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Peru: Selected Issues

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
May 2015
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Investment Dynamics in Peru1

Over the last decade, average growth in Peru exceeded 6 percent, anchored by a substantial contribution from investment. A series of structural reforms in the 1990s, growing political stability, and the implementation of a solid macroeconomic framework in the early 2000s set the stage for this investment boom, allowing the country to take advantage of a prolonged improvement in its terms of trade and historically low global interest rates. Actions were also taken to strengthen public investment implementation and to enhance the overall investment climate. Now that commodity prices have softened and interest rates are expected to rise, addressing the next generation of structural reforms will be crucial to sustain investment and growth.

A. Introduction

1. Many developing countries have focused on fostering and attracting investment as an engine of economic growth. Investment is a major component of aggregate demand for goods and services in an economy. An increase in investment expenditures directly affects the demand for the various factors of production and causes an acceleration in output. At the same time, given basic consumption smoothing behavior, changes in investment spending is also associated with more output volatility. If well placed, investments in infrastructure, technology, machinery and equipment, and human capital can increase an economy’s productivity and it’s long-term growth potential.

2. In Peru, robust investment growth has been one of the main driving forces behind the country’s recent economic success. The economy contracted in the 1980s, due mostly to a marked fall off in investment. In the 1990s, growth averaged 4 percent, with investment contributing 1 percentage point. In the 2000s, the economy expanded by 5½ percent per year with investment adding slightly over 2 percentage points. However, looking at the most recent decade (2004–13), real GDP growth averaged 6.4 percent, with investment supplying a full 3 percentage points—a contribution that is close to half of total growth.

3. Four fundamental factors have underpinned this surge in Peruvian investment:

  • Implementation of structural reforms—particularly in the 1990s. Between the mid-1980s and late 1990s, there was a sizeable improvement in structural policies in Peru. According to the IDB structural reform index, Peru has made substantial improvements in trade, financial, tax, privatization, and labor reforms. While Chile remains the regional leader in structural reforms, Peru has gone from last place among the six financially integrated Latin American (LA6) economies2 in 1985 to second place by 2010 (Lora, 2012).

  • Improved political stability. After a period of economic and political turmoil in the 1980s and 90s, Peru implemented a new market friendly constitution in 1993 and defeated an ongoing terrorism threat. Around the turn of the new century, the country entered an era of relative stability and reemerged as a stronger and more stable democracy.

  • A solid macroeconomic framework and reduced policy uncertainty. As part of the 1990s macro-financial reform, Peru ushered central bank independence and fiscal transparency and responsibility Laws. The results have been dramatic, with low inflation amidst strong growth, fiscal surpluses, low debt, and declining real and nominal interest rates. Investment surveys and rating agencies have noted the improvement in macro policies and the investment environment, leading to successive credit rating upgrades.

  • Very favorable external conditions, with significant increases in commodity prices and a sustained fall in real world interest rates. As noted in Adler and Magud (2013), Latin America has benefited from a commodity price boom in the last decade, which has been more persistent than previous booms, and associated with much higher income gains. For example, Peru has enjoyed a cumulative income windfall of around 85 percent of GDP since 2003, with a larger share of this windfall allocated to domestic investment than in previous episodes. The sustained fall in real world interest rates,3 combined with Peru’s improved credit rating, have also allowed Peruvian firms to have increased access to cheap external financing.

4. The strong export commodity price gains and favorable international financing conditions have started to reverse. Going forward, this development will impact expectations and investment in Peru, which the authorities will need to counterbalance via further structural reform measures and improvements in infrastructure and human capital. Well aware of these realities, the current Peruvian administration is implementing a number of measures that should help to streamline and speed up the investment process.

5. The objective of this chapter is to describe recent investment dynamics in Peru and to empirically assess the relationship between private investment and its fundamentals. The chapter is organized as follows: section B provides some stylized facts of Peruvian investment dynamics in the recent decades, while section C describes the empirical analysis. Section D concludes with policy implications.

B. Stylized Facts of Peruvian Investment

6. The mining industry’s need for capital equipment helped to drive the investment boom (Figure 1).

  • Private investment growth was volatile during the 1970s and early 1980s. After declining throughout 1985–91, it gradually rebounded with the implementation of fundamental reforms during the first half of the 1990s, before moderating again by the end of the 1990s as external shocks lowered capital inflows. Investment swelled during 2004–13, far outpacing a relatively healthy rise in consumption. However, private investment growth started to slow in early 2013.

