Only a few months ago, almost no one expected that Peru’s President Alberto Fujimori would have a fight on his hands to win a third five-year term. The unexpectedly strong challenge from Alejandro Toledo has suddenly increased uncertainty over the country’s future.

Surprisingly, Peru’s financial markets have taken the uncertainty in their stride. The sol, Peru’s currency, has traded within a narrow range throughout the campaigning. Share prices on the Lima Stock Exchange have slipped, as have Peruvian Brady bonds. But they were probably driven down more by the tumble on Wall Street than a surge of anxiety over rising political risk.

The calm is all the more striking given the passions unleashed during the first round of elections when Fujimori failed narrowly to take 50% of the votes and defeat Toledo outright. Instead, he must take on his challenger again in elections on May 28 in a battle which he has a good chance of winning, although victory is no longer a foregone conclusion.

Peru’s elections have come at a time of growing tension throughout the Andean region. In neighboring Bolivia, nearly 20 years of political stability and market reforms are under threat from street protests. In Ecuador, President Gustavo Noboa is struggling to restore order by implementing a controversial dollarization plan. In Colombia, President Andrés Pastrana has called a referendum that would replace Congress with a new body. In Venezuela, President Hugo Chávez faces an unexpected challenge in the May referendum on constitutional reforms.

Yet Susana de la Puente of JP Morgan and a member of Peru’s venerable Wiese banking family, says: “JP Morgan has a positive outlook on Peru. We feel the worst is over on the economic front and that the political noise will soon die down, and it will be back to business as usual. Investment flows should start up again soon.” She says JP Morgan expects Peru to grow 4.2% in 2000.

Most investors seem convinced that Fujimori would continue along the same path he has followed during his decade in power, and if Toledo were elected, he would also continue with Fujimori’s free market policies. While the markets expect economic continuity, there is a clear preference for the incumbent. “For a lot of people in the markets, the devil you know is better than the devil you don’t,” says David Roberts of NationsBanc Montgomery Securities, who adds that for all of his defects, Fujimori still commands great respect for managing Peru’s remarkable transformation.

Nevertheless, Liliana Rojas-Suárez, the Peruvian-born chief Latin American economist at Deutsche Bank in New York, warns: “There is currently a climate of uncertainty in Peru that will remain beyond the elections regardless of who wins.” Whoever heads the incoming government faces some formidable policy challenges. He must recast the privatization program and revitalize the country’s institutional framework.

Fortunately, the next president should inherit an improving economic scene. Rojas-Suárez expects that by the third quarter, the economy should be recovering significantly. Peru does not need to approach world debt markets for the rest of the year, the government has agreed a new economic program with the International Monetary Fund and commodity prices are recovering. Domestic demand is growing rapidly, and banks are slowly but surely beginning to lend to small and medium-sized businesses.

Stabilizing the public finances is likely to be the incoming government’s first priority. Piero Ghezzi, an economist with Deutsche Bank Securities, says the next president must trim the fiscal deficit, since Peru will need to pay $1.7 billion in 2000 and $1.8 billion in 2001 in debt amortizations. Most of this money is likely to come from multilateral lenders such as the World Bank and the Inter-American Development Bank. Ghezzi doubts the next government will revive the dormant privatization program or borrow on international markets. He says: “Peru will need to behave responsibly on the fiscal side to obtain the financing it needs this year and next.”

Meeting IMF Targets
Investors are likely to be scrutinizing the incoming government’s fiscal policies. The budget deficit rose to 2.7% of GDP in 1999, a sharp increase over 1998’s 1% deficit, and more than double the target Peru had agreed with the IMF. Economists say the government must cut spending after the elections if it is to meet its IMF targets and comply with the Fiscal Prudence and Transparency Law passed by Congress in December. This requires the government to gradually reduce the budget deficit and eliminate it completely by 2002.

Privatizing the few remaining state-owned companies would help reduce the budget deficit and boost investor confidence. During the early 1990s, Fujimori sold off scores of hotels, banks, and utilities to private investors, bringing in about $8.5 billion in revenues and almost $7 billion in associated investment flows. The privatization bandwagon came to an abrupt halt, however, early in his second term as the government turned its focus to amending the constitution to permit his re-election.

The government was disappointed by the indifference of international oil and gas groups to Peru’s only big ticket privatization, the sale of the rights to explore and develop the Camisea oil and gas deposits deep in the forests of eastern Peru. The government sold Camisea to an American-Argentine-Korean consortium in February and plans to hold a second auction later this year. However, Camisea’s future is uncertain following the completion of a 2,000-mile pipeline to supply Bolivian natural gas to Brazil, the potentially huge market Fujimori once hoped would import Peruvian gas.

