Tuesday, July 19, 2011

Eurasia on Peru and the run-up to the Presidential handover

The Julio Velarde news gets the Eurasia treatment in this note out today. Enjoy.

PERU: Humala sends strong signals of policy moderation, but medium term risks remain
19 July 2011 03:31 PM EDT

President-elect Ollanta Humala's decision to keep current President of the Central Bank and respected economist Julio Velarde in his post amidst concerns about slowing private investment and falling approval ratings represent the strongest signal to date over his commitment to maintain macroeconomic stability. The next most important decision for Humala now rests in who he will choose to head the Ministry of Finance, where there is growing speculation he will announce tomorrow Luis Miguel Castilla, another moderate economist, to the post. The fact that Humala is responding to early difficulties through a stronger turn toward the center reinforces our view that he will start his administration on a positive note and will prioritize stability. That said, we continue to expect economic policy to take a negative turn in the medium term as Humala gradually increases spending to meet his ambitious social and economic goals in a context where his expectations about new source of revenue are probably overly optimistic. Such a risk is particularly acute if Humala's approval ratings don't recover or drop further in his first year in government.

Humala's decision to keep Central Bank President Julio Velarde in his post, announced in an interview Sunday night (he added that Velarde accepted to stay) is the strongest indicator to date that his administration will pursue relatively moderate macroeconomic policies. Humala originally seemed to prefer a new, less conservative president for the board, so the decision to keep Velarde is a positive surprise. Of the central bank's seven board members, the executive will appoint another three (the other three are appointed by congress), but it looks unlikely that Velarde would have accepted to stay if he would not at least have a say on other executive appointments. Given that the constitution guarantees the autonomy of the central bank, and that the central bank sets inflation targets, the decision to maintain Velarde indicates that keeping inflation low will be a priority under Humala.

The next most important decision for Humala is who he will choose to head the Ministry of Finance. The strongest candidate for the post appeared to be Kurt Burneo, who was former President Alejandro Toledo's main economic advisor and joined the Humala campaign after the first round of the presidential election. Burneo has experience in office and is viewed as more moderate than Felix Jimenez, Humala's long-term economic advisor, but shares some of Humala's views about the need for a larger role for the state in the economy. Now there is growing speculation he will choose to the post Luis Miguel Castilla, a moderate US-trained economist with a more technocratic profile than Burneo. Speculation grew after Castilla resigned from his post as Vice-Minister of Finance last Friday. Humala has always been more open to appointing independent technocrats to the central bank than to head the Ministry of Finance, a post he views as highly strategic given its role on budget issues and fiscal policy. As a result, decision to appointing Castilla would represent another strong early signal of moderation.

While the decision to keep Velarde in his post and the potential nomination of Castilla to the Ministry of Finance are a bit of a surprise, we have long expected Humala to appoint respected economists to the central bank and place a premium on stability, so this doesn't change fundamentally our baseline view on his economic policies.

Humala's decision to veer more strongly to the center, however, is probably a function of concerns with slowing private investment, which would affect future economic growth and tax collection, but also with a sharp decline in support for Humala over this past month. According to an Ipsos/Apoyo poll released over the weekend support for him dropped from 70% to 41%. While part of the drop was probably driven by a high profile scandal involving his brother (who has been accused of trying to use his family ties to negotiate private deals in a recent trip to Russia), part of it may also be driven by more negative economic news associated with uncertainties surrounding the transition. The fact Humala is responding to such difficulties through a stronger turn toward moderation is certainly a positive sign, but it probably reinforced his view on the need for a "positive shock" on expectations early in his administration.

Despite the recent positive developments, we continue to expect economic policy to take a negative turn in comparison to the past administrations-particularly in year two and three of his administration. Humala is well aware that sending positive signals to investors early in his administration is critical to avoid an environment of uncertainty which could dampen investment, economic growth and tax collection. But he also wants to expand the role of the state in the economy through social programs, infrastructure investment and an active industrial policy, all of which will require more spending. He will increase spending gradually and seek to finance new expenditure with higher tax revenues on mining and measures to fight tax evasion and corruption. However, such measures look unlikely to generate additional revenue equivalent to 3% to 4% of GDP as the government expects. As a result, reconciling conservative macroeconomic policies with his more interventionist goals won't be easy. As we have been arguing, if Humala faces tough decisions later on his administration, he will probably lean towards a more heterodox economic policy mix.

The trajectory of Humala's approval ratings will be a key variable to follow. If his approval ratings don't recover or drop further in his first year in government, his incentives to pursue policies that are less-investor friendly will increase over time. While the recent decline in support for him probably contributed to a turn toward moderation, if that doesn't yield political or economic results Humala could be tempted later on in his mandate to adopt a more heterodox approach. The fact that Humala's approval ratings dropped so sharply and so early is worrisome. Past presidents started with about 60% of approval, but support for them declined over the course of their first year in office and recovered only partially towards the end of their terms. This suggests that presidential approval ratings in Peru are structurally low. It looks like Humala will start with a lower level of support, so if there is a repetition of past trends, he may struggle to recover support and his approval ratings could very well drop further. If that happens, Humala could feel that he needs to spend more to deliver on campaign promises and boost political support.

Even in this scenario Humala is unlikely to respond with a radical shift in economic policy, but the risk of a negative turn in policy would increase. He wouldn't put stability at risk, but would probably test the limits on fiscal policy, which could generate political tensions between the executive and the independent monetary authority if the central bank starts a tightening cycle that could dampen growth. There would be higher risks for the mining sector as well. While Humala looks poised to increase taxes on mining operations, which he views as a key source of new revenue, we expect him to show some restraint to avoid hurting a promising pipeline of investment (See Humala likely to show some restraint in approach to mining sector, from 1 July). However, greater fiscal pressures and a weaker political standing would increase the risk of a more cumbersome tax hike.
Erasto Almeida
Analyst, Latin America