequate reflection of Chile’s economic reality. Given that reform uncertainty remains a drag, the government has opted to prioritize the following four reforms:
(1) A tax reform intended to simplify the tax structure and increase the tax burden has already been passed.
(2) An education reform intended to make tertiary education free to the poor has been incorporated into the budget, but a permanent law to extend its application beyond this year is still pending.
(3) A constitutional reform, which is still being drafted, will aim to replace the current constitution that dates back to the military regime and is perceived as lacking legitimacy despite having been amended several times. The reform itself will likely not be approved until next year, so uncertainty is apt to remain until then. Proposed constitutional changes require the formal support of two thirds of congress, something that would require sizable consensus building and limit the possibility of introducing any broad changes.
(4) A labor reform, which has generated a lot of noise in the private sector. Even though it was not on the government’s original agenda, there has been a lot of pressure from labor unions to enact it in order to increase their power in labor disputes and conflict resolution. While the reform has already been approved by both the lower house and the senate with some changes, the constitutional court has declared unconstitutional several of its components. As presented, the reform sought to give equal weight to labor unions and non-union bargaining groups, but this article was vetoed by the government.
Improving productivity and infrastructure development are key policy priorities. The government wishes to close the discussion of the labor reform soon to start focusing on an agenda for growth, including steps to improve productivity and develop infrastructure. It is sending bills to congress for this purpose, including the creation of an infrastructure fund and measures to make financing more readily available to companies that export services. The infrastructure fund would operate as a for-profit relatively autonomous company. Its ultimate goal would be to foster infrastructure investment and flexibilize management of concessions. Moreover, the fund would be able to issue debt based on securitization of future cash flows generated by such concessions.
Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on recent trip reports to Peru and Chile. Republished with permission.