Top20 Peruvian Companies 2011

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Top 20Peruvian Companies

October2011


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Top 20: Peruvian CompaOctober 2011

IntroductionDear reader,

Standard & Poors Ratings Services is pleased to present TOP 20 Peruvian Companies a report focusingon a selected group of Peruvian entities which we consider to be among those with the best credit quality inthe country. Within the next pages, there is a detailed section on the methodology applied to determine theselected list of companies.

Over the last ve years, Perus creditworthiness has steadily improved with rising terms of trade and stablemacroeconomic policies and higher levels of investment that supported growth. Low scal decits or sur-pluses, proactive debt management, an autonomous central bank with an ination-targeting regime, a oating exchange rate, strengthening bank supervision, and numerous free trade agreements are some of the keymacroeconomic factors that underpinned the countrys economic performance over the last decade.

Perus economic performance has shaped the countrys corporate sector during the last decade. As thecountrys economy, the fate of many of the major corporations is tied to the swings of the global economy,especially the evolution of commodities in general and metals and minerals in particular. However, prudentnancial policies and cash management have allowed most players to grow and withstand external shocks

improving their creditworthiness through the cycle.

These characteristics will emerge from the individual analyses included in this publication. We have alsoincluded commentaries on the sovereign rating of Peru, the nancial system, as well as information on LatinAmerica and criteria and methodology to provide a broader analytical framework.

We trust that the investor community, both in Peru and overseas, will nd this report an important referenctool that will facilitate investment decisions.

Pablo F. LutereauSenior DirectorAnalytical Manager, Corporate RatingsStandard & Poors


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The analyses in this publication are Standard & Poors opinions based on limited publicly available inf ormation, do not constitute Standard & Poors ratings or definitive indications of w

ratings Standard & Poors w ould assign, and are not recommendations to purchase, hold or sell any securities or make any investment decision. Standard & Poors will not update, mod

or surveil t hese analyses.


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Table of Contents

Introduction

Selection Criteria and Methodology

Commentaries

Republic of Peru 8 Latin Americas Resilience, Recovery, And Consolidation 18 How Vulnerable Are Latin American Corporates To Commodity Prices? A Sensitivity

Analysis 25 Latin America Is Seeing a Rise in Privately Financed Infrastructure Projects 32 South American Banks Should Support Rapid Credit Growth 35 Will Future Flow Securitizations Help Fund Perus Growing Mining Export Industry? 40

Selected Financial Data and Credit Statistics

Peer comparison 46

Credit Reports

Alicorp S.A.A. 50 Compaa de Minas Buenaventura S.A.A. 52 Corporacin Lindley S.A. 54 Edegel S.A.A. 56 Empresa de Distribucin Elctrica de Lima Norte S.A.A. - EDELNOR 58 EnerSur S.A. 60 Gloria S.A. 62 Luz del Sur S.A.A. 64

Minera Barrick Misquichilca S.A. 66 Minera Yanacocha S.R.L. 68 Minsur S.A. 70 Petrleos del Per Petroper S.A. 72 Saga Falabella S.A. 74 Shoughang Hierro Per S.A.A. 76 Sociedad Minera Cerro Verde S.A.A. 78 Supermercados Peruanos S.A. 80 Telefnica del Per S.A.A. 82 Telefnica Mviles S.A. 84 Unin de Cerveceras Peruanas Backus y Johnston S.A.A. 86 Volcn Compaa Minera S.A.A. 88

Understanding Ratings and Definitions

Guide To Credit Rating Essentials 92Glossary Of Financial Ratio Denitions 95Incorporating Adjustments Into The Analytical Process 96Standard & Poors Rating Denitions 98

Contact List


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Selection Criteria and Methodology

Our selection process encompassed different stages aimed at building a short list of 20 Peruvian companieswith superior credit quality. For that, we scrutinized the key sectors of the Peruvian economy, identifying

those elements that help companies achieve strong business risk proles, such as size, cost efciency,management experience, degree of business integration, geographic and product diversity, etc.

