This Selected Issues paper focuses on policies to promote high, sustainable growth in Peru, the risks posed by dollarization, and key medium-term fiscal issues of decentralization and social security reform. The paper identifies the main impediments to output and employment growth and proposes steps to remove them. It uses a balance sheet approach to analyze Peru’s highly dollarized economy, and finds that the factors explaining Peru’s relatively low international trade levels are related to the impediments to growth. The paper also looks at the main impediments to high, sustainable output, and employment growth in Peru.
II. Main Impediments to Output and Employment Growth1
Main Findings and Recommendations:
While Peru has made progress in the last decade in removing obstacles to output and employment growth, further efforts are needed to improve the investment climate. The main impediments relate to the uncertainty surrounding economic policy and the regulatory and legal framework, and weak transport infrastructure.
The economy’s vulnerabilities, the difficult political situation, and uncertainty surrounding the legal and regulatory environment have deterred private investment.
Excessive regulation of the workplace raises the cost of hiring labor in the formal sector.
Sustained growth requires a financial system that operates efficiently for all firms, not just prime corporate customers.
Finally, poor transport infrastructure and customs management raises costs to Peruvian firms and reduces competitiveness.
The authorities are taking steps to address these problems, but additional efforts are needed.
The authorities’ sound macroeconomic framework is welcomed by investors. However, a strong and unequivocal commitment by the leaders of the main political parties to maintain this framework would help ensure a durable improvement in the private investment climate.
A recent law has substantially reduced labor costs for small firms. If successful in promoting formal employment in these firms, extending the law to larger firms should be considered.
A reform of the judiciary is needed, but will take time to complete; in the interim, the authorities should implement a commercial court system.
Improving credit registries and debt collection procedures are important steps to help lower lending rates to non-prime corporate borrowers.
Road and port operating concessions, including through public-private partnerships, would help provide the resources needed for investment in these areas.
7. Since the early 1990s, Peru has made important advances in removing obstacles to output and employment growth. Sound macroeconomic policies, anchored on major fiscal reforms, succeeded in stabilizing the economy from the crisis situation in the late 1980s; relations with external creditors were restored, and important structural reforms were implemented to bolster market efficiencies. These reforms focused on:
the promotion of competition in goods markets and modernization of productive capital, through steep reductions in import tariffs and the elimination of most non-tariff barriers;
financial sector reforms;2
private-sector participation in certain economic infrastructure areas;3 and,
enhancement of labor market flexibility.4
As a result of these policies, during 1993-97 per capita output surged and poverty declined.
8. However, the reform effort weakened in the latter part of the 1990s, investment and total factor productivity declined, and per capita output and employment growth slowed. These developments have been associated with adverse exogenous shocks and a difficult political environment that increased economic uncertainties and undermined investor sentiment.
9. This chapter identifies key impediments to higher private investment and employment growth and policy actions to help remove them. The main impediments relate to the uncertainty surrounding economic policy and the regulatory and legal framework, and weak transport infrastructure.5
B. Growth Constraints and Policy Actions
10. The key constraints to higher private investment and faster output and employment growth include:
uncertainty regarding economic policies, laws, and regulations and their implementation and enforcement; including regulatory-induced labor costs that deter formal employment;
inadequate and costly access to financing for much of the private sector; and,
high logistical costs owing to inadequate port and road transportation infrastructure.
Economic Policies and the Legal Framework in Peru: Uncertainties and Inefficiencies
11. Private investment is undermined by uncertainties about economic policies, laws, government regulation, the resolution of commercial disputes, and contract enforcement. In a 2002 survey of industrial-firm managers, almost 40 percent regarded economic laws and regulations and their enforcement as highly unpredictable, up from 20 percent in 1999.6 Of particular concern was uncertainty in macroeconomic and regulatory policies, and judicial system enforcement of laws and contracts.7 These concerns were even higher among managers that interacted with government. This environment appears to affect firm behavior quite strongly. According to the World Bank, investment in new machinery and equipment drops an estimated 16 percent for each one point increase (on a 5-point scale) in uncertainty. Moreover, productivity-enhancing worker training, which is presently among the lowest in the region, was found to be adversely affected by labor laws and regulations.8
12. Macroeconomic uncertainties reflect the economy’s vulnerabilities and risks to sustained implementation of prudent macroeconomic policies. Vulnerabilities and risks are associated with the relatively high public debt ratios and the large foreign-currency component of public debt; the asset/liability currency mismatches on sectoral balance sheets; and the relatively low trade levels.9 The main risk to sustained good macroeconomic policy implementation is the difficult political situation and the concern that policies could weaken, especially in the run up to the next presidential election in 2006.
