PERU



PERU

The future leader of emerging markets? An analysis of the Paradox of Plenty.

Christine Fischer

Global Financial Markets

April 26, 2011

As the world continues to fight the global economic downturn amid increasingly volatile markets, a growing number of investors are looking to emerging economies to diversify their portfolios and achieve stronger returns. Investing in emerging markets is not a recent phenomenon, but the scope of developing economies that investors are exploring is a new and flourishing trend. The BRIC nations were the trailblazers of the emerging markets movement, but due to their popularity throughout the past decade these economies have become over invested and overheated. Investors are thus searching for the next-generation of prosperous emerging nations.

One country that is increasing its international profile is Peru. A commodity rich nation with a burgeoning economy, strong fiscal credentials, and a growing presence in the global trade arena, Peru has the potential to be a future leader of the emerging markets realm. But like all developing economies, there are fundamental economic and sovereign concerns that must be analyzed in order to determine whether Peru is a viable investment prospect. This paper seeks to establish a critical analysis of investing in Peru, ultimately concluding the optimal degree of Peruvian assets one should hold in their portfolio.

Peru has experienced a dramatic evolution in its political, economic, and social condition over the past 30 years. Following a decade of rampant economic strife, environmental catastrophes, and paralyzing narco-terrorism, Peru emerged from the 1980’s desperate for reform. With the election of Alberto Fujimori in 1990, Peru began a complete restructuring of its economic landscape. Crippled by hyperinflation of 7,650% in 1990, Fujimori swiftly implemented a series of radical economic reforms that permanently shifted the government’s role from over-regulator to private sector promoter.[1] The redefinition of the state’s role was solidified in the 1993 Constitution, which explicitly defined the subsidiary role of the government in economic activity, restricting its involvement only to times of market failure. In an effort to attract foreign and domestic investment, state-owned companies were privatized, investment barriers were removed, and public finances were restructured. The impact of these reforms were felt immediately, with inflation dropping to 139% within a year of Fujimori’s election.[2]

Though Fujimori was successfully tackling Peru’s economic hardships, his means for doing so were often less than democratic. When faced with opposition to his economic proposals, Fujimori dissolved the Congress in an “auto-coup” that produced the 1993 Constitution. When new congressional elections were held, a suspicious majority of Fujimori supporters were elected to office, allowing him to govern unimpeded. One of Fujimori’s most controversial acts was the dirty-war he waged against narco-terrorist groups Shining Path and MRTA. Though the conflict successfully defeated the insurgents, accusations of human rights violations throughout the operations were extensive.[3]

Following a questionable third-term victory in June 2000, Fujimori fled to Japan, taking with him an alleged $600 million of Peruvian assets.[4] Though his leadership established the open-market economy Peru enjoys today, as well as largely quelled the country’s once pervasive narco-terrorism plight, Fujimori’s blatant criminal activity while in office could not go unanswered. In 2007 Fujimori was extradited to Peru, where he was tried and convicted of embezzlement, abuse of power, corruption, and violations of human rights. He is currently serving more than 30 years in prison. Fujimori’s right-hand man, then national security advisor Vladimiro Montesino, is also serving a lengthy sentence for corruption, murder, and arms smuggling. In the wake of the Fujimori and Montesino era, over 1,800 individuals have been indicted on various charges of corruption and abuse of power.[5]

While the efforts to prosecute Fujimori and his constituents show a distinct effort by the government to re-establish its legitimacy, Peruvian’s remain highly sensitized to political corruption. As we will see, disillusionment with authorities can result in a loss of faith in liberalizing reforms and facilitate the rise of charismatic liberals with socialist intentions.

While fears of corruption have not yet been eradicated, the economic strides Peru has made in the 21st century are helping to marginalize political concerns. The Foreign Investment Law established in 1991 has made the country a desirable outlet for foreign direct investment (FDI). Along with allowances for automatic investment authorization and national treatment of foreign investors, the Foreign Investment Law provides no barriers to profit remittances or capital repatriation. By accommodating profit remittances, multinational corporations can freely flow the profits generated from its Peruvian subsidiaries back to their country of origin. Similarly, unlimited capital repatriation allows for the unrestricted transfer of company money or property from Peru back to the parent country, a contingency that embodies Peru’s respect for the discretionary needs of its trading partners. In 2002 Peru expanded its commitment to the promotion of FDI through the creation of the Peruvian Investment Promotion Agency (Proinversion). In cooperation with the government, Proinversion seeks to negotiate international investment accords, including bilateral investment treaties (BITs) and free trade agreements (FTAs).[6] Both of these platforms have established a comprehensive Peruvian economic and commercial policy that encourages the creation of employment, technology transfer, and the growth of trade.

Between 1992 – 2001 Peru attracted almost $17 billion in FDI. Since the creation of Proinversion, FDI growth has been explosive. Peru’s Central Bank reported that FDI totaled $37 billion in 2010, and it is expected to grow to almost $50 billion by 2015. [7] The United States is Peru’s largest foreign investor, contributing $6.7 billion in FDI in 2010 alone. Peru’s aggressive trade policy has facilitated this impressive FDI expansion. FTAs with the world’s most powerful economies, among them the US, China, EU, Canada, and South Korea, have reinforced Peru’s credibility as a profitable and stable investment haven. Though there are moderate levels of investment channeled into service industries and telecommunications, FDI is primarily geared towards Peru’s strongest economic sector; its commodities oriented industries.

