Peru: Mid-Year Update

Once mired in poverty, Peru is one of the shining stars of Latin America. The Peruvian economy expanded 7.3% y/y in April, and it should finish the year with a GDP growth rate of 7.5% y/y. In addition to strong export growth, domestic demand is coming on line. Construction and retail sales are expected to grow more than 8% y/y in 2007. Meanwhile, exports will increase 11% y/y. Peru’s exports are expected to total $27 billion this year, producing a trade surplus of $8.4 billion. The increase in domestic demand is putting upward pressure on consumer prices. Nevertheless, inflation remains under control. The Peruvian central bank expects the year-end inflation rate to be slightly above 2%, versus 1.14% in 2006. Strong export earnings and capital inflows allowed the Peruvian sol to appreciate 1% year-to-date, in spite of central bank intervention. International reserves rose $4.5 billion since the start of the year. Peru is a shining example of what happens when a country focuses on its areas of comparative advantage.

Once considered to be one of the poorest countries in Latin America, Peru is now a net creditor. At the end of May, Peru had $21.3 billion in international reserves versus a foreign debt stock of $21.5 billion. Since then, the accumulation of reserves put the country in a creditor position. The Peruvian authorities are using their windfall to reduce their external obligations. Last month, the Peruvian government reached an agreement with the Paris Club to prepay $2.6 billion of the outstanding $5.6 billion debt stock. The government is also shifting more of its obligations onshore, reducing its external liabilities. All of these factors are the reasons why Peru is one of the best candidates in the region for elevation into the investment grade club. With a rating of BB+/Ba3, Peru should vaunt into the inner circle by the end of this year.

Interestingly, the Peruvians are using their new-found clout to settle some of their old scores. President Alan Garcia is pushing hard for a redefinition of the border it shares with Chile. The grudge comes from the War of the Pacific, almost 130 years ago, when Chile took on Peru and Bolivia. The war began when the Bolivian government decided to arbitrarily increase taxes and royalties on mining concessions that were being operated by Chilean companies on Bolivian territory. The Chileans retaliated by deploying troops to protect the miners, but Bolivia saw the military incursion as an act of war. Peru and Bolivia had a secret defense pact, and the onset of war brought the three countries into direct conflict. The Chilean Navy eventually gained the supremacy of the seas, allowing its land forces to advance deep into Peruvian territory. Bolivia quickly retired from the conflict, but the Chilean forces sacked and occupied Lima. In the end, a bloody guerilla war in the Peruvian sierra forced the Chileans to retreat. However, Bolivia lost its access to the sea and Peru lost much of its southern territory. Chile also became the dominant power on the Pacific coast, knocking out its northern rival for the rest of the 19th and 20th centuries.

Today, the rise of the Peruvian economy is putting the territorial issue back on the table. Ever since coming into office, President Garcia hammered away at the Chileans. The Peruvian military also started a modernization of its equipment, and Lima is bringing the case to the World Court at The Hague. The Chileans have softly, but forcefully, rebutted the advances. The disputed regions contain large mineral deposits and lucrative mining operations. Nevertheless, the growing prosperity in Peru is bringing some of the lingering feuds back into the open.