13. The authorities have been working to reduce economic vulnerabilities. In particular, they are:
taking measures to bolster tax collections, restrain non-essential expenditure growth, reform the public pension system, and implement a fiscally-neutral decentralization process;
pursuing a debt management strategy geared toward reducing the share of dollar-denominated public debt and lengthening the maturity structure;
continuing to strengthen prudential regulation and supervision of the financial system; and,
maintaining a flexible exchange rate system and high official international reserves as a buffer against shocks.
14. Uncertainty about existing labor legislation and regulation reflects a weak consensus about the beneficial effects of the labor reforms implemented during the 1990s.
Employment increased strongly in the 1990s, in line with the growth in the labor force.10 This was bolstered by the use of more flexible temporary contracts. As a result, unemployment remained broadly stable (at around 8½ percent), despite substantial economic restructuring and rising female participation.
However, job security and worker earnings remained low because of high regulatory costs in permanent employment contracts (equivalent to around half of the base wage pay), which foster high levels of informal employment, and slow labor productivity growth.
As economic growth slowed in the late 1990s, employment growth also slowed. Moreover, despite the recent recovery, employment in metropolitan Lima has grown only at a modest 2½ percent a year in 2002-03. Unemployment has remained around 9 percent and underemployment at around 18 percent.
These factors have undermined political support for the labor market reforms of the 1990s. Indeed, most of the recent proposals on labor market reform imply a reduction of labor market flexibility.11
15. Nevertheless, several steps have been taken recently to reduce non-wage labor costs.
In June 2003, regulatory requirements on vacation pay (one month of vacation pay) and severance pay (1½ months salary for each year of work up to 12 years) were reduced by 50 percent in the case of permanent employees in firms with 10 or fewer employees. In November 2003, these reductions were extended to domestic workers’ employment contracts.
Since November 2003, wage increases of up to 20 percent can be excluded from regulatory requirements, if granted by firms in the form of food or food vouchers.12
The special payroll tax (IES) was reduced from 2 percent to 1.7 percent in 2004 and is to be eliminated in 2005.
16. Reaching a broad consensus on further labor market reform will likely be difficult in the present political environment. Ongoing efforts to reach consensus among workers and business representatives on the legal framework of labor relations largely focus on consolidating and re-legitimizing the framework that was put in place in the 1990s.13 Although consideration was given recently to replacing the costly separation-related payments requirement with an unemployment insurance system, the initiative was dropped due to union resistance and perceived difficulties in administration of the system.
Commercial dispute resolution
17. Uncertainty regarding the resolution of commercial disputes and contract enforcement reflects institutional weaknesses in the judiciary and non-judicial dispute- resolution mechanisms. According to World Bank data, the time spent to collect an unpaid debt through the court system averages around 750 days, with the total collection cost averaging over half of the recovered debt. Even more serious is the widespread perception of corruption in the courts. Most of the recently surveyed private company managers viewed the court system as dishonest, biased, inconsistent, slow, high-cost, and ineffective in enforcing contracts or settling commercial disputes. In this context, firms’ typical response is to engage in defensive behaviors that lower the chances of disputes but reduce market efficiency (e.g. transacting only with suppliers or clients that they know to have good track-records). In addition, court interference in disputes between firms and regulatory entities adds to regulatory uncertainty.
18. There is broad consensus on the need for judicial reform. However, improving the efficiency of the judiciary will be a complex process that will take years to accomplish. In the meantime, the authorities are giving priority to steps that would facilitate the prompt resolution of commercial disputes and improve contract enforcement, such as;
improving the efficiency of non-judicial dispute-resolution mechanisms, by enhancing arbitrator and mediator accreditation and training. As part of this process, the Ministry of Justice has drafted the terms of reference for a study of the existing mediation system and its impact on commercial cases;
establishing effective commercial courts. In August 2003, the Supreme Court approved a proposal for the creation of commercial courts, and discussions are underway for the creation of financially sustainable commercial courts in several districts in metropolitan Lima and in selected provincial towns.