Peru is endowed with a remarkable scale of natural resources. Due to its unique topography, Peru is home to nearly all of the planet’s climates, producing a multifaceted, commodity-rich landscape. Peru has a significant export market in agricultural products, particularly coffee, asparagus, and paprika. While these crops accounted for 12% of total exports in 2010, the majority of Peru’s agricultural potential has largely remained untapped. Peru is the third largest country in South America, with 7.6 million hectares of agriculture potential but only 3.6 million hectares in use.[8] The country cultivates a diverse array of products beyond its primary food exports, including rice, potatoes, and corn. With a rapidly growing world population and the inherent variability of weather patterns, the need for sustainable food resources has never been greater. The demand for starches is particularly profound, as they are the primary carbohydrate consumed worldwide.[9] Peru’s agriculture industry thus presents an aggressive investment opportunity.

Supported by a grant from the Inter-American Development Bank (IDB), Peru’s Agricultural Health Service (AHS) has been producing sterile male fruit flies which they release intro rural, agrarian areas. Fruit flies are one of the greatest threats to crop production, making their eradication a necessary step in increasing the profitability of the Peruvian agricultural market. Currently fruit flies have been completely eradicated on the southern coast, resulting in an 18% increase in production and a 19% - 41% growth in income for local farmers.[10] The project is now moving into its second phase, with sterile fruit flies being released throughout the country’s northern provinces. The AHS anticipates that phase two will mimic the resounding success of the first installment.

One unexpected benefit from the fruit fly extinction is that nearly 88% of the country is free of foot-and-mouth disease, a success that will undoubtedly bolster the nation’s growing beef industry. As Peru expands the use of its available hectares and as infectious threats to agriculture are eliminated, the outlook for the industry is extremely favorable. Reinforced by the success of the fruit fly initiative, IDB has begun to finance land reform projects that regularize land tenure and provide legal certainty over property ownership. Security of private property is a critical tenement of stable capitalist economies and is a promising development for the Peruvian workforce, a third of which is employed by the agricultural sector.[11] Peruvian food companies such as Alicorp (ALICORC1:PE) and Casa Grande (CASAGRC1:PE) have performed strongly since 2008. While these companies have exhibited a recent downward trend, political uncertainty surrounding the current Presidential elections is a key contributor to this movement. While in the short-term these stocks will likely continue to fluctuate until a President is elected, the long-term prospects for these equities is extremely bullish.

Much of Peru’s economic expansion is accredited to its concentration in the commodities market, and none has made a greater contribution to this growth than the metals industry. Peru is the world’s top producer of silver, second largest of copper, and fifth largest of gold. It is also a primary world exporter of lead, zinc, tin, and iron ore. In 2010 metals accounted for over 60% of Peru’s total exports, which reached an all-time high of $33.5 billion.[12] The metals market has thrived since the privatization of over 200 state-owned mining companies began in late 2002, and the current upward trajectory is unlikely to subside. The metals industry fueled GDP growth of 8% last year and will again be a key contributor to the 7% growth that is anticipated for 2011.[13]

Mining companies like Southern Copper Corp. (SCCO) and Buenaventura (BVN) have experienced strong upward momentum over the past three years. With global demand for gold and silver continuing to rise and China’s growing infrastructure contributing to its insatiable demand for copper, these companies are well positioned to continue to profit from the run on metals. While there is reasonable skepticism over whether metals can serve as a lasting engine for growth, Peruvian companies are implementing prudent financial measures to hedge against any unforeseen fall in prices. Since 2006 SCCO has decreased its long and short-term debt, resulting in a quick ratio of 2.7% and current ratio of 3.4% as of Q4 2010. Such strong liquidity metrics reflect an ample capacity to cover short-term liabilities. SCCO’s financial strength has translated into high profitability, with a return-on-equity (ROE) of 40.1% and a return-on-assets (ROA) of 25.3%.[14] BVN has followed a similar path, with a fiscally conservative quick ratio of 3.8% and current ratio of 4.2% resulting in ROE of 30.1% and ROA of 25.7%.[15] These sound fundamentals become all the more impressive when measured against industry and S&P averages, which SCCO and BVN beat by significant margins. Overall, the health of these companies combined with a continuing bull metals market makes Peru’s mining industry a competitive investing opportunity.

While the metals market may be sustainable in the current outlook, the future of Peru’s export industry lies in petroleum. Peru is a plentiful source of petroleum, with natural gas reserves estimated at 13 trillion cubic feet, and crude oil reserve estimates ranging from 1.6 – 6 billion barrels.[16] The bulk of Peru’s oil resources are heavy crude, a variant of oil that requires expensive refinery due to its higher viscosity and difficulty to transport. While the mechanics of heavy crude refinery currently pose an issue, techniques for expedited, cheaper refinery are being researched and tested worldwide. It is estimated that global heavy crude reserves are more than twice that of light crude[17], making it inevitable that cost-efficient methods of refinery and transport will be developed. And when these methods of refinery have been perfected, there is no doubt that they will be implemented by those who have contracted nearly 90 million acres of the Peruvian Amazon for oil exploration and extraction, including American companies Occidental and ConocoPhillips.[18] These zoning contracts generate profits not just from their leasing terms, but from stipulations guaranteeing Peru a percentage of the earnings that may be garnered from any oil extracted. Given these considerations, it is nearly undeniable that as heavy crude processing becomes more economical, the profit margins Peru may realize are potentially limitless.

