Peru’s debt rating moved a notch to investment-grade Two rating agencies, the US agency Fitch Ratings and

the Dominion Bond Rating Service (DBRS) from Canada, awarded Peru with the investment grade on April 2 this year and last October, respectively. S&P would be the third rating agency if it assigned the investment grade as anticipated this month. Currently, the rating issued by S&P is BB+ with positive perspective, very close to investment grade. The rating agency said that the outlook for Peru is positive, based on the country’s strengthening economic, fiscal, and external factors, despite the fragility its social and political environment. Further, it said that although political risk is a negative factor in the Peruvian government’s credit profile, it is not a binding constraint on Peru’s rating. Sebastian Briozzo, an analyst at S&P in New York commented that Peru was on the right track, and had to reduce the social conflict between the rich and the poor, to take the next step to investment upgrade. Moody’s on the other hand, lingers with its Ba2 rating as it seems to focus on the relative restrictions of the foreign currency debt burden and the degree of dollarization. Fitch Ratings is the first major credit rating agency to raise Peru’s longterm foreign currency issuer default rating to BBB- with stable outlook, an investment grade, from BB+, citing strong improvement in fiscal and external solvency ratios. It has upgraded Peru to due to the 71 months of continuous growth despite an unfavorable international economic environment, and has highlighted an budding structural shift in the drivers of Peru’s economic growth,

saying that non-primary sectors now generate the most dynamic growth rates. Public finances have been buoyed by high commodity prices and the strength of the economy. The country has managed to keep inflation low and improved its government debt burden relative to peers. The Garcia administration has resisted current spending pressures and has used commodity windfall to invest in infrastructure, pay down public debt and increase assets.

Great expectations Debt markets play an important role in any economy as they provide economic agents with alternative options to banking for allocating their savings efficiently or for financing needs at favorable terms. Foreign capital flows represent an important source of financing for economic growth in most emerging markets. In this light, sovereign credit ratings play a critical part in determining a country’s access to international capital markets, and the terms of that access. Sovereign ratings help to foster dynamic growth, stability, and efficiency of international and domestic markets. It permits the country to get foreign funding under better terms, as the risk premium developing countries have to pay for their higher default probability and bad credit track record falls. It also helps to generate a better business environment, because it permits to increase credibility in foreign investors concerning their investments in a rated country. It also invites investors to make more long-term investments, because they can base their expectations on certainty that debtor country can be punctual in its obligations.

Generally, investment can be done in three ways: portfolio equity investment, portfolio debt investment, and foreign direct investment. FDI is considered as the most beneficial to a country. When offshore money moves into a country via stocks or bonds, it’s relatively easy for capital to move out again. But FDI money is there for the long term and is more stable by nature. The increased role of FDI in developing and emerging economies has raised expectations about its potential contribution to their development. FDI can bring significant benefits by creating high quality jobs, positive wage effects, knowledge spillovers, and introducing modern production and management practices. An investment-grade rating for Peru should attract new fixed income flows, as well as equity flows, into the market. Peru’s currency is also likely to receive a strong boost from the move initiated by Fitch’s.

Show me the money Investment decisions are not made in a sterile, isolated environment. Many investors rely on ratings opinions. Credit rating agencies play a significant role in evaluating and disseminating information on risk characteristics. The overall quality of the work done by rating agencies may be evaluated by their acceptance in the business and academic community. Their work is respected and well-received. Credit ratings are referred to in various regulatory and supervisory frameworks both at the international level and national level.

