Tuesday, June 28, 2011

Eurasia on Peru's transition under Humala

PolRisk dudes Eurasia Group has just published its note on how the upcoming Humala government is shaping. Read it through but I'll say two things here.

1) I agree with this good analysis
2) Peru exposed companies are about to rebound.

Read on, kind lector...

PERU: Roadmap for the early Humala administration
28 June 2011 01:28 PM EDT

President-elect Ollanta Humala will soon appoint moderate figures for key economic and political posts in his administration, and that will be an important signal that he will not pursue radical policies. Nevertheless, Humala may soon have to face a trade-off between his fundamental goals of pursuing change while maintaining macroeconomic stability. During his first months in office, he will announce measures that will increase spending, such as an expansion of social programs. But he will probably increase spending gradually and seek to keep it within the parameters of Peru's fiscal responsibility law, at least in the near to medium term. Nevertheless, Humala's popularity looks set to drop during his first year in office due to high expectations of change among the electorate and the challenges he will face in delivering on campaign promises. This will increase political pressure on Humala, generating more incentives to pursue an expansive fiscal policy and take measures that could worsen the environment for investment.

Ollanta Humala will begin his administration by signaling that he will pursue relatively moderate policies, and by reaffirming his commitment to macroeconomic stability, a market economy and the rule of law. Such moderation is probably sincere and will be a function of several factors. First, he believes that maintaining macroeconomic stability and attracting private investment are both prerequisites for the generation of the conditions needed to achieve his social and economic goals. Second, he is well aware that most voters prefer moderate change over radical change. According to a recent Ipsos/Apoyo poll released on 16 June, 61% of voters think that Humala's government should be like that of Brazil's former president Luiz Inacio Lula da Silva, while only 11% said it should be like that of Venezuela's President Hugo Chavez. Third, he will need the technical expertise and political support of centrist political forces in congress where his coalition won only 36% of seats (particularly from former president Alejandro Toledo's group) to implement policy.

Humala's key advisors will be moderate

One important signpost of policy direction under Humala will be the appointments for key cabinet posts. He is likely to announce as early as this week moderate and reasonably respected figures. His transition team, led by Vice-president Marisol Espinoza, provides some hints on who will be his most influential advisors. Kurt Burneo, who was Alejandro Toledo's main economic advisor and became the main voice on economic matters in Humala's second-round campaign, will lead the economic team with the help of Oscar Dancourt and Felix Jimenez, who will oversee financial and budget issues, respectively. Burneo looks like the strongest candidate to head the Ministry of Finance. He has experience in office and is generally perceived as a moderate, but also believes that the state should play a larger role in the economy and invest more in social programs, a point of view which helped him win Humala's trust. In an interview over the weekend, Espinoza stated that the minister of finance would be from her party, but this doesn't seem to exclude Burneo, who has been working closely with Humala since the beginning of the second round campaign. In fact, Humala stated yesterday that is up to him to make appointments, suggesting some discomfort with Espinoza's comments.

Dancourt and Jimenez are also likely to occupy important posts in the administration. Dancourt has experience as a central bank official and is perceived as someone who has good technical credentials, which make him a good fit for president of the central bank's board. Humala has made a strong commitment to maintaining the autonomy of the central bank and is aware that higher inflation could undermine popular support for him. But he also seems to believe that the current president of the central bank's board, Julio Velarde, is too conservative. Felix Jimenez is a longtime Humala advisor with clearer leftist positions, but his background probably makes him a less likely candidate than Burneo to fill the post of minister of finance. Still, he will probably be appointed to a post in the ministry, where he would work with Burneo, possibly focusing on budget issues and the allocation of resources for Humala's social and industrial policies.