While Peru’s heavy crude resources present future profit possibilities, it is the countries natural gas reserves that are generating returns today. In 2004, Peru inaugurated operations for the Camisea natural gas project, a pipeline that runs 20,000 km in northern Peru.[19] The Camisea project is part of the larger Peru liquefied natural gas (LNG) initiative. When natural gas is liquefied it can be exported worldwide. By pursuing liquification of its natural gas resources, Peru has tapped into one of the world’s most rapidly growing energy demands. Natural gas is the cleanest burning fossil fuel, producing fewer emissions and pollutants than oil or coal.[20] Natural gas is highly demanded by China, South Korea, and other Southeast Asian countries as a means for supplying their mounting energy needs. In addition, the United States, EU, and Mexico have all recently presented initiatives which aim to curb their dependency on oil by investing in natural gas infrastructure. Peru is particularly positioned to profit from this development because of their free trade agreements with all of the aforementioned nations. In addition, natural gas has transformed Peru’s own energy landscape, significantly reducing the country’s dependency on imported diesel and allowing for power rationing during droughts. Though Peru’s largest natural gas company, Petroperu, remains under state ownership, international companies like Spain’s Repsol YPF (REP: SM) and South Korea’s SK Group (096770: KS) have significant stakes in the Camisea project and the Peru LNG initiative, making them an appealing portfolio prospect.

Despite the impressive economic growth Peru’s commodity market has facilitated over the past decade, a third of Peru’s population continues to live in poverty, and unemployment rates remain high. Though since 2001 the economy has sustained annual average GDP growth of 6.5% and average inflation of just 2.8%, political uncertainty and corruption continue to be a destabilizing concern. According to the 2010 Transparency International’s Corruption Perceptions Index (CPI), Peru measures a 3.7, a less than ideal rating on a scale where 0 signifies extreme corruption.[21] While public institutions have improved from the infrastructure weakness of the 1980s, reform is still needed and managerial capacity in the public sector is consistently poor. The World Economic Forum Global Competitiveness Report for 2010 reiterates the sentiments of the CPI, identifying corruption as the primary factor threatening to undermine Peru’s private sector and as the major obstacle for business operations. Although regulatory oversight has improved in recent years, a sub-culture of bribery continues to impede transparency.

Beyond the liability of bureaucratic corruption, Peru’s gravest domestic security threat is narco-terrorism. Narco-terrorist organizations from the Fujimori era, namely Shining Path, have witnessed a revival in recent years. Peru is close to surpassing Colombia as the world’s largest producer of coca leaves, plants which are cultivated to produce cocaine. Colombia’s bitter experience fighting the Revolutionary Armed Forces of Colombia (FARC) reveals the devastation that the drug trade can unleash. In cooperation with the United States, Peru is making strides to combat drug trafficking. With US aid supporting expanded technology, intelligence, and financial resources, Peru is aggressively increasing security operations and establishing alternative development programs for coca farmers. Peru hopes that these policy prescriptions, which are modeled on the tactics successfully leveraged by former Colombian President Alvaro Uribe, will undermine the authority of drug lords and diminish the prospect of a full-scale guerilla war.[22]

The rising threat of narco-terrorism, combined with the government’s perceived inability to ensure a wider distribution of wealth during a time of rapid economic expansion, has generated a growing level of public discontent over the past year. Civil unrest has lead to an increase in protest and strike activity, and has been a major propellant for the resurgence of radical populist Ollanta Humala, who at present is the frontrunner in the 2011 Presidential elections. Humala is a member of the Peruvian Nationalist Party (PNP), a left-wing political party with socialist ideologies. Humala is a questionable candidate for a multitude of reasons, among them his open admiration of Venezuela’s Hugo Chavez, his desire to nationalize Peru’s mining industry, and a checkered past involving allegations of murder and torture.[23] A Humala Presidency could prove disastrous for Peru, leading to a curtailing of the nation’s economic growth and a return to populist statism. Even if Humala does not win, PNP may gain control of several regional governments, a result that could impair the governing capacity of the next President.

Competing against Humala in the June 5, 2011 run-off is Keiko Fujimori, the daughter of disgraced former President Alberto Fujimori. While Keiko’s democratic credentials have also been questioned, she is viewed to be considerably more market friendly than her opponent. Keiko has gone on record promising absolute respect for democracy, freedom of the press, human rights, and the rule of law. Though Keiko is far from an ideal candidate, she is widely seen as the lesser of two evils, particularly from an economic standpoint. Keiko has secured support from the bulk of the media, the private sector, and the upper class of Lima.[24] Most observers close to the election believe Keiko’s base will be sufficient for her to capture the election, and that her Presidency would be characterized by sustained economic liberalization and respect for the private sector.