  • Equipment and construction investment were key drivers of private investment over the last decade. Total private investment growth averaged about 15½ percent during 2003–08, with equipment investment contributing about 8¾ percentage points and construction contributing about 7 percentage points during this period. After a sharp drop during the height of the global financial crisis in 2009, private investment growth rebounded, averaging 13¼ percent in 2010-13. Equipment investment contributed the lion’s share, particularly in 2010–11.

  • The majority of construction investment had been non-residential investment. Non-residential and residential investment in percent of total investment averaged 32 and 24 percent, respectively, during 2007–11 (the most recent period with detailed breakdowns). Non-residential investment growth contributed 7½ percentage points to the 11 percent growth in construction investment during this period. Machinery and equipment (which included exploration and research) averaged 32 percent of total investment, while transport equipment was 9 percent. Other installations and software made up the remaining 3 percent.

  • Investment in the minerals sector boomed during 2003–12. Investment in the sector grew at an annual rate of 32 percent in real terms, over the period. As a share of total private investment, investment in the minerals sector increased from 3 percent to over 20 percent. Mineral commodity investments are concentrated in copper (68 percent), gold (13 percent), iron ore (13 percent), copper-zinc (4 percent), and other poly-metallic minerals (6 percent). About 70 percent of all foreign direct investment goes into the extractive industry sector. Peru, on par with Chile, was fifth in the global destination for exploration of nonferrous metals, behind Canada, Australia, the U.S., and Mexico. A number of copper mines are set to come on stream between 2015 and 2022, expected to expand copper production significantly.

Figure 1.Investment Dynamics

Sources: World Economic Outlook; the Peruvian central bank (BCRP); official statistics institute (INEI); mining and energy ministry (MEM); and Fund staff estimates.

7. Public investment spending has increased in line with private investment, reflecting investment promotion initiatives and the need to fill large infrastructure gaps (Figure 2).

  • As a percent of GDP, public investment spending increased from about 3 percent in the early 2000s to about 5.5 percent in 2014. In the same period, private investment jumped from about 14 percent to about 20 percent of GDP. Over the last decade, public investment contributed 2¾ percentage points (21 percent) to the average annual growth in total real fixed capital investment of 12¾ percent.

  • Local government spending has been a major factor in the rise in public investment. Local investment spending has tripled, increasing from less than 1 percent of GDP in 2007 to 2½ percent of GDP by 2014. Taken together, national and regional fixed investment spending has gone from about 1½ percent to 3 percent of GDP. To some extent, these results are a reflection of the decentralization process and the government’s efforts to bring investment projects to the local and municipality levels.

  • Implementation of planned public investment spending has improved. The increase in metal prices and thus royalty and “canon” revenues have relaxed financial resource constraints at the national and at lower levels of government in specific mining regions. At the same time, the decentralization process has created a number of new jurisdictions with relatively inexperienced capital spending administrative units. Nevertheless, the public sector is getting much better at implementing capital spending budgets. Overall, fixed public investment spending is about 79 percent of budgeted amounts—up 27 percentage points from 2007.

  • Infrastructure gaps remain large. According to the World Economic Forum’s 2014 measure of infrastructure quality Peru is ranked 105th out of 144 countries. The Peruvian Association National Infrastructure Investment (AFIN (2012)) has estimated that the national infrastructure gap for 2012–21 at a third of projected GDP). Deficit areas include energy, telecommunications, transport, health, and education. Clearly improved infrastructure would have a positive effect on productivity, investment, and growth.

Figure 2.Public Investment Dynamics

Sources: INEI; EIU 2012 Infrascope report; and Fund staff estimates.

8. Long-term capital flows have contributed to Peru’s investment boom. During 2007–13, long-term capital inflows averaged about 8 percent of GDP, up from about 4 percent during 1994–2005. Foreign direct investment (FDI) comprised the lion’s share of long-term inflows (about 5¼ percent of GDP on average during 2006–13). A substantial amount of FDI inflows emanate from profits that have been generated from current FDI stocks. About half of the profits generated from the FDI stocks (i.e., about 3 percent of GDP) during 2006–13 were re-invested in Peru.4

9. The commodity price boom and the favorable external financing that have underpinned vigorous private investment growth in the past decade have receded. Commodity prices have been falling since 2012 and the costs of external financing have increased following the U.S. Federal Reserve’s announcement of tapering unconventional monetary policy in May 2013. As a result, growth of private investment has slowed down in Peru. The private investment to GDP ratio in Peru declined from about 21½ percent in the first quarter of 2013, when it was at its peak, to 20 percent at the end of 2014. Similarly, long-term capital inflows also weakened in 2014. Commodity prices are expected to fall further in the medium term due to the expected moderation and rebalancing of growth in China and global interest rates are expected to rise due to anticipated monetary policy tightening in the U.S.