There is probably a higher risk that Humala's appointment to head the Ministry of Mines and Energy will have stronger nationalist views given his desire to increase taxes on mining and prioritize the domestic market in the supply of natural gas. Nonetheless, strategic decisions for the sector will probably be taken by his inner circle of advisors. Humala looks likely to pick one of three figures who are participating in the transition team: leftist former legislator Manuel Dammert, who has a track record of opposing privatizations and exports of natural gas; Humberto Campodonico, a leftist engineer and intellectual who is a longtime Humala advisor and has advocated supplying the domestic market first; and Herrera Descalzi, a former minister of mines and energy who joined the Humala campaign after the second round and is perceived as having more moderate views.

Relatively moderate figures predominate in Humala's inner circle of political advisors and strategists. His main political operator will probably be legislator Daniel Abugattas, who has developed close ties with Humala and who played a central role in the campaign. As a former businessman, he has relatively moderate policy views. There is speculation that he could become head of the Council of Ministers (a post also known as prime minister), whose role has varied in past administrations from a more political one-for example, as the point person for relations with congress-to one more focused on administrative coordination between the different ministries. But Humala may opt to keep Abugattas in congress, where he would lead efforts to advance the administration's legislative agenda, possibly as president of congress. Given Humala's lack of majority in congress, he will need a strong leader there. In that case, Humala could opt for someone with a more administrative profile for the post of prime minister, perhaps Ambassador Luis Chiquihuara, who is in charge of affairs related to this post in the transition team. Despite some speculation that Humala could appoint to the post respected independent lawyer Beatriz Merino, who was prime minister under Toledo and currently is head of the association of private pension companies, we see this as unlikely given Humala will probably pick someone with closer ties to him.

Another member of Humala's inner circle is Salomon Lerner, a businessman who has been one of his key strategists and point person with the business community. There is speculation that he could become the presidency's general secretary or even that he will not occupy a post in government, but he will probably continue to be an important advisor, even if an informal one. Finally, Humala's wife Nadine Heredia, who has played a role as a political advisor and strategist, will probably be a very influential figure. Early speculation that she could run in 2016 to succeed Humala indicates that she will be a key advisor and influential figure within his administration.

A gradual increase in spending

Humala will most likely announce during his first months in office some measures to implement key campaign promises that would lead to more spending, but he will seek to reassure voters and markets that this can be reconciled with responsible fiscal policy. Humala's advisors say that in order to meet their social and economic goals, the overall tax burden would have to increase by three or four percentage points of GDP, but spending will probably increase gradually. He will focus initially on expanding social programs that can have a significant social and political impact at a relatively low cost. The most important initiatives to be announced would be an expansion of existing cash transfer social programs, one which the largest is called Juntos, and the creation of a new, non-contributive pension benefit for the elderly called Pension 65. Humala's advisors estimated the cost of the new pension benefit at 0.8% of GDP and a substantial expansion of Juntos would probably cost much less (the program, which the previous Alan Garcia administration had already expanded substantially, currently benefits almost 500,000 families and its cost represents about 0.15% of GDP). Relatively strong economic growth-estimated to be somewhere between 5% and 6.5% this year and a bit lower in 2012-will help boost tax collection. So a Humala administration would probably have some fiscal room to increase spending without violating Peru's fiscal responsibility law which established a 1% of GDP cap on the public sector deficit, at least in the near term.

Humala will look to the mining sector as an additional source of revenue and will seek to expand the role of the state in other strategic sectors. While he has provided few details on specific measures, Humala has signaled that his administration will not seek to take over private assets. He has also hinted that he is moderating his views. For example, the policy document his campaign issued during the second-round campaign (called Hoja de Ruta, or roadmap) softened the wording about his plans to hike taxes on mining and says his administration will seek to keep the tax burden competitive. While the document maintains the position that the administration will renegotiate natural gas contracts to prioritize supply to the domestic market, Humala has signaled more moderation in fuel pricing policy. During the campaign he promised to lower the price of liquefied petroleum gas (LPG), but now says that this will come over time as LPG is replaced with locally produced (and cheaper) natural gas.