Having identied those companies with good business risk proles, we centered our analysis on those thatmake public disclosure of its nancial statements. Among those, we searched for the ones with healthynancial risk proles, evidenced by cash ow stability, conservative debt leverage, prudent nancial policies,adequate liquidity and nancial exibility and good access to debt markets.


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Commentaries


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Major Rating Factors

Strengths:

High real GDP growth, supported by a signicantrise in investment.

A low and declining general government debtburden.

Weaknesses: Still-evolving political institutions in the context

of signicant economic, social, and ethnicfragmentation as well as high poverty levels.

A signicant (albeit declining) level of nancialdollarization, with 45% of bank claims onresidents in U.S. dollars as of June 2011.

RationaleThe ratings on the Republic of Peru reect ourexpectation that broad scal and monetary policycontinuity under Ollanta Humalas new governmentwill support stronger economic policy exibilityand growth. In July 2011, Mr. HumalaPresident-Elect at the timesignaled macroeconomic policycontinuity by reappointing the respected presidentof the central bank, Julio Velarde, and appointinganother respected technocrat, Luis Miguel Castilla,to head the nance ministry.

Since taking ofce on July 28, the government hasemphasized its goal to promote social inclusionand has laid out plans to increase social andinfrastructure spending as well as boost public-sectorwages. However, the government has also signaledits intent to implement these priorities graduallyand within the limits of a prudent scal approachby tying expenditures to increased revenues, partlyfrom the mining sector. Therefore, assuming a fairlysteady currency, net general government debt to

Republic of Peru

Richard Francis, New York (1) 212-438-7348; [email protected];

Sebastin Briozzo, Buenos Aires (54) 11-4891-2125; [email protected]

GDP likely will continue to decline gradually overthe next three years. Although raising taxes onmining will be a policy priority, Mr. Humala has

stated that keeping the sector reasonably attractiveto investors is critical to economic growth and taxcollection.

The governments commitment to economic stabilityand a positive investment climate support theratings on Peru. We believe that these factors likelywill underpin solid growth through 2013 despiteglobal uncertainties. Perus still-evolving politicalinstitutions in the context of signicant economic,social, and ethnic fragmentationas well as highpoverty levelscontinue to constrain the ratings.The countrys monetary vulnerability is also a

constraint. Peru has a signicant (albeit declining)level of nancial dollarization, with 45% of bankclaims on residents in U.S. dollars as of June 2011.Perus diversifying economic structure and highlevels of investment, including foreign directinvestment (FDI), should support the countrysrobust growth prospects over the next three to veyears. Although the countrys net external liabilityposition was 86% of current account receipts atyear-end 2010, close to 40% of the gross liabilityis FDI. Standard & Poors Ratings Services expectsthat Perus net inward FDI will continue to exceedthe current decit, which we estimate to be 2%-3%

of GDP from 2011-2013.

Our local-currency rating on Peru is one notchhigher than the foreign-currency rating because inour opinion, the combination of monetary exibilityand the growing local-currency debt marketprovide slightly better capacity to service nuevossoles-denominated debt issued in the domesticmarket. Our A- transfer and convertibility (T&C)assessment reects our opinion that the likelihood of

Current Rating

Sovereign Credit Rating

Foreign Currency

BBB/Stable/A-3

Local Currency

BBB+/Stable/A-2


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the sovereign restricting access to foreign exchangethat Peru-based nonsovereign issuers need for debtservice is moderately lower than the likelihood ofthe sovereign defaulting on its foreign-currencyobligations. Although the government has someforeign-exchange restrictions, they are on the capitalaccount, and the economy is open to trade.

OutlookThe stable outlook balances Perus ongoing successin attracting gas and mining investment with thecountrys political and external vulnerabilities.We likely would upgrade Peru if economic growth

outside sectors related to energy and miningaccelerates, dollarization diminishes signicantly,and scal performance does not fall victim topotential political rifts.

Conversely, we could lower the ratings if politicalpressures arising fr om the large informal economy,widespread poverty, and signicant incomedisparities make the country susceptible to populism.In our opinion, the governments ability to addressthe underlying causes of its populations discontentwill be key to the continued improvement of thegovernments creditworthiness.