One factor that is instilling confidence in a Humala defeat is Peru’s growing Juntos program. Juntos, meaning “together” in Spanish, is a government-sponsored initiative tackling poverty and income inequality. Juntos is based on cash-transfer programs established in Brazil (Bolsa Familia) and Chile (Solidario), both of which have been proven to tackle poverty, vulnerability, and social exclusion. Juntos provides a monthly dividend of 100 Sol (~$35 USD) to mothers living in extreme poverty, often doubling family income. Participants qualify for the program by verifying that their children receive periodic medical check-ups and that they attend school regularly. The Juntos stipend is contingent on recipients upholding these qualifying standards, and an intricate system of checks-and-balances is in place to ensure that compliance continues to be met. While it would be premature to declare Juntos a resounding success, in the brief period since its establishment the program has already fostered improved literacy rates of 93% (up from 87.7% in 2007) and has increased child immunization rates for major infectious diseases like Hepatitis B and Malaria.[25] Though Juntos is still in its early phases, public support has been strong. While popular opinions towards the government have been waning throughout the past year, the promise of Juntos has helped minimize the level of discontent. While many remain frustrated with Peru’s economic inequality, the strides Juntos has made detracts from Huamala’s populist platform, helping sway the election out of his favor.

The results of the Presidential election pose ramifications not only for Peru’s long-term economic prospects, but in the near-term, it could negatively impact their credit rating. In recent years Peru’s credit ratings have gradually improved to medium-grade with moderate credit risk. The S&P currently rates Peru at BBB- with a positive outlook, a position echoed by Moody’s rating of Baa3.[26] Both ratings reflect agreement that Peru has the capacity to meet the financial commitments of its government bonds. While the ratings are generally positive, they do however imply that in the event of adverse economic or political conditions, Peru will be less likely to make good on its obligations than countries of a higher standing. This variability makes the current election outcome particularly significant. Moody’s has announced that Peru’s favorable growth forecasts and anticipated improvements in fiscal and debt metrics may lead to a ratings upgrade. However, whether or not Moody’s follows through with this change largely rests on who wins the Presidency, a development that it noted it would be closely monitoring. Favorable election results would likely guarantee an upgrade within 6-12 months, an improvement which would only further the appeal of Peruvian investment.

One immediate ramification of the election uncertainty has been a recent spike in credit default swap (CDS) activity. Widening CDS spreads equate to increased demand for credit protection, implying that there is a growing consensus that Peru has become more likely to default on its debt. Broadening spreads have been accompanied by a rise in the yield of Peruvian government bonds. The Dow Jones LATixx Global Peru Government USD Bond Index (^DJLGPGD) is an index used to measure the performance of Peruvian government global issues in USD. Since Humala has taken the lead in the election, yields have been climbing, reflecting a growing fear of default risk. Since December 2010, Peruvian government bond yields have risen from 5.9% to 6.7%, a notable increase.[27] It should be mentioned that since Humala and Keiko were announced as the run-off candidates, the ^DJLGPGD has begun to rebound (0.7% since 4/10/11), embodying the confidence many have that in the end, Keiko will be able to secure the election.

The recent up-tick of speculation on Peruvian stability has not been a result of purely domestic circumstances. The recent earthquake in Japan has fueled concern throughout the Latin American CDS market, with spreads also widening in the neighboring nations of Brazil, Chile, and Colombia.[28] Concern over how Peru may be affected by the Japanese fall-out is especially strong due to Peru’s export-oriented economy and it’s strong trading relationship with Japan. While in the short-term CDS spreads may remain elevated and exporting activity may be stifled, long-term worries are minimal. Since 2008 the market has been increasingly reactionary to any signs of risk, making it likely that the volatility instigated by Japan will gradually be priced into the market, reversing the CDS upswing. Similarly, while Japan’s capacity for Peruvian imports may be limited during the immediate adjustment phase, Japan’s recovery will ultimately require the copper, zinc, and tin Peru provides, suggesting that rebuilding will have a net positive impact on export levels to Japan.

The Japanese earthquake, as well as the recent environmental disasters in Chile, and Haiti, shed light on the importance of incorporating geographical risks into analysis of emerging markets investing. Several indexes are available which gauge the probability of a disaster within a given country or region. The Disaster Deficit Index (DDI) measures the economic loss that a country could suffer should a catastrophic event take place. When the DDI measures a 5% chance of a disaster occurring in the next 10 years, Peru ranks 1st among all vulnerable nations, with a predicted loss of $4.47 billion. At a 2% chance of occurrence over 10 years, Peru ranks 4th with anticipated losses of $11.4 billion. The DDI estimates that Peru requires an annual investment budget of 8.7% of capital to finance a potential disaster.[29] Such ample fiscal exposure suggests that Peru would suffer greatly in the wake of an environmental catastrophe.

