Peru: The wild card of politics

Political crises have not held back economic reform in Peru, although the risk is always present. While paramilitary groups have resurfaced (as the now-resolved hostage crisis at the Japanese ambassador’s residence all-too-publicly demonstrated), the economic programme should stay on course in the medium term.

The government’s resolve to keep the reform momentum going means that investors should not be put off by the country’s less than straightforward path to democracy. There are plenty of opportunities in Peru for knowledgeable investors.

Instruments which mitigate political risk, such as the securitization deals recently closed by mining companies Southern Peru Copper and Cerro Verde, are popular. Meanwhile, there is a frozen loan pipeline thawing out after the tequila crisis. International issues, such as the recent Ferreyros ADR, are also on the rise.

In a recent television appearance, president Alberto Fujimori discussed the crime wave he believes is responsible for attacks against opposition party members. He denied that right-wing paramilitaries are marauding the streets. According to Fujimori, thieves are so plentiful in Peru now, that given the law of averages they are bound to hit a sensitive political target or two.

Such a lively political situation begs the question: can Fujimori keep the armed groups, the opposition and the current account deficit under control? True to form, he is expected to simultaneously tackle these problems with varying degrees of success.

For Peru observers, there is an inherent risk in the juxtaposition of the country’s transition to democracy with economic reform. As the president appeases foreign investors and the IMF, he could sacrifice his local popularity, his re-election in the year 2000, and consequently, the stability of his economic programme.

“The main challenge the country faces is the strengthening of institutions to allow for a smooth transition of power in the future without disrupting the main economic reforms,” notes a recent report by Deutsche Morgan Grenfell (DMG).

Peru’s northern neighbour, Ecuador, provides a reminder of what can go wrong. Former Ecuadoran president Abdala Bucaram was recently thrown out of office after his popularity plummeted, partly due to public opposition toward his economic policies.

Fujimori’s popularity suffered during the hostage crisis. Any move to tighten economic policy to correct the current account deficit – estimated to hit 6.1% for this year – or to reach public finance goals, could further hurt his image on the home front.

The government is expected to loosen its tight fiscal and monetary policies, says Georgette Montalban, an analyst at DMG. “So, there could be a risk of an increase in consumer imports,” she says. But Montalban foresees enough growth in petroleum and mining exports to cover the deficit.

A proposal by the central bank to revise GDP measurements could further affect the current account deficit. If approved, the change would automatically raise it from 6.1% to 7.2% of GDP. The adjustment could reduce GDP from a current estimate of $60 billion to $51 billion. On the other hand, the revision would favour the government’s goal for a 1.3% fiscal surplus by increasing tax revenue from 14.1% of GDP in 1996 to 16.7% of GDP. The government turned a 0.3% fiscal deficit in 1995 into a 1% surplus last year.

Last year, for the first time since 1990, inflation did not decrease from the previous year. But inflation is expected to fall to around 9% this year.

Overall, the economic programme should stay on course in the medium term. With continued economic growth and foreign investment flows, earnings should rise steadily, which some believe could culminate in a growth explosion once investments mature. The consensus is that GDP growth should reach 4.4% to 4.5% this year compared with 2.8% in 1996 and 13.1% in 1994. The sectors likely to lead the way include mining, energy, construction and finance.

The financial sector will drop out of that list if proposed new regulations are approved. New provisioning requirements would hit hard at bank earnings, says Andrew Marshall, director of research of Santander Investment in Peru.

On the other hand, given Peru’s unpredictable politics, it is just as possible the law will never be passed at all. Politics, as usual, is the wild card in the deck.

Unblocking the loan pipeline

Peru’s project financing is skyrocketing as companies gain access to long-term loans. Innovative deals are being put together by both local and foreign banks

The tequila crisis blocked Peru’s growing loan pipeline for two years. Now, with the positive development of the Brady Plan, loans are starting to be made again.

Overall, the loan market has already discounted the effect of the Brady deal. As a result, there won’t be dramatic changes in loan pricing, says Miguel Palomino, head of Merrill Lynch’s Peru office.

However, in the year since the Brady debt restructuring was announced, terms have lengthened, notes one banker. “There’s a series of syndicated term loans, especially for certain sectors such as mining.”

While on average most companies obtain loans for a maximum of 12 months for working capital, and three to five years with 18-month average life for long-term financing, some companies are able to stretch out maturities.

BankBoston, the new bank created from the Bank of Boston/Baybank merger last year, has joined the ranks of foreign banks that are sinking roots in Peru. Banco Bilbao Vizcaya, Santander Investment, Deutsche Morgan Grenfell, ING Barings, ABN Amro, Société Générale and Citibank provide considerable lending competition for the local banks.

Banco de Credito, in particular, has risen to the challenge by putting together top-notch teams, particularly in loans. It recently arranged an internationally syndicated loan for copper company, Cerro Verde. While the Peruvian bank recruited Toronto Dominion and ABN Amro to help with the deal, insiders reluctantly admit, Banco de Credito did all the work on the successful deal.

In 1994, lending was going ahead smoothly, only to be devastated by the Mexican peso devaluation in late December. Deals placed on the back burner took twice as long to close, if at all.

Some sectors, particularly mining, petroleum, energy and electricity, are prime project finance candidates.

Mining, with its billion-dollar investment commitments to exploration, stands out as the most fertile loan territory. It produces half of Peru’s total exports and is indirectly responsible for 23% of GDP. Since Peru is among the world’s top producers of gold, silver, copper, zinc and tin, there are ample investment opportunities.

To date, export-backed mechanisms have provided the most creative lending. Mining giant Southern Peru Copper recently closed a $750 million financing which combined a $400 million revolver with a $200 million backstop facility and a $150 millon export note programme. Citibank arranged the revolver and the backstop with CS First Boston in charge of the note programme.