Table 1 | Perus Summary Statistics

Year end ed Dec . 31

2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f

GDP per capita (US$) 2,848 3,276 3,763 4,400 4,352 5,215 5,596 5,939 6,454 6,966

Real GDP per capita grow th (% ) 5.5 6.4 7.6 8.6 (0.3) 7.6 5.3 4.8 4.8 4.8

N arrow net ext ernal debt /current account receipt s (% ) 61.1 32.9 11.6 (0.1) (9.0) (15.5) (27.7) (31.1) (34.4) (39.2)

Gross external financing needs/ current account receipts +usable reserves

85.5 78.2 89.5 85.4 72.5 76.7 72.9 72.7 72.8 70.7

Change in general government debt/ GDP (% ) (3.9) (1.8) (0.9) 2.2 3.6 (1.5) (1.0) (0.5) (0.5) (0.5)

N et general governm ent debt / GDP (% ) 32.4 25.5 19.8 17.9 20.4 1 5.5 13.1 11.6 10.3 9.0

General government interest paid/general governmentrevenues (%)

10.3 9.3 8.5 7.4 6.8 5.7 5.1 4.4 3.8 3.3

Domestic claims private nonfinancial public enterprises/GDP (% )

19.4 17.8 21.0 25.5 25.0 25.1 27.4 27.4 27.4 27.4

CPI grow th (% ) 1.6 2.0 1.8 5.8 2.9 1.5 3.0 2.5 2.0 2.0

e Estimate. f Forecast.

Political Environment: Broad Consensus On

Macroeconomic Policy Amid A Still-Fragile

Political Environment

Maintaining and enhancing stabilityIn July 2011, Ollanta Humala, President-Elect atthe time, signaled macroeconomic continuity byreappointing the respected president of the centralbank, Julio Velarde, to his post and appointing

another respected technocrat, Luis Miguel Castilla,to head the nance ministry. On the scal front, thegovernment has emphasized its goal of promotingsocial inclusion while reafrming its commitmentto keep spending within the limits of a prudentscal policy. The government has laid out plans toincrease social and infrastructure spending as wellas boost public-sector wages, but it has signaledits intent to implement these initiatives graduallyand tie them to increased revenues, partly from themining sector. Although raising taxes on the mining

sector will be a policy priority, President Humalawould like to keep the sector reasonably attractiveto investors, as this is critical for future economicgrowth and tax collection.

Growing consensus on the macroeconomic front, but alack of debate on reformThere is a stronger consensus on soundmacroeconomic policies across Perus political

class than ever before. Most of the political partiesin Congress, including Mr. Humalas NationalistParty, approved a bill strengthening the old FiscalResponsibility Law. More than in the past, thepolitical class in Peru seems to accept the restrictionsthat a sound macroeconomic framework imposeson other areas of public policy. However, the debatehas yet to touch on more fundamental issues,namely, how to improve the countrys still-weakpolitical and economic institutions. Social issuessuch as education, health, and justicehave only


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10 Top 20 Peruvian Compani es October 2011

recently gained priority in the governments politicalagenda in the aftermath of the presidential victoryof President Humala. He will seek to balance hiskeeping his campaign promises to increase socialspending with maintaining sound macroeconomicpolicies and a good investment climate that supportsgrowth.

There are risks aheadA decade of high GDP growth has led to higheremployment and purchasing power. Rapidlyincreasing levels of consumption in middle-incomeareas of Lima further demonstrate this trend. If itcontinues, it is likely that economic growth andsocial cohesion will sustain each other. However,despite the governments intention to boost socialspending, its ability to implement social programs todate has proven weak, given institutional capacityconstraints. For example, although the governmenthas sought to reduce income inequalities through

substantial revenue transfers to the poorest regions,weak local institutions have made it difcult toincrease infrastructure and social spending. Largetransfers of mining revenue to municipalities andregions have also shown that many of these entitiesdo not have sufcient expertise to evaluate orimplement projects. In fact, some municipalities inPeru have high levels of liquid funds that they areunable to spend.

Social conict in mining areas has proven difcult tomanage and could be a signicant challenge to thenew administration.