The Natural Disaster Hotspots report conducted by the World Bank is another metric of disaster risk. The report ranks Peru high for flood and earthquake risk and mid-range for landslide risk. The report highlights that total relief costs for flood, earthquake, and landslide disasters between 1992 – 2003 were $2.5 billion. $2 billion of this aid was distributed to just 20 countries, Peru being one of them. The El Nino weather front ravaged Peru in the 1980’s, resulting in widespread flooding, severe droughts, and a debilitated fishing industry. El Nino has been a repetitive problem for Peru, afflicting the region again in 1997-1998, and most recently in 2010. Both the environment and the Peruvian tourism industry have suffered during these periods. In 2010 alone, El Nino cost the tourism industry $250 million. The 2010 El Nino impact was at one point so dire, Peru had to borrow helicopters from Brazil to airlift nearly 4,000 tourists out of the Machu Picchu region.[30] While rural Peru has historically been hardest hit by weather patterns, Peru’s capital, Lima, faces its own unique danger. Lima is situated on two of the world’s largest tectonic plates. This area of high seismic activity has reaped severe damage throughout the country’s history, including the catastrophic Ancash earthquake of 1970. The Ancash, or “Great Peruvian” earthquake killed over 80,000 people and left 1 million homeless.[31] Investors should be considerate of how Peru is working to protect themselves from the precariousness of environmental threats.

Though Peru cannot shift its exposure to natural disasters, it is actively making strides to convert this vulnerability into a source of economic potential. One speculative prospect investors would be keen to observe is Peru’s expansion of its hydropower industry. Peru has embarked on a series of initiatives to harness the power of its high rainfall and extensive geography of rivers and streams. Micro-hydro stations are small-scale installations that convert the energy of running water into electricity. Accompanied by modest dams and reservoirs, Micro-hydro stations generate up to 500 KW of power with minimal input, making them a cost-efficient and sustainable source of energy. Stations that have been erected throughout the eastern Andes have provided nearly 30,000 people with electricity, reaping remarkable scales of development.[32]

The village of Tamborapa is one example of the economic development that hydropower can facilitate. Since the construction of Micro-hydro stations, Tamborapa has doubled in population, as nearby villagers eagerly migrate to capitalize on the electricity availability. Over 25% of Tamborapa households have used their electricity to leverage small business ventures, with incomes increasing an average of 60% per family since electricity became available.[33] Education and health services have also improved dramatically. Tamborapa schools are now equipped with computers, photocopiers, and audio-visual equipment, and children are able to continue their studies into the evening by having electricity at home. Health centers have also vastly improved, as they can now operate vaccine refrigerators and maintain computer records. In addition, families are no longer being exposed to the harmful toxins of kerosene lighting, which have been linked to asthma and underdeveloped lungs.[34] The impressive growth that has been realized at Tamborapa now serves as a model for future Micro-hydro installment projects throughout rural Peru.

Encouraged by the successes of Micro-hydro stations, Peru has commenced a series of large-scale hydropower initiatives. Just as the power of rain and streams can be used to supply energy to small villages, the strength of Peru’s Amazonian rivers can similarly be harnessed to provide energy for broader infrastructure needs. Recently, hydroelectric power concessions have been awarded to Israel’s Inkia Energy Corp. along with Grana y Montero of Peru and Odebrecht of Brazil. Government officials estimate that these investments will total $1.8 billion by 2016.[35] The man-made dams that are planned for construction will power Peru’s mining and manufacturing sectors, significantly decreasing production costs and increasing operating income in both the long and short term. Though dams would be particularly vulnerable to destruction in the event of a severe earthquake, measures are being taken to insulate them from such an incident. Dam construction is planned for locations considerably distant from the Lima fault-line, and safety features like emergency draining are being incorporated into each structure. While there is no guarantee that these dams will ever be completely secured against natural disasters, the appropriate steps are being taken to minimize the likelihood of a failure.

While there are legitimate considerations to be made over Peru’s political stability, exposure to narco-terrorism, and geographical vulnerability, Peru’s ability to weather the 2008 global financial crisis embodies how the rewards of Peruvian investment greatly outweigh the risks. Peru showed remarkable resilience in the face of global adversity, achieving GDP growth of 9.8% in 2008. After a contraction in 2009, Peru again displayed impressive growth, with an 8% GDP expansion in 2010. 2011 is poised to be another profitable year, with GDP growth forecasts of 7%. By maintaining a proactive trade policy, improving tax collection, managing expenditures, and supporting a broader base of private investment, Peru has been able to avoid the credit crunch that has enraptured the world’s dominant economies. If Peru can continue to enforce the policies that have made it one of the fastest growing markets of the 21st century, a future of prolonged development is imminent.

Some of the strongest investment news that has come out of Peru in recent months is confirmation that the joint stock market venture between Peru, Colombia, and Chile will go live on May 30, 2011.[36] One of the greatest challenges the Peruvian equity market has faced is its limited number of securities, lack of liquidity, and slow development of a derivatives market. All of these conditions are now poised to change with the coming stock market integration. The group, known as the Integrated Latin American Market (MILA), will offer the advantage of economies of scale and scope; issuers and investors alike will receive a higher aggregate value in financing terms without increasing transaction costs. The merger will not only strengthen the Peruvian financial market but will provide Peru with a competitive edge it would not likely have been able to achieve on its own.

MILA is projected to have a market capitalization of $470 billion, making it the second largest Latin American exchange next to Brazil ($1 trillion) and surpassing that of Mexico ($350 billion). Peru will be contributing 15% of the market capitalization total to the newly merged market, significantly less than the 34% from Colombia and 51% from Chile.[37] This places Peru in a position to gain the most from integration. Prior to these plans, Peruvian market liquidity was extremely poor, with a turnover ratio of just 9 and a stock market concentration of 69%. In comparison, the United States has a turnover ratio of 183 and a stock market concentration of just 27%.[38] Integration will thus benefit investors who were unable to diversify due to Peru’s specialized internal market.