Inadequate and expensive access to financing14
19. Domestic financial intermediation in Peru remains relatively low and inefficient, notwithstanding the comprehensive economic and financial reforms of the 1990s. Private sector access to finance investment is constrained relative to other countries.
Financial sector credit to the private sector is only about 30 percent of GDP.
A 2002 World Bank/CAF survey of industrial firms found that: (i) only 51 percent of firms had loans from financial institutions;15 (ii) firms relied less on retained earnings and credit, and more on equity injections; (iii) only 3 percent of surveyed firms had access to credit of more than five years’ maturity; and (iv) many firms opted out of credit markets because of high interest costs and collateral requirements.
20. The cost of credit is very high, particularly for medium- and small-size firms, and loan collateral requirements are difficult to meet. Interest rates vary between 3.3 percent on U.S. dollar-denominated loans for the largest creditworthy firms to over 50 percent on domestic currency loans to micro firms.16 The World Bank/CAF industrial firm survey found that: (i) about 70 percent of firms with loans reported that they had to post collateral or personal guarantees equivalent to over 120 percent of the loan values; and (ii) loan collaterals are largely in the form of real estate, with only 9 percent of small- or medium-sized firms using new machinery (27 percent for large firms).
21. High lending rates reflect commercial banks’ operating costs and high credit risk. Lack of competition in credit markets contributes to the high operating costs, reflecting the relatively shallow domestic capital market (which is only just beginning to provide competition to banks). Factors that contribute to the high credit risk include: the substantial dollarization of deposits, commercial bank lending in U.S. dollars to firms and persons with incomes in domestic currency, and information deficiencies that contribute to uncertain and costly recovery of loans and pledged assets. Although there are private credit bureaus, collateral registries are weak—information on movable assets is poor, and the registries are not connected for information sharing—and there are no regulations for establishing precedence among claims in different registries.
22. The authorities are working to improve access to domestic financing. Efforts underway include:
regulatory changes to promote competition and administrative efficiency in financial intermediation and fostering efficient risk-taking;
strengthened prudential regulations to discourage U.S. dollar-denominated lending to firms and individuals earning in local currency;
legislation that facilitates the use of moveable property as collateral and that provides for an effective security registry system;17
strengthened debt collection procedures, including by allowing seizure of assets for specified asset groups without recourse to judicial action;
establishing commercial courts and alternative commercial dispute resolution mechanisms.
High logistical costs
23. Logistical costs are a serious burden on firms’ profitability and competitiveness. According to the World Bank, these costs (such as cargo handling, insurance, and warehousing) account for almost 30 percent of firms’ revenues on average, compared with 15 percent in Chile and 9 percent in OECD countries. These costs result mainly from inadequate maintenance and investment in road and port infrastructures, as well as with inefficient port and customs administration.
24. Port legislation recently passed should open the way for structural improvements. Port concessions are now expected to be granted following the approval of the institutional and regulatory legal norms for the National Port System Framework Law enacted in March 2003. The framework includes: (i) putting in place national and regional port authorities; (ii) issuing regulations clarifying the working relations between these authorities, the Ministry of Transport, and other relevant regulatory agencies; and (iii) adopting and publishing a National Port Development Plan.
25. Peru’s road infrastructure quality ranks low compared with other countries in the region. There has been a substantial decline in miles of “good” roads since 1995. At present only about 45 percent of the road network is in proper condition, and approximately 13 percent of roads are paved.18 This contributes heavily to firms’ costs—for instance, the average speed of transport over long distances is around 25 km per hour in Peru, compared with over 50 km per hour in Chile; and industrial firms surveyed in the World Bank/CAF report relatively high losses due to breakdowns, theft, or spoilage during transport.
26. Peru’s maritime transport and port and customs procedures are inefficient. Freight costs are among the highest in the region, averaging 16 percent of import value, compared with 6 percent in Chile and 12 percent in land-locked Bolivia. This is largely because of insufficient investment in equipment and facilities to handle container traffic, which leads to a low share of containerized cargo, delays and high costs of moving cargo within the port, and relatively high turnaround times of ships at port. Moreover, port and customs administration inefficiencies raise costs because of relatively long clearance times and uncertain delivery of merchandise.