Economic Prospects: Expectations Are For

Solid Growth Over Next Three Years

Economic structure: diversification is underwayPerus GDP per capita, expected at $5,596 in 2011,is nearly double the level in 2005 (the year beforePresident Alan Garcia came to power). Economicgrowth will likely reach 6.5% in 2011 and willlikely remain at more than 5.5% from 2012-2014.Continued high levels of investment, especially inthe mining sector, will largely fuel this growth. FDIis expected to top $35 billion over the next fouryears. As a result of the high level of investment,we expect that exports will rise by more than 8%in 2012. Perus extended growth trajectory startedwith the boost stemming from investment in large-scale projects (gas development by Camisea andother mining projects, for example) and the rise incommodity prices in late 2002. However, todayssources of growth are more diversied. Because ofrising levels of employment and disposable income,

private consumption will likely rise by more than5.5% over the next three years, further underpinninggrowth prospects.

Investment is a key driver of economic growthOver the past two years, there has been a strongresurgence of domestic investment, particularlyprivate investment, after a decline in 2009 as aresult of global economic uncertainties. Investmenthas rebounded strongly and should reach 28% ofGDP in 2012. A continued high level of investmentis crucial to achieving growth rates higher than6%, allowing Peru to reduce poverty, which affectsabout 30% of its population. Maintaining economicgrowth and social stability will depend on risingemployment. Another positive development is that

employment levels, which lagged the economicexpansion at the beginning of the cycle, have grownmore rapidly since mid-2005, in tandem withincreasing domestic demand.

Total FDI was $7.3 billion in 2010. While themining and hydrocarbons sectors continue to drawthe largest share of private investment, it has becomemore broad based. A number of large privateinvestments continueincluding the second phaseof Camisea, a liqueed natural gas project. Largemining investments continue as well, includingSouthern Peru Coppers projects such as Ta Mara

and the expansions of the Toquepala and Cuajonemines. Investments are also funding the expansionof mines and concentration plants at Yanacocha,Shougang, and Milpo. There are several large oil andgas projects underway. In addition to more broad-based sectoral investment, there has been increasedFDI from Asia, especially China, South Korea, and

Japan. Peru has signed free trade agreements witheach over the past three years.


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Despite the increase in investment, variousbottlenecks remain. Although Peru is rich inresources, improving human capital (and,therefore, productivity) is still a major challengefor the countrys medium- and long-term economicdevelopment. School attendance is not low by LatinAmerican standards, but the poor quality of publiceducation is a major weakness; a comprehensivereform in this sector is still pending. One ofbiggest constraints for growth is infrastructure.

However, over the longer term, education willlikely be a bigger factor. The government wouldneed to reduce high labor market informality andimprove the quality of public investment and socialspending across all levels of government to alleviateinfrastructure and social gaps, supporting ongoingexport diversication and poverty alleviation.Strengthening public institutions, advancingadministrative simplication, and promotingeducation attainment would boost human capitaland entrench high productivity growth.

Table 2 | Perus Economic Indicators

Year ended D ec. 31

2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f

GDP per capita (US$) 2,848 3,276 3,763 4,400 4,352 5,215 5,596 5,939 6,454 6,966

Real GDP per capit a grow t h (% change) 5.5 6.4 7.6 8.6 (0.3) 7.6 5.3 4.8 4.8 4.8

Investment / GDP (% ) 17.9 20.0 22.8 26.9 20.7 25.0 26.9 27.9 27.7 27.1

N et f ore ig n di re ct i nve st me nt / GD P (% ) 3.3 3 .8 5 .1 4 .9 4 .1 4 .6 4 .9 4 .3 4 .2 3 .8

Depository corporation claims on the residentnongovernment sector/ GDP (%)

19.4 17.8 21.0 25.5 25.0 25.1 27.4 27.4 27.4 27.4


External Finances: Moderate Current Account

Deficits Going ForwardPeru has had signicantly favorable terms of trade in2011, as expectations are for the price of metalsespecially copperto rise by 18% after increasing

by nearly 38% in 2010. Despite these improvedterms of trade, the current account decit willlikely deteriorate to 2.7% of GDP in 2011-2012 asimports grow even more rapidly than exports, partlybecause of FDI. It is important to note that aftertwo years of stagnation, the volume of traditionalexports will likely expand by more than 8% perannum in 2012-2013 as a number of large miningprojects begin.