Humala's approval ratings will probably decline during his first year in office

While Humala will most likely start his term with high popular support, his approval ratings look set to decline during his first year in office, something that could lead him to face some policy trade-offs relatively early in his administration. According to the latest Ipsos/Apoyo poll, 70% of respondents approve of Humala as president-elect, which is significantly higher than the 51.5% of votes he had in the second-round run-off. This is due in part to the good will that presidents-elect usually enjoy, but there is also much expectation that Humala will be able to deliver on his campaign promises. Fulfilling such expectation will be challenging given that it will involve addressing difficult structural issues. For example, according to the Ipsos/Apoyo poll, most voters believe Humala should focus primarily on fighting corruption and crime. While Humala will probably announce initiatives on both fronts, delivering results will take time. Given that corruption remains well-rooted in the Peruvian state, it would not be a surprise if some high-profile scandal emerges in the near term, and that would disappoint many voters who have overly optimistic expectations about Humala.

In addition, Humala could lose some support because of social conflicts. Such issues, which have typically involved local complaints against natural resources projects, are commonplace in Peru and sometimes turn violent, as occurred recently in the southern region of Puno, where locals protested against mining concessions. Humala will certainly make efforts to consult more with local communities and diminish conflicts, but resolving the underlying structural issues that motivate conflicts won't be easy, so new tensions are highly likely and could hurt Humala's approval ratings.

If trends seen during the last two administrations are any indication of the future, Humala could see a rapid decline in support. This happened under both Alejandro Toledo and Alan Garcia, who started with approval ratings above 60%, but saw them decline sharply during their first year in office (see graphs attached).

Support for Humala looks unlikely to drop as much as support for previous presidents, however. The popular measures he will announce in the beginning of his administration will help maintain support for him among the poor, who constitute his social base, and create a perception that he is pursuing change. From a structural perspective, economic improvements and the social programs of past administration could be slowly reducing popular dissatisfaction with the political class, which has been widespread in Peru. One possible indication that this is occurring is the fact that Alan Garcia's approval rating bottomed out at a higher level than Toledo's did. While Toledo's approval rating dipped below 10% in his third year in office, Garcia's lowest popularity was around 20%. It is important to note that both saw a recovery in their approval ratings toward the end of their terms.

Policy repercussions

This means that a decline in Humala's approval ratings probably wouldn't lead to a fundamental policy changes, but it would increase incentives for him to deepen his social and statist policies, contributing to a negative turn in economic policy. We have made the case that he will not be radical, but that he will push the limits on both macro and microeconomic policy when facing difficult trade-offs between maintaining macroeconomic stability and pursuing his goal of expanding the role of the state in the economy. If his approval rating drops, he will have a greater incentive to do so as a way to recover some political ground.

For macroeconomic policy, this means that Humala would pursue an increasingly expansive fiscal policy. He will expand social programs, invest more heavily in infrastructure, increase public sector wages, and seek a greater role for state-owned companies. He could, however, move more aggressively on all those fronts if needed to boost popular support. Humala probably wouldn't go as far as completely abandoning Peru's fiscal responsibility law as a reference for fiscal policy. But he could very well violate the 1% limit on deficit-it is important to remember that there is no severe penalty for doing so. He is unlikely to undermine the autonomy of the central bank, but if it tightens monetary policy enough to dampen economic growth, political pressure on the central bank and tension with the executive would increase.

Humala's sector specific policies could also take a more negative direction. For example, he would have a greater incentive to extract more rents from the mining sector to finance new spending. It would probably take at least a few months before his government has a tax proposal ready to send to congress, so Humala's declining approval rating would increase the risk that he will opt for an aggressive tax hike. His weaker political standing could force him to make some concessions in order to win congressional approval for the proposal given that he will need support for centrist parties. However, this could increase the risk that he will take a tough position in talks with companies who have tax stabilization agreements as he seek to renegotiate the terms of these contracts (they represent about 25% of Peru's mining production). Humala could also take a tough position on negotiations with natural gas producers to redraft existing contracts and prioritize supply to the domestic market, and more actively seek to develop the state's capacity to operate in the hydrocarbons sector.
Erasto Almeida
Analyst, Latin America