27. The authorities are beginning to address the need to reduce logistical costs.
Legal norms are now in place that allow operating concessions for ports. The necessary investment for the ports is estimated at about US$600 million (0.3 percent of GDP) and should take about three years to complete.
Plans are moving ahead to increase investment in road infrastructure. Part of this investment will come through concessions and partnerships with private companies. In 2004, the authorities intend to grant concessions for the rehabilitation, operation and maintenance of some 3,200 km. of roads, with corresponding capital outlays totaling US$630 million over a three year period (roughly 0.3 percent of annual GDP). This would raise the percentage of paved roads to 38 percent.
Prepared by Jorge Guzmán (WHD).
In the early 1990s, interest rates were liberalized, first-tier public development banks were liquidated, and financial intermediation in foreign currency and free capital movements were allowed. Together with an improved domestic security situation, the return of macroeconomic stability, and improved supervision, these actions supported a deepening of financial intermediation, and promoted financial stability.
Privatization and the granting of operating concessions opened sectors previously confined to the public domain (including in energy, telecommunications, and transport).
In the early and mid-1990s, labor regulations became more flexible as absolute employment stability requirements that existed in the 1980s were replaced by performance-based relative stability requirements. Also, temporary employment contracts were introduced to reduce the costs of hiring and firing and other labor costs. Notwithstanding, regulatory costs remain high, particularly in permanent employment contracts. For details, see Chapter 1 of Peru: Selected Issues, March 2001,
The chapter draws on the findings of recent reports of the Inter-American Development Bank (IDB), the World Bank, and the Andean Development Corporation (CAF). In particular, CAF and World Bank: “Peru—Microeconomic Constraints to Growth,” unpublished mimeo, 2003. Melo, Alberto: “La Competitividad de Perú Después de la Década de Reforma: Diagnóstico y Propuestas,” IDB, November 2003. Lora, Eduardo: “Competitiveness Reform Program” IDB, forthcoming. Lora, Eduardo: “La Posición Competitiva del Perú” unpublished PowerPoint presentation, 2002. Lora, Eduardo: “Se Buscan Buenos Empleos: Los Mercados Laborales en America Latina” unpublished presentation, November 2003. The chapter does not address the issue of Peru’s weak human capital.
This compares with 8 percent in Thailand and 15 percent in China.
Policy instability has been mitigated to some extent for some large investments by the signing of “stability contracts” between the government and investors. These contracts lock in the prevailing policies (especially as regards taxation and labor regulations) when the investment commitment is made. There are around 600 such contracts currently in effect.
“Peru—Microeconomic Constraints to Growth, the Evidence from the Manufacturing Sector,” World Bank, September 25, 2003.
See following Chapters, III-VI.
Between 1990 and 1999, total employment (in metropolitan Lima, including the underemployed) grew by 46 percent, in line with the growth of the economically-active population.
Some proposals would reinstate full stability rights and raise the already high level of mandatory indemnization payments.
There is an initiative in Congress to exclude all pay increases up to 20 percent from the non-wage labor cost requirements.
A “Lev General de Trabajo (LGT)” may be enacted in 2004. At end-2003, worker and firm representatives had agreed on about half of the articles of the proposed LGT. The agreed articles deal mainly with collective bargaining, although the continuation of collective bargaining at the firm level is not agreeable to worker representatives. The remaining parts of the LGT deal with individual worker rights (e.g. restrictions on layoffs), on which consensus may be difficult to reach.
This section draws heavily on: Banco Central de Reserva del Peru: “El Costo del Crédito en el Peru,” November 2002.
This excludes formal-sector enterprises with less than 10 employees, which typically have very little access to credit. The 51 percent in Peru compares with 58 percent in Bangladesh and 87 percent in Malaysia.
Inflation was 2.5 percent in 2003, and as of end-2003, about 75 percent of bank loans were denominated in U.S. dollars.
Draft legislation in this area is being prepared.
This compares with 19 percent in Chile, 22 percent in Costa Rica, 29 percent in Argentina, 46 percent in India, and 75 percent in Malaysia. See “Peru—Microeconomic Constraints to Growth, the Evidence from the Manufacturing Sector,” World Bank, September 25, 2003.