Political brinkmanship (with updated political information)
Political brinkmanship has been the focus since March, when the election of a new Congress resulted in an open confrontation between a Congress that wanted to pass populist legislation, and former president Martin Vizcarra, who faced bribery accusations. This led to Vizcarra’s November 9th impeachment, and Congress’ dubious election of Manuel Merino as president on November 10th, followed by Merino’s resignation of the night of November 15th, after a week of massive nationwide street protests in which two young men died in confrontations with the police.
The first signs of this confrontation easing were offered on the night of November 15th, when Congress decided to elect a new president from among legislators who voted against Vizcarra’s impeachment. After a tense weekend when Congress went back-and-forth with different lists, finally elected Mr. Francisco Sagasti as head of Congress and Mirtha Vásquez as vice-president. With the resignation of Mr. Merino and according to the Constitution, Mr. Sagasti became the president and Ms. Vásquez the new Congress head. Mr. Sagasti is a congressmen from the center-left Purple party, and a former academic who holds a PhD from the University of Pennsylvania in Operational Resarch. He would become the caretaker president and oversee the country only until the next elected government takes over on July 28th, 2021 and should call a national reconciliation Cabinet
Political turmoil started on November 9th, following a tense all-day impeachment process, when Congress voted by 105 to 25 to oust Vizcarra. Vizcarra was investigated by the Attorney General’s Office for alleged acts of corruption while he was governor of Moquegua, between 2011 and 2014, a small state in southern Peru.
Later that night, Vizcarra acknowledged defeat, and announced that he was leaving the presidential palace; his entire Cabinet subsequently resigned. It is apparent that he did not anticipate such a large vote against him in Congress. Moreover, the Constitution is clear that, once the president is notified of the impeachment vote, he or she must leave office immediately. In the absence of the two vice presidents, the president of Congress takes over. Officials called a congressional session for the following day, and Merino, the former president of Congress, was sworn in as the new president of Peru.
However, as Congress is currently very unpopular and the impeachment publicly perceived as an arbitrary decision from radical political parties, which invoked an ambiguous article in the Constitution to declare the president “morally unfit” (as the previous Congress had against Pedro Pablo Kuczynski, before his eventual resignation), Merino was not welcomed. Massive street protests started on Nov. 11th, and ran until his Nov. 15 resignation.
A period of protracted political confrontation began when Kuczysnki was elected president in June 2016, defeating Keiko Fujimori by the narrow margin of 41,057 votes. Since then, and in a single presidential term, Peru has had four presidents, and two congressional elections. The upcoming presidential and congressional elections on April 11th prompt two key questions: First, what would a Mr. Sagasti administration look like? And second, what is the most likely outcome of the April elections? With this high level of political uncertainty, we can attempt to answer the first question, and offer some guidance on the second.
Congress is associated with populist legislation that posed major threats to the country’s fiscal stability and long-term economic performance. However, with Merino’s resignation and the populist parties in retreat, Mr. Sagasti and his Cabinet would have more room for maneuver. Peru’s 1993 Constitution is very clear with respect to the roles of the executive and legislative powers in terms of budget appropriation, and in protecting key economic reforms undertaken in the early 1990s, during Merino’s term as president of Congress, and in alliance with radical political parties, legislation approved in Congress challenged these constitutional impediments.
Congress having acted with scant regard for checks and balances, and with questionable legitimacy, one is tempted to conclude that Congress will continue with such populist policies. However, Mr. Sagasti, in his first speech as president outlined his main objectives as president in a conciliatory tone but, at the same time, very straightforward. He had made a commitment to fiscal discipline and against populist policies. True that he may need congressional support to govern and pass important legislation, such as the 2021 Budget Laws due to be considered by Congress on November 30th, but he has opted for negotiation and not confrontation with Congress. One of the last decisions of Mr. Merino as president was to promulgate the Pension Law that allows workers to withdraw up to PEN17,200 (US$4,777.8) that was approved by Congress. However, Mr. Sagasti has hinted that would blocked the other Pension Law that calls for workers to withdraw their contribution to the pay-as-you-go system (the so-called, Oficina de Normalización Previsional, ONP) that Vizcarra had blocked, with the intention of seeking arbitration from the highest court, the Constitutional Tribunal (CT), because his government presumed that they violated the Constitution.
Mr. Sagasti is aware that the executive role of the president demands other duties that may enter into open contradiction with the populist demands of the radical political parties in Congress. The new president seems to have chosen to implement sound policies, gain legitimacy and reject a populist policies.
