Will Kuczynski unlock Peru’s economic potential?

Will Kuczynski unlock Peru’s economic potential?

Unlike other countries in the region, Peru has been able to absorb external shocks and avoid prolonged economic malaise. However, the old days of the Peruvian Miracle are gone. Will the new president, Pedro Pablo Kuczynski, be able to pass through his ambitious reforms to unlock the country’s economic potential?

Extractive sector impact

The 77-year-old Pedro Pablo Kuczynski’s win over Keiko Fujimori, the leader of the strongest political party in the country, the Fuerza Popular (FP), came mainly thanks to the anti-vote against Fujimori. Ironically, he will have to rely on the support of her party to push forward his reforms. While the Kuczynski program could fix many issues of the Peruvian economy, he will ultimately have to revive the extractive sector.

Despite China’s economic slowdown and US monetary tightening, Peru was able to absorb these external shocks much better than other regional countries. Thanks to its large foreign currency reserves of about USD 60bn accumulated from its peak of metals exports, the country was able to limit the Peruvian sol’s depreciation and inflation.

Still, the economy’s dependency on mainly gold and copper exports did see its GDP decrease by half to 2.4% in 2014, and 3.3% in 2015. This led to the fiscal deficit growing to 2% of the GDP. Soon afterward, a fall in public spending by 6.8% in 2015 halted progress on social development.

This is a crucial area for a country with a 22% nationwide poverty rate that reaches 50% in some provinces. Despite recuperating private investments, trade balance has experienced a 20 percent decrease in the last five years.

Peru’s fiscal deficit as of % of the GPD

Source: Peruvian Central Reserve Bank

Tax burden difficulties

One of the unsurprising changes is an overall decrease of the tax burden, resulting from a 3% cut of the sales tax. Peru has an ineffective tax system, rampant tax evasion, and decreasing tax revenue which shortens its GDP by an estimated 9%. Previous governments could somewhat ignore this fact thanks to the income from commodity exports.

Kuczynski wants to compensate for lower taxes by making tax collection more effective and formalising the large informal sector, that includes 64% of the labour force. The goal is to incentivise small and medium-sized businesses (SMEs) to make their operations legal in exchange for tax amnesty. This, by the campaign’s own estimates, could formalise up to 1.5 million jobs and bring in more tax revenue.

Such initiatives could help tremendously, however they are complex and will take time. So another plan of the administration is to increase the budget deficit ceiling from 2 to 3 percent to boost public spending and stimulate the economy.

However, with the deficit expected to reach 3% in 2016 anyway, there is not much room to work with. Ultimately, Kuczynski will have to rely on a recovery of the extractive industry, something he, as a former mining minister and World Banks mining expert, knows very well.

Peru’s extractive sector is complex and despite its partial recovery the inherent problems remain the same. Months-long unrest, road blockades and deadly protests over the environmental impact and lack of basic social services chronically erupt across rural resource-rich regions. The exploitation of these very same areas helped to create the Peruvian economic miracle; however, most of the riches were centralised in Lima.

Consequently, unrest in the impoverished, but resource-rich regions, combine with complicated regulations, tax codes, and the system of mining permits. This combination has, at times, led to a downturn in commodity prices in Peru’s extractive sector . No one is expecting commodity prices to return to its bonanza of the early 2000s, but efficiency can make up for it.

Future of Kuczynski reforms

Kuczynski’s administration wants to set clear environmental standards and creating a functional political space. This space, in turn, would result in  a dialogue between local communities and government officials in order to limit chronic turmoil in rural areas. Furthermore, his reforms would ensure the funds from mining, now handled only on the provincial level, would be directly spent on projects at local communities where extractive projects take place.

A flexibility of the regulatory framework and of bureaucracy over issuing mining permits could unlock the USD 20bn of unrealised mining projects and bring in much more in the long term.

The main issue is the political viability of these reforms. Kuczynski won’t be able to pass anything without at least a partial support of Fujimori’s FP, who holds 73 seats out of the 130 in the Congress. Kuczynski’s Peruanos Por el Kambio party has 18 and has so far only received the support of a smaller leftist APRA party. His announcement to include both FP and main leftist Frente Amplio party in his cabinet, accompanied by an apology to his election rival for the heated political exchanges during the campaign haven’t been answered yet.

The promised increase of the minimum wage to 850 Peruvian sols on the first day in the office might help PPK with the leftist parties which could object to the tax amnesty or proposed severance pay cuts. His pro-market reforms could, in turn, be favoured by at least some parts of the FP. However, the conservative party will try to dominate his government in order to make a statement early on and force PPK to make many concessions.

What offers another chance for the government is a possible internal split in the FP between Keiko Fujimori and her brother Kenji, who did not vote for her and plans to run for the presidency in 2021. What is certain, however, is that Kuczynski will have to rely on the two strongest political entities in Peru – the Fujimorismo and anti-Fujimorismo – a difficult, but not impossible task. A political paralysis would continue to impede another Peruvian Miracle and could see deepening fiscal deficit and further mediocre economic performance.

Categories: Economics, Latin America

About Author

Petr Bohacek

Petr Bohacek is a Political and Security Risk Analyst for Latin America at Riskline, a travel risk management company. He is also a research fellow at the Association on International Affairs, a Czech think tank, where he publishes and comments on foreign policy in local media. He has previously worked as an analyst at the Czech Ministry of Defense. Petr holds an MA in Security studies from Charles University in Prague, a BA in Political Science from St. Norbert College and studied Latin American politics at Universidad de Buenos Aires and Universidade de Nova Lisboa.