C. The Empirical Framework

10. Most empirical studies on aggregate investment are based on a version of the neoclassical flexible-accelerator theory of capital. This theory shows that the desired level of capital is positively related to the level of expected output and negatively related to the expected user cost of capital (Jorgenson, 1963). For developing countries, the models are often applied with modifications since key assumptions such as perfect financial markets and little or no government investment are not applicable in developing economies (Greene and Villanueva, 1991).

11. One important modification to the neoclassical flexible-accelerator theory of capital is incorporating the role of uncertainty. Bernanke (1983) and Pindyck (1991) argue that investment is sensitive to uncertainty because expenditures on fixed capital are economically irreversible in the sense that they are mostly sunk costs that cannot be recovered. Since new information relevant for assessing the returns on long-run projects arrives over time, an uncertain environment increases the incentives for waiting and hence reduces investment. Le (2004) incorporates the role of uncertainty into an investment model based on the optimal condition for a representative agent maximizing his/her expected utility. In this model, the optimal level of investment depends positively on the expected value of the return and negatively on the variance (uncertainty) of the return on domestic investment.

12. For empirical purposes, the modified neoclassical flexible-accelerator model is specified as:

Where, yt is the log of private investment to GDP ratio; Xt represents logs of a set of variables that affect investment through their effects on the expected rate of return, the variance of the return, and the user cost of capital; εt is the stochastic error term; α is the constant term; β are the elasticities to be estimated; and ‘t’ refers to time indices.

  • GDP or growth of GDP is often used as a key determinant of expected rate of return in empirical studies.5 The problem with this practice is that both output and investment are endogenously determined. Most studies attempt to address this problem by using lagged GDP/growth of GDP instead of contemporaneous levels. Nevertheless, investment decisions are made based on the expected rate of returns and the past levels of output may not be a good indicator of expected output, in particular in developing economies. To address the simultaneity problem in the investment-output relationship, this study specifies private investment as a function of underlying exogenous factors that determine expected output and investment. The factors include the real prices of major export commodities, structural reforms, and government investment in infrastructure and human capital. The Appendix shows that the explanatory variables have predictive value for private investment.

  • In commodity dependent economies, in particular, the real prices of major export commodities are key determinants of output and the expected return on investment. Commodity price affects investment and output not only in the commodity sector, but also in the rest of the economy through its effect on income and the current account, the budget, and the profitability of sectors that are correlated with the commodity sector (Cardoso, 1993). There is a high correlation between the real commodity export price index and expected growth of the Peruvian economy. Structural reforms such as trade and financial openness, labor market reforms, and privatization can also affect the expected rate of return on investment through improving the productivity and efficiency of private investment. Similarly, government investment in complementary goods and services such as infrastructure, human capital, and improvements in the efficiency of public services can enhance the productivity of the private sector and encourage private investment.6

  • Empirical studies show that macroeconomic volatility, resulting from policy and external shocks, and political instability are major sources of uncertainty in developing economies with significant negative impact on private investment.7 A number variables including, real exchange rate volatility, inflation volatility, output volatility, terms of trade volatility, and external debt burden are often used as indictors of macroeconomic uncertainty. For the sake of parsimony, however, this study relies on real exchange rate volatility, which could reflect the uncertainty resulting from both macroeconomic policy and external shocks. A measure of political risk is also included to control for the role of political uncertainty.

  • For financially open economies, the world interest rate is a key determinant of the user cost of capital. An increase in the world real interest rate leads to an increase in the user cost of capital and is expected to have a negative impact on private investment in financially open developing economies. World interest rates can also be a proxy for availability of external finance (capital flows) as lower world interest rates could push capital to emerging economies as international investors search for better yields.

D. Data and Sources

13. Data on private and government investment are obtained from the central bank, while the structural reform index is obtained from Lora (2012). The structural reform index measures improvements in trade, financial, tax, privatization, and labor policies. The total structural reform index (standardized from 0 to 1) is a simple average of sub-indices in these 5 policy areas. Lora’s data from 2010–13 was extended using similar indicators from the World Economic Forum’s Global Competitiveness index (GCI) database.