Supporting him there are four drivers of disciplined economic management: market pressure; disciplined budget management; the growth challenge; and the need to ensure that credit rating agencies keep their rating of Peru’s debt unchanged.
How the new president would juggle the support needed from a Congress favoring populist policies with these four drivers of disciplined policy is unclear. Investors would certainly follow this process closely. We don’t rule pressure from Congress but, as these four factors start to exert their own pressure, the new president and his Cabinet would incline towards more disciplined policy.
A more fundamental question is: Would the April 11th presidential and congressional elections affect this political brinkmanship? At this juncture, it is difficult to offer a definitive answer. While the first-round presidential and congressional elections are only five months away, given Peru’s current troubles, this seems an eternity and, with 24 political parties competing in these elections, anything could happen. While some commentators are watching opinion polls closely, their accuracy is dubious, and most voters are in the “don’t know” or “undecided” categories. Only with the publication on December 21st of political parties’ presidential and congressional slates will the identity of candidates be known -- and the polls may then offer a more accurate assessment of the contest.
Following the change of government, we have decided to tweak our 2020 and 2021 forecasts. Certainly, the election of Mr. Sagasti as president introduces an upside risk, but we would need to assess carefully his initial policies. We are trimming slightly our 2020 real GDP growth forecast to -13.9% y/y, from -13.7% y/y previously; and our 2021 forecast more sharply, to 6.7% y/y from 11.1% y/y. As we went to press, four trends were justifying our decision.
In the opposite direction and boosting the cyclical (but not potential) growth rate are two developments: the pull effect of external demand and the reopening of the economy. Vizcarra only partially reopened the service sector; with the COVID-19 infection and death curves continuing to flatten, and the next president’s government may decide to continue with this process. It is apparent that the service and retail sectors have driven the economic expansion since August, and our forecast expects this trend to gain further momentum in October, when the reopened service sector strengthens.
One side effect of political brinkmanship has been the drop in local market asset prices, although there is some divergence in terms of performance. Through November 13th, the local stock market index and the currency registered the sharpest drops. Less straightforward has been the quick response of the currency. With the Banco Central de la República del Perú (BCRP, the Central Bank) holding a large stock of international reserves (probably the largest among emerging markets’ central banks), one presumes that the currency will remain relatively stable. According to our own analysis, and unlike other central banks, the BCRP has a reaction function in which currency stability plays a key role.
However, when these political shocks occur, a new consideration comes into play. With foreigners holding 54% of Soberanos bonds ($18.2 billion), the BCRP’s preventing the PEN:USD exchange rate from playing its role as a shock absorber could backfire, and may signal that it is offering a free FX option to bondholders, covering their FX risk. Studies have shown that fixed exchange rate regimes have fared worse than flexible ones during currency crises. Allowing the currency to play its role as shock absorber would make the exit of investors in local currency denominated bonds more difficult by ensuring that investors accept the currency risk. In fact, we are revising our 2020 year-end spot PEN:USD rate to 3.7, from 3.5 previously, leaving the end-2021 rate unchanged at 3.6.
Against this backdrop, bondholders’ decisions about whether to sell their positions becomes more difficult. It is apparent that, despite the political shock, foreigners have decided to retain their bond positions. We presume that, instead of selling local currency denominated bonds, bondholders have hedged their FX positions in the forward and swap markets. Moreover, it seems that they have not been eager to sell, as would have been apparent in the dollar-denominated bond market, and the evidence is that investors have stayed put. Accordingly, we are revising our end-2020 10-year Soberano and Global bonds yield to maturity to 4.3% and 2%, and for 2021, to 5.5% and 3.5%, respectively.
One event that can shake investors’ expectations was the Mr. Merino’s government decision to sign into law the bill that allows workers to withdraw up to PEN17,200 ($4,777.8) from their pension funds. The Ministry of Finance had calculated that this could result in PEN14.5 billion ($4 billion) in withdrawals, and while this does not provide an estimate of how much would be met by selling government bonds, soles or dollars, according to our forecasts could be around PEN4 billion ($1.1 billion).
In May 2020, when a similar law was approved and workers were allowed to withdraw up to 25% of their pension funds, the BCRP offered a repurchase agreement (repo) against their Soberanos holdings in pension funds. This allowed them to meet the withdrawal of funds without selling their Soberanos positions. The BCRP’s president, Julio Velarde, has already stated that the institution is willing to offer this kind of protection again, although the amount involved would be lower (from around PEN5 billion in May-July to PEN2.2 billion).
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