MILA will consist of 561 issuers from the three exchanges. The Colombia stock market lists mostly industrial and financial firms, while the Santiago exchange mainly caters to firms in commercial services and banking. The joining of these markets will thus add nicely to the mining and construction companies that currently dominate the Lima exchange.[39] Of the top ten holdings of the MSCI iShares Peruvian ETF (EPU), seven companies are in the mining and metals industry.[40] Though EPU has performed strongly since entering the market in 2009, realizing returns of nearly 50% since inception, MILA will provide the global exposure needed for additional, more varied Peruvian ETFs to be introduced. Beyond the diversification benefits, the greater liquidity realized by integration will allow the market value of companies to be more accurately reflected in their share prices, improving the capacity for precise risk-assessment. Similarly, more accurate gauges of risk will pave the way for development of the derivatives market, as well as create a more transparent environment that will hedge against systemic crisis.

Liquidity is by far the greatest advantage Peru will reap from MILA, as greater liquidity is the foundation on which large-scale diversification, improved corporate finance, and sustainable growth of the securities market is based upon. The liquidity achieved by MILA will attract new Peruvian firms to enter the market, as well as encourage companies to establish transparent accounting practices so that they too can take advantage of the rewards of integration. In emerging economies, especially those with histories of deep corruption, many firms are averse to joining the formal economy. MILA may serve to indirectly persuade more Peruvian businesses to enter the formal market, leading to overall societal gains. Furthermore, small companies will no longer have to depend exclusively on bank credit to finance their developmental needs, as MILA will provide a vehicle for debt and security issuance which can be used to leverage costs. Growing companies such as Bear Creek Mining (BCM:CN) and Fortuna Silver Mines (FVI:CN) will now have broader access to the financing mechanisms they need to capitalize on their thriving stock returns of 78.5% and 121%, respectively, in the past 12 months.[41] And finally, a stronger, more diverse, and more liquid market ultimately means greater FDI ventures, as well as a larger pool of resources for projects in infrastructure and social development.

While market integration will create a more favorable investment environment for domestic and foreign investors alike, MILA does not address all elements of Peruvian risk. Foreign exchange risk is an innate element of international investment, and these concerns, minimal as they may be, will persist. While the Peruvian Sol is strong against the USD, the exchange rate between the two currencies has been largely stable over the past decade. From 2001 – 2008, the Sol depreciated against the dollar from ~$3.60 USD/Sol to ~$2.80 USD/Sol. Following a brief period of appreciation from September 2008 to February 2009, the USD/Sol exchange rate has essentially stayed constant, registering at $2.81 USD/Sol as of April 2011.[42] With the United States as Peru’s most important trade partner and largest foreign investor, Peru is inclined to keep its exchange with the US stable. Peru operates under a managed float exchange policy, allowing for natural, yet minimal, fluctuations in its currency. The Peruvian central bank has helped maintained an average inflation rate of 3% since 2005, and its interest rate has stayed similarly constant, only recently being risen 50bps to 3.5%.[43] Despite the stability of the USD/Sol exchange rate, lingering concerns may remain. If an investor were to have fears over a Sol appreciation, Sol-denominated investments can be hedged via forward contracts, which can tailor to individual reservations towards exchange rate uncertainty.

Taking into consideration all of the variegated elements of Peru’s investment landscape, we would recommend an overweight position in Peruvian assets against other Latin American holdings. Peru’s ability to weather the 2008 financial crisis solidifies its position as a source of diversification. While most markets move together in a worldwide downturn, Peru did the opposite, strengthening our belief in the profitability of its investments and its capacity to provide diversified returns when they are needed most. The upward-trend Peru has enjoyed is also a perfect compliment to our momentum-investing philosophy, and we anticipate that this drive will only continue to strengthen in the coming years.

While we are bullish on the prospect for future returns, a range of innate and systemic risks are being incorporated into our recommendation. Peru’s susceptibility to natural disasters is concerning, particularly in light of its current hydropower expansion. Though proactive measures are being taken to minimize the impact of natural disasters, we remain wary of the widespread ramifications environmental hazards can ravage. However, we acknowledge further that natural disaster liability, to a significant degree, is an undiversifiable risk, one that we accept in our endorsement of Peru. Fundamentally we believe Peru’s hydropower initiatives will benefit the aggregate economy and that the rewards of sustainable, cost-efficient energy independence greatly supercede any environmental threats.

Social instability is another investment concern that we have recognized and are willing to tolerate. Social unrest is an inherent risk in all developing nations, and we do not believe the public discourse in Peru is an overly destabilizing factor. Growing pains are a natural part of expanding economies, and the effects of prosperity often move slower than is demanded. Nevertheless, the government is endorsing initiatives that will tackle the issues of GDP per capita distribution and unemployment. It is also making strides to eliminate the threat of narco-terrorism, a safety measure that will instill confidence in the populace. Admittedly, political uncertainty is at present a rogue variable. While we believe that in the end Humala will fail to rally the support needed to win the Presidency, the unexpected must be prepared for. The consequences that would be rendered by a Humala government are by and large our strongest concerns and the greatest risk threatening the future growth and profitability of Peru.