14. The rest of the variables are constructed as follows:

  • The real commodity export price index is constructed as the weighted average of world price indices of copper, gold, lead, and zinc (Peru’ major export metals) deflated by the manufacturing export unit value index of advanced economies

  • Real exchange rate volatility is measured by the variance of a generalized autoregressive conditional heteroskedasticity process of order 1 (GARCH(1,1)) specification. Specifically, the real exchange rate volatility is constructed as follows. First, the log of the real effective exchange rate is specified as an AR (1) process on monthly data for the period 1980–2013. Second, the estimated variance of the error term from this model is specified as a function of its first lag and the first lag of the square of the error term. The predicted value from the dependent variable (the variance of the error term), expressed in percent, is taken as a measure of real exchange rate volatility. The quarterly figures are obtained by averaging corresponding monthly data. The GARCH-based variance is considered a better measure of uncertainty than alternatives such as the sample standard deviation because it specifically reflects the unpredictable innovations in a variable instead of simply showing the overall variability from past outcomes.

  • Political uncertainty is constructed from the Political Risk Service Group (PRSG)’s political risk rating indictor. PRSG’s political risk rating evaluates the political stability of a country on a comparable basis with other countries. It assesses risk points for each of the component factors of government stability, socioeconomic conditions, investment profile, internal conflict, external conflict, corruption, military in politics, religious tensions, law and order, ethnic tensions, democratic accountability, and bureaucracy quality. The ratings range from a high of 100 (least risk) to a low of 0 (highest risk). The political uncertainty variable used in this study is the reverse of PRSG’s risk rating, calculated as 100-‘PRSG’s risk rating’, so that higher values reflect higher political risk/uncertainty.

  • Real world interest rate is the real interest rate on U.S. Treasury 10-year bond, calculated as the difference between the nominal interest rate and the Cleveland Fed’s 10-Year expected U.S. inflation rate. Data source is Haver.

E. Estimation Methods and Results

15. The sample covers quarterly data during 1984–2013 based on data availability for all of the main variables. Unit root test results show that all of the variables have unit root. Hence, the baseline results are based on an Error Correction Model (ECM). Since the structural reform index is available at the annual level, it is assumed that all quarters of a year have similar values.8

16. The estimation results are broadly in line with expectations (Table).9 The baseline results, column (1), are estimated using the ECM. With the exception of the real exchange rate volatility, which becomes statistically significant with unexpected positive sign, all of the explanatory variables have statistically significant coefficients with expected signs.10 The unexpected sign on the coefficient of real exchange rate volatility appears to be due to the high co-linearity between political uncertainty and the real exchange rate volatility, with a correlation coefficient of about 0.8. When the political risk indicator is dropped from the model, (column (2)), the sign of the real exchange rate volatility coefficient becomes negative but statistically insignificant. According to the baseline results, a 10 percent increase in commodity prices or in the structural reform index or in the government investment to GDP ratio could lead to a 4.8 percent or a 3¼ percent or a 4½ percent, respectively, increase in the private investment to GDP ratio. On the other hand, a 10 percent increase in the political risk index could lead to a 16¾ percent drop in the private investment to GDP ratio. Similarly, a percentage point (100 bps) increase in the U.S. real interest rate would lead to a ¼ percent decrease in private investment to GDP ratio.

Table 1.Long-Run Determinants of Private Investment in Peru 1/
(1)(2)(3)(4)
Real export commodity price index0.4810.4480.3940.444
(6.306)***(4.279)***(5.065)***(4.712)***
REER volatility0.055−0.0070.0650.004
(4.434)***(-0.378)(4.504)***(0.264)
Structural reform index0.3200.6670.133
(2.347)**(3.178)***(0.769)
U.S. real interest rate−0.189−0.250−0.151−0.158
(-6.137)***(-6.115)***(-4.210)***(-4.440)***
Political uncertainty−1.683−1.935−1.103
(-7.606)***(-7.507)***(-4.335)***
Government investment0.4640.2150.4940.169
(8.574)***(2.496)**(8.011)***(3.724)***
Source: Staff estimates.

All variables except the U.S. real interest rate are expressed in natural logarithm form. Constant terms, trends, and seasonal dummies are included in all specifications, but the results are not reported. Lag length for the ECM specifications is 2.

(1) Baseline regression estimated by ECM method.

(2) Baseline regression without the political risk indicator.

(3) Baseline regression without the structural reform index.

(4) Results estimated by the FMOLS method.

Numbers in parenthesis are t-values. *, **, and *** indicate significance at 10%, 5%, and 1% levels, respectivelly.

Source: Staff estimates.

All variables except the U.S. real interest rate are expressed in natural logarithm form. Constant terms, trends, and seasonal dummies are included in all specifications, but the results are not reported. Lag length for the ECM specifications is 2.