While the company originally wanted a 15-year maturity, the bankers settled for 10 years, which counts as one of the longest terms on record. For its part, mining company Milpo closed a $17 million straight-term loan for six years. Meanwhile, Cerro Verde recently received an eight-year, two-tranche secured loan for $110 million led by Banco de Credito. This followed on the heels of the Southern Peru Copper deal.

“They were either lucky or very shrewd that they coat-tailed on the Southern deal,” remarks one banker on Credito’s ability to attract 20 banks to the loan.

Looking ahead, the Arias Group is expected to refinance one of its mining projects. In 1995 the group received a three-year loan for $15 million, which should be turned over next year.

Other companies, such as La Granja, are reportedly looking for advisors on debt projects which are likely to involve straight syndication with parent support.

The power sector is as thirsty for finance as mining. The recently-privatized electricity sector is also hungry to finance its much-needed expansion.

Gas stations, on the other hand, are looking for investment. According to analysts, in the next two years, Peru needs to increase its current supply of 1,200 gas stations to 2,000. Financing for these small franchises will probably come in the form of a 15-year mortgage loan for $200,000 to $300,000 a piece with a seven-year average life.

One company is looking for a $100 million bank loan to finance an acquistion. Others, such as Luz del Sur, will probably rely on their international parent companies to help structure favourable deals.

Project financing is set to explode in Peru. While few deals will appeal as strongly as the Southern Peru Copper deal, the opportunities are there for the taking.

Pension funds push

At one time bank loans were the most popular financing methods, and local capital markets remained undeveloped. Now stabilization and the advent of private pension funds have provided both supply and demand for issues

In the past, Peru’s local markets faced tough competition from banks so flush with funds that loans were the most popular financing method. Now, the growth of the country’s private pension fund system is spurring the rapid development of local capital market instruments.

More local companies are finding sole denominated financing in the local capital markets an attractive option. The private pension funds, known as AFPs, have voracious appetites for just about anything – fixed income, equity and whatever markets develop next.

The funds are growing at a rate of $50 million to $60 million a month, which alone gives them an additional $17 million to invest each month. Considering the average daily volumes of the stock exchange reach between $12 million to $15 million, the AFPs claim significant influence domestically.

Since the creation of the private pension system in 1993, domestic savings have increased to 14% of GDP by September 1996. Andrew Marshall, head of research at Santander Investment in Peru, predicts they will reach 18% of GDP by the end of this year.

Such healthy domestic savings and robust AFP growth, with a rising fiscal surplus, monetary stability and greater bank deposits can only help the development of local markets. After a 17% plunge in 1995 and a slight 2% jump last year, the Peruvian stock market is poised for steady growth, according to equity analysts in Peru.

Last year stock prices lagged behind earnings. In the past two years, the average earnings growth of 21% outpaced stock prices. The Selective Index, which comprises of the top 15 blue-chip companies, registered most of last year’s growth. Analysts at Deutsche Morgan Grenfell (DMG) predict the market will gain momentum this year as second-tier stocks, or those listed in the General Index, recover. The second tier had already grown substantially by the end of March, and the banking and telecommunications sectors sprang to life during that period. Second-tier mining companies displayed robust growth. Small mining company, Vulcan, for example, shot up close to 100% in the first quarter.

Last year, beer company Backus spearheaded the blue-chip growth with a 97% lead, followed by 28% growth in the banks, 17% in utilities and 16% in mining.

DMG foresees 30% earnings growth this year. More than half of that had occurred by mid-March. Santander has a 20% target in dollar terms for the Peruvian stock market this year. It also expects foreign flows into the stock market to increase by at least 20%, depending on what happens on the New York Stock Exchange.

Most observers believe foreigners will invest between 20% to 40% more money, up to $700 million, in the Lima exchange this year. Last year, the exchange received net foreign inflows of $500 million, excluding the $1.1 billion foreign and domestic investment in Telefonica del Peru shares.

Some analysts believe the foreign funds flow will spur a growth explosion. “Peru is receiving the greatest inflow of foreign capital in its history which should give a second wind to growth by the second half of this year,” says a DMG analyst.

Most foreign money will likely to be spent first in the mining, fishing, construction, commerce, and agricultural sectors. Later, foreigners might look toward the local telecommunications industry and, much later, the consumer sector.

For Santander, the top three companies in terms of growth for the year will be: mining companies Milpo, Minsur and electricity distributor Luz del Sur. Zinc producer Milpo is slated for growth given the upward price of zinc. Milpo is also expected to announce the development of its joint venture with Phelps Dodge, a zinc/copper deposit worth some $200 million, known as Cerro Lindo. Minsur prices should jump with the results of its new tin refinery which started to operate at 100% capacity in April.

Other issues enticing foreign investors include April’s $26 million issue from Ferreyros and an expected issue later in the year from Banco Continental.

Later in the year, the government is expected to sell the 20% stake, worth around $95 million, it holds in Banco Continental. Continental might be an ADR in two tranches, international and local, with 10% sold to the citizen participation programme.

Other companies are turning to the local fixed income market for sole denominated financing. Last year, Telefonica del Peru completed a 150 sole million bond issue at inflation plus 5.7% while retail company Fabril Pacifico (now AliCorp) managed to get close to that pricing with a bond issue at inflation plus 5.75%.

Meanwhile, Peru is expected to establish its benchmark Eurobond this year. Last year Merrill Lynch won the mandate to arrange what was to be the benchmark established by the national development bank, Cofide. But that issue is all-but cancelled in favour of a more “pure sovereign”, says Merrill’s Palomino.