Rating agencies base their assessment on quantitative (macroeconomic variables) and qualitative indicators (political and institutional risks). The widelyknown among world-class firms devoted to rating credit risk for each country are S&P, Fitch Ratings, and Moody’s. Investment grade is the passing mark awarded by risk rating agencies to a country based on debt considerations. The agencies trust the debtor country will timely honor its liabilities. Having the investment grade is important because it shows a country has given signs of economic health and sufficient reliability for investors. The level of interest payment on debt is inversed to the quality rating. The spread between the yields changes from time to time and is closely monitored by the financial community as a barometer of future movements in the financial markets. A relatively small spread between two rating categories would indicate that investors generally have confidence in the economy. As the yield spreads widen between higher and lower rating categories, this may indicate loss of confidence. Investors are demanding increasingly higher yields for lower rated bonds or other debt instruments. Their loss of confidence indicates they will demand progressively higher returns for taking risks. Investor confidence depends in part on efficacy of policies and government economic management. If the country has the ability to honor its debt, it can benefit from investment, particularly from foreigners, as capital remains critical to future growth. Being a net importer of capital, foreign and domestic investment could be the solution for permanent growth in the Latin American region.

Peruvian economic leaders expect that this investment category would attract cheaper capital and would bring in more foreign investments to the country that would create more jobs and livelihood opportunities. If considered together with the implementation of the FTA between Peru and US and other important trade partners such as China and European Union, the investment upgrade would help sustain economic growth which was fueled by a period of historically high profits from strong demand for minerals and metals. The ratings upgrade would have a positive impact on the local economy. It would allow more pension funds and insurers to buy Peru’s debt, driving the spread down, and should boost the local stock market and the local currency in the short term. A decline in the dollar cost of capital will benefit Peruvian equities. Currently at 5.96 percent, it will likely come down further to 5.5 percent over time, closing in on investment-grade Mexico’s dollar cost of capital at 5.31 percent. Peru has a comparatively small and inactive stock market. The Peruvian index is dominated by Compaña de Minas Buenaventura (BVN), the largest publicly-traded precious metals company in Peru. About 80 percent of MSCI Peru consists of the materials sector and about 20 percent is made up of financials, such as Creditcorp Ltd. (BAP). In the medium to long term, domestic demand will be benefit from higher private investment and the improvement in Peru’s financial channels. Already, banks, like RBOS, are taking position in the country. The continuation of high, broad-based economic growth and a solid fiscal position should alleviate Peru’s vulnerability to a commodity price shock and sudden stop of capital flows.

As good as it gets For the first time in its history, Peru has ranked 35th in the Global Competitiveness Index, issued for 20 years now by the IMD’s World Competitiveness Center, the first business school in Europe (Forbes, 2007). Being included in the ranking’s measurement done by IMD, mandatory source of consultation for governments and investors, dares Peru to improve such evaluation through market development, attracting direct foreign investment, developing infrastructure, and above all, fostering Peruvian’s well-being. IMD evaluates four main factors for its Global Competitiveness Index, and Peru obtained the following qualifications. Peru bagged the 14th place in economic performance (among the 55 countries), ranking first in the Latin-American region, ahead of countries like Mexico, Brazil and Chile. The result still reflects the period of sustained economic growth the Peruvian country is experiencing up to the first semester of 2008, yet price remains stable as inflation is one of the lowest worldwide. In government efficiency, Peru was 15th Place. Its management of public finances was its best relative indicator. Garcia’s administration’s policy responses not only have been acquiring fiscal surpluses, but also mounting up higher international reserves, therefore fortifying the country’s foreign exchange position. In business efficiency, Peru was 47th place, behind Chile and Brazil. Business productivity and efficiency was the weakest point and its best indicator

