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April 3rd 2017

Growth in 2017 will be lower than initially expected

In late February, the Banco Central de Reserva del Perú (the central bank) released expenditure-side
GDP growth figures for 2016. Although the Peruvian economy expanded at a good pace in 2016,
investment and government consumption were lower than expected. The trend has continued into
2017. This, added to the devastation caused by recent natural disasters, makes the outlook for this year
more subdued.

In 2016 the Peruvian economy expanded by 3.9%, a good result and an acceleration from the 3.3% growth
registered in 2015. However, the results also revealed a reliance on the external sector, which provided
3 percentage points to the overall 3.9% result, making it the largest contributor. Given the dependence on
external demand, this puts the sustainability of current growth rates into question. At the same time, the
intensity of the coastal El Niño weather phenomenon has increased markedly since early March, causing
worse than expected destruction of property, loss of life and disruption to economic activity.

Internal demand must recover to sustain growth

Looking at production-side GDP figures, it is clear that most of the growth in 2016 came from mining output,
which expanded by 21% in 2016. Sectors more closely associated with consumption or investment, such as
commerce, services and construction, either contracted or showed sluggish growth. This is supported by the
expenditure-side GDP numbers, which show that internal demand contributed only 0.9 percentage points to
the overall level of growth seen in 2016. However, internal demand behaviour was far from monolithic.
While private consumption expanded by a respectable, if unremarkable, 3.4% in 2016, both private
investment and public demand fell, declining by 6.1% and 0.5% respectively.

The growth performance in 2016 is unlikely to be repeated. Mining output will not post the high growth
numbers of last year, as those results were caused by the culmination of a string of capacity-expanding
investments. No large projects are underway and, even if they were to be undertaken in 2017, they would not
lead to higher production levels until years from now. As such, future GDP growth will depend on an
expansion of domestic demand.

Data on consumption also show a less than encouraging picture: consumer confidence is down to its lowest
point since mid-2015, and the unemployment rate in the capital, Lima, rose to 7.7% in February,
0.8 percentage points above that of a year earlier. A small positive is the pickup in consumer credit, which
has broken a downward trend that began in late 2015, but still only grew by 3% year on year in January.
Private investment, meanwhile, continues to show a negative outlook. In addition to a continued contraction
in capital goods imports, surveys show that business leaders expect a slowdown in economic activity, and an
increasing number plan on delaying investments. Meanwhile, the climate of political instability that has

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descended on the country as a result of the opposition's renewed resistance to the agenda of the president,
Pedro Pablo Kuczynski, will do little to reassure investors.

The hopes for more dynamic domestic demand in 2017 are placed squarely on public expenditure, both
current and capital. After a fiscal consolidation effort that resulted in public expenditure contracting in real
terms, Mr Kuczynski has promised that public expenditure will increase strongly in 2017, declaring a year-
on-year growth target for capital expenditure of 14% (about 11% in real terms). To this end, a fiscal stimulus
plan was announced in mid-March. Its financing, a key aspect to consider when judging its impact on GDP, is
still somewhat murky. Regardless of this, The Economist Intelligence Unit thinks it unlikely that the
government will be unable to hit such high capital expenditure targets. The administration had trouble
pushing through projects in 2016, and this was before the Odebrecht corruption scandal, which has prompted
the opposition to impede the progress of projects in the interest of investigating potential corruption.
This unstable environment around public works will also harm private investment, as most large public
projects are undertaken with private firms in public private partnership schemes.

The coastal El Niño presents another setback

A weather phenomenon known as the coastal El Niño, which has brought heavier-than-normal rains and
flooding to coastal areas of Peru, has been affecting Peru since mid-February. The phenomenon started
unremarkably, but gained intensity after early March, and has subsequently been upgraded in both its
categorisation and its expected duration; authorities now expect it to last until at least mid-April. So far, there
have not been any final official estimates on the overall economic damage, but we expect this to be
considerable.

On March 23rd the Ministry of Agriculture announced that 8,600 ha of cultivated land has so far been
completely destroyed (compared with less than 300 ha in last year's rainy season), which will have an effect
on agricultural exports and food prices. Fishing and associated manufacturing activities, which showed the
only obvious growth in their respective sectors, will see production downturns, as the cause of El Niño is
high sea temperatures, which reduces ocean biomass levels. The rains have also caused considerable damage
to infrastructure, with at least 225 collapsed bridges and 3,290 km of damaged roads resulting from wet
weather. Destruction of infrastructure will undoubtedly affect both the commerce and transportation sectors.
Finally, mining exports will also suffer, as key routes for the transport of minerals have been damaged. For
instance, the main railroad used by mining companies that have operations in the centre of the nation will be
out of service until late April.

The extreme weather will provide a considerable test of Mr Kuczynski's administrative and political acumen.
So far most criticisms that have been levelled at Mr Kuczynski have been political in nature—the
implementation, prioritisation and success of the relief efforts have not drawn any serious criticism from the
opposition. However, Mr Kuczynski is in a position of political weakness. His popularity is at an all-time low
of around 30%, corruption scandals surround him and his party only holds 17 of 130 seats in the unicameral
congress (the main opposition party, the right-wing Fuerza Popular, holds 72). The way that Mr Kuczynski
handles the disaster and the opposition criticism will determine both his popularity and his negotiating
position with his political opponents.

All signs point towards lower growth

Even in the absence of the coastal El Niño, economic indicators point towards even more sluggish private
demand in 2017. The administration recognises this, and is pinning its hopes for dynamic GDP expansion on
strong public capital expenditure growth while, at least publicly, maintaining a non-financial public sector

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deficit target of 2.5% of GDP for 2017. However, we believe that the government will face significant
roadblocks that will prevent it from fully achieving the planned expenditure increase.

As a result of this combination of higher expenditure and lower economic dynamism in the context of the
natural disaster, we will be revising our 2017 growth forecast downwards from 3.5% and increasing our
public deficit forecast from its current level of 2.6% of GDP.

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