Higher levels of international reserves and currentaccount receipts have kept the countrys externalliquidityas measured by its gross external

nancing needs to current account receipts plususable reservesrelatively stable at an estimated72.9% despite a larger current account decit (seeChart 2).

Favorable terms of trade, coupled with rising exportvolumes, have led to continued improvement inPerus external accounts. Perus narrow net external

position (net of liquid assets only) is at an expected27% of current account receipts in 2011.


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Mining exports changing the scalesAs noted, strong mineral pricescombined withsignicant volume expansionwill lead to continuedimprovement in Perus external indicators. Thedynamism of traditional exports, which accountfor 79% of total exports, support the strongperformance of exports in 2011. However, weexpect that nontraditional exports will rise by nearly21% in 2011. Although 21% is relatively a smallportion of total exports, this gure is still signicant,particularly because nontraditional exports havemore of an impact on employment than traditionalexports. Some of these latest developments weresupported by access to the U.S. market through thefree trade agreement with the U.S. that went intoeffect on Feb. 1, 2009. Furthermore, Peru has signeda number of other free trade agreements, includingthose with Canada, Singapore, Mexico, Chile,China, South Korea, and Japan.

Mineral exports account for roughly 60% of Perustotal exports, with copper alone constituting 24%and gold 18%. Oil and gas exports are growing as a

share of total exports as well. They now account fornearly 10% of the total.

Perus external position should improve furtherover the next ve years. It is important to note thatthis is not solely based on higher commodity prices.In addition, we expect that export volumes willincrease substantially for many of Perus key miningsector exports. However, higher levels of importsstemming partly from FDIwill likely lead tocurrent account decits of 2%-3% in 2011-2013.In addition, the central banks international reserveshave increased signicantly over the last two years,growing by nearly $15 billion (nearly 50%) to reach$48 billion in 2011 compared with $33 billion in2009.

Standard & Poors expects that the combination ofgood scal management, volume growth of exports,and high FDI levels will continue to underpin Perus

external accounts over the medium term. In thefuture, the governments scal consolidation strategyand successful nancing through the domesticmarket using local-currency-denominated debt willconstrain the growth of the stock of external debt.

Table 3 I Perus External Indicators

Year end ed Dec . 31

2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f

Gross external financing needs/current accountreceipts plus usable reserves

85.5 78.2 89.5 85.4 72.5 76.7 72.9 72.7 72.8 70.7

N arrow net external debt / current account receipts 61.1 32.9 11.6 (0.1) (9.0) (15.5) (27.7) (31.1) (34.4) (39.2)

Current account receipts/ GDP 27.8 32.2 32.9 31.1 27.5 28.4 30.5 30.7 30.7 30.8

N et foreign direct investment / GDP 3.3 3.8 5.1 4.9 4.1 4.6 4.9 4.3 4.2 3.8

Current account balance/ GDP 1.4 3.1 1.4 (4.2) 0.2 (1.5) (2.7) (2.7) (2.6) (1.4)

Current account balance/ current account receipts 5.2 9.7 4.1 (13.5) 0.6 (5.3) (8.9) (8.7) (8.4) (4.5)

N et external l iabil i t ies/ current account receipts 111.2 74.1 92.0 75.2 83.6 85.6 63.9 56.1 47.5 36.6

Usable reserves/current account payments(months)

5.6 4.9 5.0 6.3 8.8 7.1 8.2 8.1 7.8 7.8

Usable reserves (M il . US$) 11,002 14,006 23,555 25,347 27,331 38,041 40,230 42,484 45,176 49,911


Fiscal Policy: Higher Revenues Will FinanceThe Governments Social ProgramsIn the midst of an election year, with buoyantrevenues and restrained government spending, thegovernment ran a large scal surplus of 5% of GDPin the rst half of 2011. However, an increase inspending in the second half of the year will likely

lead to an overall scal surplus for the year of 1%of GDP in 2011. Tax revenues should rise by 13%in 2011 to reach 20.5% of GDP, up from 19.8% in2010. Spending, which was subdued in the rst halfof 2011, will likely rise signicantly over the secondhalf of the year to reach 19.5% of GDP, but this isstill down from 20.4% in 2010.