Ultimately, the undeniable advantages of being a resource rich country in a world of finite resources propels our conviction that Peru will soon be a leader of the emerging markets landscape. The wealth of raw materials Peru is endowed with, combined with the secure macroeconomic conditions, open trade policy, and liberalized investment structure needed to capitalize on these resources make Peru a compelling investment recommendation. Furthermore, we believe the advent of MILA will hedge against the threats a Humala Presidency poses for the open-market economy. MILA’s ability to increase liquidity, expand the levels of diversification, and broaden the depth of private investment only adds to Peru’s already substantial appeal. Though commodities will remain at the core of Peru’s economic success for the foreseeable future, MILA will facilitate the development of new industries, positioning Peru to enjoy revenue-generating sectors beyond the commodities world and protecting its economic well being from any potential downturns in commodity prices. Given our understanding of CAPM and the desire to achieve the optimal risk/return portfolio balance, we confidently recommend an overweight position in Peruvian investments.

Works Cited

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Web. 1 Apr 2011.

“CDS: Spike Not Concerning Over Long Term.” Emerging Markets Monitor Feb 2011.

Web. 1 Apr 2011.

Cespedes, Teresa and Caroline Stauffer. “Update 2-Peru expects $1.8 bln in hydropower

investment.” Reuters 24 Mar 2011. Web. 26 March 2011.

Chavez, Benjamin and Jaime Dupuy. “Inward FDI in Peru and its policy context.” Vale

Columbia Center on Sustainable International Investment. August 4, 2010.

“Chile, Colombia, Peru launch integrated stock markets beginning May 30.” MercoPress. Web. 6 April 2011

Dancourt, Oscar. “Neoliberal reforms and macroeconomic policy in Peru.” CEPAL

Review 67, April 1999. Web. March 2011.

Dilley, Maxx. “Setting Priorities: Global Patters of Disaster Risk.” Philosophical

Transactions: Mathematical, Physical and Engineering Sciences 364.1845

(2006): 2217-2229. Jstor. Web. 30 March 2011.

Dilley, Maxx, et al. “Natural Disaster Hotspots: A Global Risk Analysis: Synthesis

Report.” International Bank for Reconstruction and Development/ The World

Bank and Columbia University. 2005.

Gross, Daniel. “ Peruvian Peaks: The small, poor country that made the right economic

moves.” Newsweek 29 Jul 2009. Web. 30 March 2011.

“IMF: Executive Board Concludes 2010 Article IV Consultation with Peru.” Public

Information Notice 10/50 (2010). Web . 31 March 2011.

“Israel’s Inkia plans hydropower plant in Peru.” . Web 27 March 2011

“Land rights in Peru. Whose jungle is it? A scrabble for land sets investors against

locals.” The Economist 19 Mar 2009. Web. 23 March 2011.

Maldonado, Stanislao. “Resource Windfall and Corruption: Evidence from a Natural

Experiment in Peru.” University of California, Berkeley. 2010.

“Market Volatility To Persist On Election Uncertainty.” Emerging Markets Monitor Feb

2011. Web. 1 Apr 2011.

McMillan, John and Pablo Zoido. “How to subvert democracy: Montesinos in

Peru.”Journal of Economics Perspectives 18, March 2004. Web. March 2011.

Moffett, Matt. "Leftist, Ex-President’s Daughter Lead Peruvian Vote." Wall Street

Journal 10 Apr 2011. Print.

“Moody’s ups outlook on Peru’s Baa3 rating.” Market . Market Watch, n.d.

Web. 30 March 2011.

“On the brink.” The Banker. 1 Sept. 2009. LexisNexis. Web. 30 March 2011.

“Peru’s agriculture gets a boost from IDB-backed projects.” Inter-American Development Bank. Web. 27 August 2010

“Peru and the IDB at a glance.” Inter-American Development Bank. Web. 4 April 2011

“Peru: Country Overview.” EDC Economics. Web. December 2010.

“Peru’s energy ambitions: Hydro-powered dreams. Hopes and fears of a regional energy

hub.” The Economist 10 Feb 2011. Web. 23 March 2011.

“Peru’s flood-hit tourism ruined. Making do without Machu Picchu.” The Economist 11

Feb 2010. Web. 23 March 2011.

“Peru’s Natural Gas Solution.” Living in Peru. Web. 9 June 2010.

“Peru's presidential election unpredictable”. Associate Press 2011. Web. April 2011.

“Peruvian Nuevo Sol Exchange Rate Chart (USDPEN).” Trading Economics. Web. 12 April 2011

Rojas, Carlos Ignacio. “Strength in Numbers.” Americas Quarterly. Web. 13 January 2011.

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US Department of State. “Background Note: Peru.” Web 30 January 2010

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Global report: Reducing Disaster Risk. A Challenge for Development.” UNDP

2004. Web. 26 March 2011.

WealthDaily. “Peru Mining Stocks.” Web. 26 February 2011

World Market Pulse. “Exploring Investment Opportunities in Peru.” Seeking Alpha 26

Aug 2010. Web. 23 March 2011





Quotes: ^DJLGPGD

-----------------------

[1] Maldonado, Stanislao. “Resource Windfall and Corruption: Evidence from a Natural Experiment in Peru.” University of California, Berkeley. 2010.

