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Castillo’s victory increases uncertainty in Peru and could delay recovery

Investment Insights

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Castillo’s victory increases uncertainty in Peru and could delay recovery

After more than two weeks of vote counting, Pedro Castillo will be announced as the next President of Peru. Castillo, a left-wing candidate and former primary school teacher who entered politics in 2017, beat Keiko Fujimori by a margin of less than 45,000 votes, approximately 0.2% of the total. He is supported by the rural areas of the country and benefited from public discontent with growing income inequalities. In this Macro Flash Note, Joaquin Thul looks at the potential implications of the election result.

Joaquin Thul
Joaquin Thul

The first round of the Presidential election on 11th April saw a record 19 candidates. Castillo and Fujimori were the two candidates with the most support, with 19% and 13% of total votes, respectively. The narrow difference between the candidates in the second round, on 6th June, reflected the division between their two proposed economic models. Fujimori has not accepted the election result yet, alleging electoral fraud.

Keiko Fujimori, daughter of former President Alberto Fujimori, was perceived by market commentators as a candidate who would ensure continuity with the current economic model. However, in recent years she has faced accusations of corruption making her unpopular in some parts of the population. Pedro Castillo was largely unknown before the election. He campaigned on a strong platform of nationalisation, increased government intervention in the economy and tax hikes for the rich, which made him popular after the country’s poor economic performance in 2020.

Peru’s economic success over the last 20 years was based on orthodox economic policies, improvements in the mining industry and promotion of trade. Until the end of 2019, Peru was growing faster than the Latam average (see Figure 1). The primary fiscal deficit was less than 1% of GDP, gross government debt represented less than 30% of GDP and inflation hovered around 2%. Additionally, the economy has benefited from rising commodity prices since 2008, particularly copper, which accounts for one third of Peru’s exports, and other metals, which account for another fifth of the country’s total goods exports.

Figure 1. GDP growth

Source: IMF and EFGAM calculations as at 23 June 2021.

Covid-19 had a strong negative impact in Peru, with 2 million cases registered since the start of the pandemic and 190,000 deaths attributed to the virus. Reflecting the slowdown in activity and the mobility restrictions imposed, GDP declined by 11% in 2020 and the unemployment rate increased to 14%. The government’s large fiscal package, equivalent to over 15% of GDP, and a reduction of the policy rate to a historical low of 0.25% could only partially limit the impact on activity.

Peru has experienced marked political instability in recent years, with four Presidents since 2016.1 The large political divisions boosted the populist profile of Castillo, who called for a constitutional assembly to write a new constitution. However, Castillo will struggle to gather enough support for policy changes since the elections left no party sufficiently strong to pursue this kind of reform in Congress.

In Peru’s system the President is both the head of state and head of government. Although the President can block and propose legislation, only Congress can pass new reforms. Congress consists of 130 members from multiple parties elected by proportional representation in the first round of the election. After April’s election Castillo’s party, Peru Libre, obtained less than a third of total seats, meaning he will need to seek alliances to govern.

In the short term he is likely to focus on controlling the virus, expanding the vaccination program and reducing unemployment. Castillo’s weak mandate will prevent him from implementing significant changes to the economy. Because of his disagreements with the opposition, he is also less likely to benefit from the honeymoon period that the incoming President usually enjoys in the first months in office.

Asset prices in Peru reacted negatively to the electoral uncertainty and Fujimori’s accusation of fraud. Stock prices, historically correlated with copper prices, fell by over 6% on the day after the election (see Figure 2.A). The Peruvian sol depreciated by more than 2% against the US dollar on the day, adding to a 20% depreciation since the start of 2020 (see Figure 2.B).

Figure 2 – Market reaction to the election result

A) Peru’s stock market and Copper price


B) Peruvian sol real exchange rate and PPP estimates

Source: Refinitiv and EFGAM calculations as at 23 June 2021.

After the election, as Castillo’s victory became more likely, his party issued a statement to calm markets. It played down nationalisation plans, exchange rate controls, price controls or import prohibitions, and pledged to respect the autonomy of the central bank.

In the short term the economic situation in Peru will remain challenging, driven by political disputes and the Covid-19 pandemic. The currency is expected to depreciate further if political tensions persist. Inflation pressures have been contained, with a year-on-year increase in consumer prices of 2.45% in May driven by supply-side pressures. Based on our analysis of inflation dynamics, we expect it to remain low for the rest of 2021 (see Figure 3). The central bank (BCRP) intends to mitigate the market volatility created by recent electoral uncertainty by maintaining an expansionary monetary stance. The output gap and anchored inflation expectations will also help to keep price increases within the target of 2% per year, +/-1%. The fiscal deficit is seen declining to 5% of GDP in 2021 as some of the emergency fiscal measures are gradually removed. However, the country will face greater pressure to expand social spending as the unemployment rate stays close to 12%.

Figure 3. Inflation rate and forecast range (%)

Source: EFGAM calculations as at 23 June 2021.

Overall, we expect Peruvian assets to remain volatile in the second half of the year. The Presidential election outcome has increased uncertainty and will test Peru’s institutional strength. The moderation in President Castillo’s rhetoric will be welcomed by markets but not by his core voters. Attention will turn to policies oriented to control the pandemic, which will gather more political support. Inflation is not a problem for the time being, but emergency fiscal support remains essential. As in most Latin American countries, the economic impact from the Covid-19 crisis will challenge incumbent governments that will have to balance short-term needs with long-term economic sustainability. Peru will be no exception so until there is more clarity on policies, we maintain a cautious outlook for Peru.