Fritz du Bois, manager of the Peruvian Institute of Economics (IPE), a Lima-based think-tank, estimates that Peru still has $3 to $4 billion in assets it could sell to private investors, including Mantaro, the nation’s largest electricity generator and the Sedepal water and sewage facility. In addition, he estimates the government could easily raise another $8 to $10 billion in long-term investments from the tender of concessions for highways, airports, seaports, and water treatment systems. “Whereas 70% of the privatization program has been completed, only 10% of the concession program has been finished, so there is plenty of work left to do,” he says.

The work is not likely to be done quickly. Many analysts doubt Fujimori has the conviction or the will to sell the country’s remaining state-owned assets. “I don’t expect Fujimori to push the privatization envelope very far if re-elected, although I wouldn’t be surprised to see action on the concession front,” says Gian Franco Bertozzi, an economist at Lehman Brothers.

An added constraint on the new government will be the uncertain political scene. If Fujimori wins a third mandate, governing the country a much more challenging exercise since a divided and quiescent opposition has mobilized around Toledo . The loss of his party’s congressional majority means Fujimori would have to engage in coalition-building and horse-trading to win approval for his policies. Toledo could face an even greater challenge in Congress, where his ‘Perú Posible’ movement controls less than a quarter of the 120 seats.

The next president’s choice of cabinet ministers will have a considerable impact on investors’ views of Peru. Even the faintest whiff of populism would discourage foreign investment, which has slowed in recent years. Foreign investment inflows last year totaled $8.1 billion, almost the same as in 1998.

The Unnerving of Investors
Craig Smith, BankBoston Peru’s vice president of treasury, fixed income and derivatives, says Toledo has unnerved investors with campaign promises to create thousands of new public-sector jobs and reduce the sales tax to 16% from 18%. But he admits that campaign promises are a poor indicator of actual policies: “Toledo has been talking the populist talk, however, it remains to be seen whether he would walk the populist walk.”

A surprising number of investors and business people are concerned at the erosion of Peru’s institutions. They seem to be saying that if Peru is to block the spread of political instability in the Andean region, the next government must address broad social policy issues such as job creation and reconstruct the country’s weak institutions.

“If Toledo were victorious, we would view this as the best case scenario,” says Siobhan Manning, PaineWebber’s senior debt strategist for Latin America. She believes a “Toledo administration could address the debilitated institutional framework, particularly the judicial system and other political reforms.”

Manning notes that if the next government deals with these issues, the rating agencies would react favorably (Moody’s currently rates Peruvian foreign currency debt Ba3 – one notch below Standard and Poor’s rating of BB). S&P recently commented that the country’s weak judicial system “weighs on investors’ sentiment toward Peru, hence on growth prospects and creditworthiness.”

Investors say they want the next Peruvian president to undertake reforms that would simultaneously foster a more robust democracy and a healthier business climate. The reforms should include decentralizing power from the state to local governments, depoliticizing the military, providing more equal access to the state media for opposition political candidates, and overhauling the judiciary.

Andrea Bonime-Blanc, senior vice-president at PSEG Global, the US utility which owns and operates Luz del Sur, the Peruvian electricity distribution company, says her company has a clear interest in a predictable political and judicial system. She says: “it is very important to us that governments in countries in which we do business respect the democratic rules of the game. It is also critical that there be an existing or developing political institutional framework that is both transparent and reliable, most importantly with regard to the economic regulatory system and the judicial system.”

Although she says PSEG is not immediately worried about institutional weakness in Peru, she warns that a resurgent authoritarianism or a violation of the rule of law would threaten Peru’s progress toward a fully democratic system which is attractive to both domestic and foreign investors.

She says that even “if Fujimori is re-elected in a less than transparent manner and/or continues to rule in a quasi-authoritarian way, it won’t necessarily send investors fleeing the country in droves.” However, she adds that there would be a “long-term, negative effect on the country’s appeal to foreign investors, and it could hamper existing or new investors’ willingness to commit large amounts of new capital for new or expansion projects.”

Foreign investment is, of course, badly needed to create the new jobs necessary for a growing population as well as combating poverty. The next president will also have to promote effective job-creation policies.

Carlos Penny, a Peruvian-born managing director at the fund manager UBS Brinson says Peru’s large fishing industry has recovered recently from el Niño and should continue growing. However, he says many domestic fish mel producers fishing fleet operators are still deeply indebted and the industry needs to undergo significant restructuring. Considerable debt restructuring is inevitable and banks’ loan portfolios will probably continue to suffer. Consolidation and foreign investment is a must to rejuvenate the historically world class industry.