was the labor market. The result reflects the general dynamics of employment regarding companies of all sizes. In infrastructure, Peru ranked 52; this is clear evidence that investment gap exists. All in all, the factor that had thrown in most weight to Peru's ranking was economic performance. The improvements on the Peruvian macroeconomic condition would indicate that the country could have the resiliency to weather external shocks like a commodity price drop or demand drop and sudden stop of capital flows due to uncertainty of world economic activity and international credit crisis. The IMF staff mission led by Martin Cerisola visited Peru in May and held discussions on the third review under Peru’s 25-month Stand-By Arrangement (SBA), which the authorities are treating as precautionary, for SDR 172.37 million that was approved by the IMF’s Executive Board on January 26, 2007. The completion of the second review was requested by Luis Carranza, Peru’s Minister of Economy and Finance and Julio Velarde, President of Central Bank of Peru in December in light of the strong performance under the program and the important progress being made in the structural reform agenda. In the statement issued by the IMF mission, it says that the outlook for Peru for the remainder of 2008 is favorable, despite the uncertain growth prospects and inflation pressures in the world economy. Moreover, it claims that the mission is encouraged by the authorities’ firm commitment to maintaining macroeconomic stability.

Feeling left out The resource-rich Peru is the world’s second biggest producer of silver, the third biggest producer of zinc and copper, and the fourth biggest producer of lead. Considering the Peruvian positive perspective and the better than expected economic results registered in the most recent years, specifically the six-year minerals and metals boom, it is noteworthy that its population remains largely poor. The economic growth is not reaching everyone. Cut off from the market economy, poverty remains stubbornly high in rural areas at 65 percent. Many Peruvians still labor in the informal sector of unregistered businesses where productivity is low and wages for the unskilled have been slow to rise. Peruvian workers and farmers have marched in Lima against García, whose free-market policies, they say, have failed to benefit the poor during the six-years of booming economic growth. García has said free trade will help lift incomes. Protesters demand that government do more to spread the Andean country’s new wealth to workers and the poor. For almost two weeks now, mining unions have been on strike, hoping to pressure Congress to pass a bill that would eliminate caps on profit sharing so workers can benefit more from sky-high metal prices. Mine workers claim that they are not getting a fair share of the boom. Farmers also join the series of protests, saying they are frustrated by the rising cost of living, want debt relief, and object to the free-trade deal with the US

that will make their produce compete with imports of subsidized agricultural goods in the local markets. Given that one-half of its population living in poverty Peru has a long way to go in terms of reducing poverty and inequality. The government has set an ambitious target of cutting poverty to 30 percent at the end of its term in 2011. The extra revenue provided by strong cash flow of economic growth will García room to implement his promised policies to reduce social inequality, but will also inflate expectations. Within the constraints of sustaining fiscal stability, he will attempt to reduce inequalities by increasing public investment in basic infrastructure. But the results of these initiatives will take time, and may be not enough even then. Structural reforms are of great importance as the country’s institutional framework is somewhat problematic. Public institutions remain ineffectual, and the managerial capacity in the public sector is inferior. The country is also rife with corruption and lack of transparency problems. Money for public investment in roads or to aid farmers lies unspent at all levels of government, partly because of fears of corruption. The people’s lack of faith in its own institutions poses a serious threat to the policy framework. Potential social and political instability are constant risks. If García’s popularity recedes even further, because of failure to deliver his highly publicized "investment shock" to reduce poverty and inequality, or an economic downturn due to deterioration in external conditions, it would provoke deepening of social

divisions and heat up discontent among those who feel left out. This could undermine his ability to govern and sustain current policies, and tempt Garcia, whose approval rating is 30 percent, to adopt more populist solutions. Investors worry that high poverty could pave the way for a leftist leader to win the presidency in 2011; this could reverse the pro-business programs of Garcia. García tells reporters that protests won’t improve the economic situation; rather, they could scare away foreign investors, who he believes have helped transform Peru into an Andean tiger. The country’s endowment of mineral deposits makes it very attractive to investors; what’s repulsive is the political instability engendered by insidious poverty brought about by social and development gaps. To retain its investment-grade status Peru must be able to further reduce net public external debt; show evidence that Peru can maintain prudent macroeconomic management even through an economic down cycle; push for a deepening of fiscal reforms to widen the tax base and strengthening of political institutions; press on economic and export diversification; and demonstrate steady progress in bridging the large social and development gaps in Peruvian society. 30 Submitted by Kosh for quarterly report July 10, 2008