[2] Dancourt, Oscar. “Neoliberal reforms and macroeconomic policy in Peru.” CEPAL Review 67, April 1999. Web. March 2011.

[3] Dancourt, Oscar. “Neoliberal reforms and macroeconomic policy in Peru.” CEPAL Review 67, April 1999. Web. March 2011.

[4] All dollar figures throughout report are USD.

[5] Dancourt, Oscar. “Neoliberal reforms and macroeconomic policy in Peru.” CEPAL Review 67, April 1999. Web. March 2011.

[6] Maldonado, Stanislao. “Resource Windfall and Corruption: Evidence from a Natural Experiment in Peru.” University of California, Berkeley. 2010.

[7] US Department of State. “Background Note: Peru.” Web 30 January 2011

[8] World Market Pulse. “Exploring Investment Opportunities in Peru.” Seeking Alpha 26 Aug 2010. Web. 23 March 2011

[9] World Market Pulse. “Exploring Investment Opportunities in Peru.” Seeking Alpha 26 Aug 2010. Web. 23 March 2011

[10] “Peru’s agriculture gets a boost from IDB-backed projects.” Inter-American Development Bank. Web. 27 August 2010

[11] “Peru’s agriculture gets a boost from IDB-backed projects.” Inter-American Development Bank. Web. 27 August 2010

[12] US Department of State. “Background Note: Peru.” Web 30 January 2011

[13] “Peru: Country Overview.” EDC Economics. Web. December 2010.

[14]

[15]

[16] “Peru’s Natural Gas Solution.” Living in Peru. Web. 9 June 2010.

[17] “Peru’s Natural Gas Solution.” Living in Peru. Web. 9 June 2010.

[18] “Peru’s Natural Gas Solution.” Living in Peru. Web. 9 June 2010.

[19] US Department of State. “Background Note: Peru.” Web 30 January 2010

[20] US Department of State. “Background Note: Peru.” Web 30 January 2011

[21] “On the brink.” The Banker. 1 Sept. 2009. LexisNexis. Web. 30 March 2011.

[22] “Peru: Country Overview.” EDC Economics. Web. December 2010.

[23] “Peru's presidential election unpredictable”. Associate Press 2011. Web. April 2011.

[24] “Peru's presidential election unpredictable”. Associate Press 2011. Web. April 2011.

[25] Gross, Daniel. “ Peruvian Peaks: The small, poor country that made the right economic moves.” Newsweek 29 Jul 2009. Web. 30 March 2011.

[26] “Moody’s ups outlook on Peru’s Baa3 rating.” Market . Market Watch, n.d. Web. 30 March 2011.

[27] “CDS: Spike Not Concerning Over Long Term.” Emerging Markets Monitor Feb 2011.Web. 1 Apr 2011.

[28] “CDS: Peru Over Columbia To Continue.” Emerging Markets Monitor March 2011. Web. 1 Apr 2011.

[29] “The Disaster Deficit Index (DDI).” Inter-American Development Bank 2008. Web. 26 March 2011.

[30] “Peru’s flood-hit tourism ruined. Making do w/o Machu Picchu.” The Economist 11 Feb 2010. Web. 23 March 2011

[31] United Nations Development Programme Bureu for Crisis Prevention and Recovery. “ A Global report: Reducing

Disaster Risk. A Challenge for Development.” UNDP 2004. Web. 26 March 2011.

[32] “ Peru’s energy ambitions: Hydro-powered dreams. Hopes and fears of a regional energy hub.” The Economist 10 Feb 2011. Web. 23 March 2011.

[33] “ Peru’s energy ambitions: Hydro-powered dreams. Hopes and fears of a regional energy hub.” The Economist 10 Feb 2011. Web. 23 March 2011.

[34] “ Peru’s energy ambitions: Hydro-powered dreams. Hopes and fears of a regional energy hub.” The Economist 10 Feb 2011. Web. 23 March 2011.

[35] “Israel’s Inkia plans hydropower plant in Peru.” . Web 27 March 2011

[36] “Chile, Colombia, Peru launch integrated stock markets beginning May 30.” MercoPress. Web. 6 April 2011

[37] Rojas, Carlos Ignacio. “Strength in Numbers.” Americas Quarterly. Web. 13 January 2011.

[38] Eun, Cheol S. and Resnick, Bruce G. “International Financial Management.” McGraw-Hill, 2009. Pages 313-314.

[39] Rojas, Carlos Ignacio. “Strength in Numbers.” Americas Quarterly. Web. 13 January 2011.

[40] World Market Pulse. “Exploring Investment Opportunities in Peru.” Seeking Alpha 26 Aug 2010. Web. 23 March 2011

[41]

[42] “Peruvian Nuevo Sol Exchange Rate Chart (USDPEN).” Trading Economics. Web. 12 April 2011

[43] “Peruvian Nuevo Sol Exchange Rate Chart (USDPEN).” Trading Economics. Web. 12 April 2011

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