Penny says mainly two copper companies – Southern Peru Copper and Grupo Buenaventura – are likely to post good and consistent results in the near future. He says current forecasts for the new Antamina copper mine may be over-optimistic. He argues that the government should offer incentives for the consolidation of the country’s medium sized mining companies -Volcán, SIMSA and Atacocha – into a single large, efficient and low-cost zinc producer.

Peru’s neglected forestry industry could be developed into an important export sector. However, Peru has no laws governing the industry. The government has offered concessions on several occasions but these have not tempted foreign investors.

If South America is becoming increasingly divided between the tumultuous Andean countries and the more stable and prosperous countries to the south, then Peru may now be approaching a fork in the road. If all goes well, economic policy continuity and institutional reform under either Toledo or Fujimori would set the country on a path to rapid, sustainable growth. However, investors are unlikely to give Peru a second chance if there are indications that the next government resorts to the same populist policies that have helped pitch its neighbors into crisis.

Alberto Fujimori, 61, has transformed Peru during his decade as president. He rose from obscurity as an agricultural instructor to defeat the novelist Mario Vargas Llosa in the 1990 presidential election. As the son of working-class Japanese immigrants, he caught the imagination of an electorate fed up with traditional politics. That year Peru was on the verge of collapse as hyperinflation tore the economy apart and Maoist guerrillas of the Sendero Luminoso controlled large tracts of the interior and parts of Peru’s big cities. Fujimori halted inflation with bold, free-market policies. He defeated the guerrillas with a relentless military campaign that culminated in the 1992 capture of Sendero Luminoso leader Abimael Guzmán. The same year he staged his celebrated “self-coup” in which he dissolved Congress and the judiciary and seized sweeping powers. His other major achievements include restructuring Peru’s foreign debts of over $30 billion. He crushed powerful drug lords. In 1998, he signed a historic border peace treaty with Ecuador, eliminating Latin America’s last territorial flash point. This won him the gratitude of a country weary of privations and was reelected in 1995 with 64% of the vote after writing a new constitution that lifted a prior ban on consecutive presidential terms. During his second term, Fujimori’s reforming zeal waned as public opinion began focusing on abuses of power and reports of government corruption.

Alejandro Toledo, 54, was born in Cabana, a remote Andean village in northern Peru. He is one of 16 children, born into a family of peasant farmers. His parents moved to the northern port city of Chimbote, where he grew up. As a high school student he earned pocket money as a shoeshine boy and began writing as a local correspondent for La Prensa, the now defunct Lima newspaper. He later won a scholarship to study economics in the US and entered Stanford University where he took two masters degrees and a doctorate in economics and human resources. He went on to work as a consultant at the United Nations, the World Bank and the Inter-American Development Bank. Toledo was an economics research associate at the Harvard Institute for International Development in 1991-1994. Toledo first took a run at the Peruvian presidency in 1995, but made scarcely an impression during the campaigning. He sharpened his message in the April 2000 race with a platform that combined crude populism and left-wing rhetoric while promising to maintain Fujimori’s free-market policies. He has also traded on his Indian ancestry in a country where prior to the rise of Fujimori, political life was dominated by Peruvians of European origin. Toledo is married to Eliane Karp, a Belgian-born anthropologist. They have one child, Chantal, aged 17.

Foreign Investment in Peru
A decade ago, Peru could attract hardly any foreign investment. Hyperinflation and political instability eventually gave way to one of Latin America’s most impressive economic reform programs and by the mid-1990s, inward investment rose rapidly as Fujimori kicked off a wide-ranging privatization program. Foreign direct investment stabilized at close to $8 billion in 1998 and 1999 as the privatization program wound down and emerging economy crises discouraged investment. Investment could recover once the elections are out of the way and the incoming president has announced a cabinet and set out his economic policies. However, Peru must compete with Latin America’s big economies for investment as well as Asia’s resurgent economies.

Bond Prices
Secondary market bond prices are highly sensitive indicators of investor confidence. Peru’s PDI and Flirb Brady bond prices have fluctuated within a reasonably narrow band over the years, except for a dive in late 1998 following the Russian default. Prices began recovering a year ago following Brazil’s currency crisis in January 1999 and Ecuador’s default the following September. Prices this year have remained relatively firm given the political uncertainty during the election campaign, although bonds have fallen recently with the sell-off on Wall Street.

Equity Markets
The Lima stock market has never recovered from its 1997 record high. Equity prices kept tumbling for about two years before staging a tentative recovery at the beginning of the year, when investors may have expected Fujimori to easily win reelection. Prices slipped in recent weeks, losing about 14% in dollars, but probably affected more by the ill wind from Wall Street than by troubles at home. Although domestic economic factors are looking positive for equities and analysts are downplaying political risk factors, harder times in world capital markets do not bode well for Peruvian equities.