(1) Baseline regression estimated by ECM method.

(2) Baseline regression without the political risk indicator.

(3) Baseline regression without the structural reform index.

(4) Results estimated by the FMOLS method.

Numbers in parenthesis are t-values. *, **, and *** indicate significance at 10%, 5%, and 1% levels, respectivelly.

17. The estimated results are robust to specification changes. The baseline regression was re-estimated without the structural reform index to see if the results are affected by our ad-hoc assignment of quarterly values in this variable. As shown in column (3) of the Table, the results of the remaining variables are not sensitive to the exclusion of the structural reform index. Finally, column (4) shows the cointegration relationship re-estimated using the FMOLS method to test the robustness of the baseline results to changes in specification/methodology. With the exception of the structural reform index, which becomes statistically insignificant, the rest of the results remain broadly unchanged.

F. Concluding Remarks

18. This chapter investigated the dynamics and determinants of private investment in Peru using both descriptive and empirical analyses. The results show that external factors (commodity prices and U.S. real interest rate), political stability, and structural reforms are key factors driving private investment in Peru. There is also strong statistical evidence that public investment is complementary to private investment.

19. Given the less favorable external conditions going forward, policy makers in Peru need to redouble structural reform efforts to support investment and growth. Maintaining macroeconomic and political stability and rebooting structural reform measures are crucial to enhancing private investment in Peru. Compared to the 1980s and 1990s, macroeconomic and political institutions are now much more developed. Consequently, the room for further improvement in this area is somewhat narrower and the marginal contribution to private investment growth will most likely be smaller. Nonetheless, reversals of these progresses could derail confidence and private investment and need to be avoided at any cost. This leaves second round structural reforms and public investment in complementary goods and services as the main policy tools for jumpstarting private investment in Peru. In this regard, ongoing efforts to diversify exports, increase education and R&D spending, and to reduce red-tape and the overly complicated system of permits are most welcome.

Appendix. Granger Causality Tests

Tests confirm that the explanatory variables granger cause private investment. The interpretation of the regression results as causal effects of the explanatory variables on private investment was based on the assumption that causality runs from the explanatory variables to private investment, but not in the reverse direction. The assumption was made in part because most of the variables are exogenous by choice. Granger causality tests confirm that the explanatory variables have predictive value for private investment. The null hypothesis that ‘X does not Granger Cause private investment’ is rejected for all explanatory variables ‘X’, whereas the reverse null hypothesis could not be rejected at conventional levels of significance.

Granger Causality Tests
P-Values for Lag length:
Null Hypothesis12
Commodity price does not Granger Cause private investment0.00230.0657
Private investment does not Granger Cause terms of trade0.76320.7771
REER volatility does not Granger Cause private investment0.00200.0223
Private investment does not Granger Cause REER volatility0.35550.2128
Structural reform does not Granger Cause private investment0.00210.0449
Private investment does not Granger Cause structural reform0.77910.8562
U.S. real interest rate does not Granger Cause private investment0.00210.0629
Private investment does not Granger Cause U.S. real interest rate0.46540.2099
Political uncertainty does not Granger Cause private investment0.00200.0998
Private investment does not Granger Cause political uncertainty0.95230.4276
Government investment does not Granger Cause private investment0.05820.0001
Private investment does not Granger Cause government investment0.20250.1221
Source: Staff estimates.1/ Based on quarterly data from Peru. All variables except the U.S. real interest rate are expressed in natural logarithm form.
Source: Staff estimates.1/ Based on quarterly data from Peru. All variables except the U.S. real interest rate are expressed in natural logarithm form.
References

Prepared by K. Ross and M. Tashu.

Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

The 10 year U.S. Treasury real interest rate fell from about 5½ percent, on average, during the 1980s to about 1½ percent, on average, during the last decade (2004–13).

Reinvestment rates tend to be relatively high in extractive industry countries given sizable capital import requirements and high profitability. During 2004–13, reinvestment rates were around 25 percent for Mexico and Colombia, and close to 60 percent for Chile.

If involved directly in the productive sector of the economy, government investment may also affect private investment negatively by competing for limited physical and financial resources (Greene and Villanueva, 1991).

Although this is an arbitrary assumption, it may not affect the analysis significantly since the structural reform index is a slow changing variable except during the early 1990s, when it jumped significantly following the constitutional reform.

Johansen cointegration tests (both the Trace and Maximum Eigenvalue cointegration tests) show evidence for a statistically significant cointegration vector between private investment and the dependent variables.

Constant terms, trend, and seasonality dummies are included as exogenous variables in the cointegration specification.

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