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There is a growing consensus on the importance ofscal responsibility in Peru. Fiscal rationalizationbecame easier when relatively high economic growthallowed the government to make some expenditureconcessions without damaging the nal-balancetarget. Continuing scal consolidation under aless-favorable international economic environmentwill still be a risk. The Fiscal Responsibility Lawestablished a ceiling of 1% of GDP for governmentdecits in periods of economic expansion.

Despite recent improvements, expanding thecountrys still-relatively-low tax burden will bean ongoing challenge, especially given its highdependence on mining-related revenue (accountingfor nearly a quarter of total central-governmentrevenue). Tax rates are already high, and the

problem has its origins in high levels of informalityand tax evasion. In addition to windfall taxes on themining sector, expanding the tax base would likelybe more fundamental to increasing the tax burdenwithout damaging the formal economy. Enhancedtax administration at SUNAT, the Superintendencyof Tax Administration, could also expand taxrevenues.

As noted, on the expenditure side, President Humalahas made explicit his major objective of boostingsocial expenditure as well as improving publicinfrastructure.

The decentralization process, initiated in 2002,continues to transfer functions to local and regionalgovernments. Some decentralization of healthand primary education has begun as well. Thevarious levels of government still need to clarifyresponsibilities to avoid duplication. Under PresidentGarcias administration, transfers to the local andregional governments doubled by increasing theirtake of the value added tax (VAT) to four percentage

points of the total 19% VAT from the current twopercentage points as well as their take of variousmining revenue sharing funds to 20% of the totalfrom 10%.

Perus still-high dependence on the commoditysector highlights the importance of developing

stronger countercyclical economic policies.Because dollarization and low levels of nancialintermediation still constrain monetary policy,scal policy must play a dominant role. The FiscalResponsibility Law incorporated a countercyclicalscal fund into Perus government structure. Thatfund totaled only about 2% of GDP at year-end2010. The government introduced multiannualbudgeting in 2010 to move toward a medium-termexpenditure framework.

Debt and interest burdensOne of Perus major accomplishments was debtreduction and improved debt structure. Standard &Poors expects the governments debt to reach 13%of GDP (in net terms) in 2011 compared with nearly20% in 2009. (Government depositsboth at thecentral bank and the local banking systemwilllikely total 8% of GDP at year-end 2011).

Active debt management has recently graduallyreduced interest- and exchange-rate vulnerabilityand postponed major amortization over the next

four years (in particular, after the Paris Club debtbuyback operations). The government has alsobeen working extensively to deepen the domesticcapital market for issuances in Peruvian nuevosols, allowing the country to replace foreign-currency-denominated debt with its local-currencycounterpart. Signicantly, Peru issued a 30-yearbond denominated in local currency in the Peruvianmarket at a xed interest rate in 2007. More than46% of Perus total debt is now denominated in


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local currency, having increased very rapidly from18% at year-end 2006. Also, exposure to variableinterest rates declined to about 12% of debt inMarch 2011 from 55% in 2002. Furthermore, theduration of Perus total debt is now nearly eightyears, diminishing the burden of servicing the debtand rollover risk.

Table 4 I Perus Fiscal Indicators

Year ended Dec. 31

2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f

Change in general government debt/ GDP (3.9) (1.8) (0.9) 2.2 3.6 (1.5) (1.0) (0.5) (0.5) (0.5)

General government balance/ GDP (0.5) 1.8 3.1 2.4 (1.9) (0.4) 1.0 0.5 0.5 0.5

General governm ent primary balance/ GDP 1.4 3.7 4.8 3.9 (0.6) 0.8 2.0 1.4 1.3 1.2

General government revenue/ GDP 18.4 20.0 20.8 2 1.1 18.9 2 0.0 20.5 21.0 22.0 22.5

General governm ent expendi ture/ GDP 18.9 18.2 17.7 1 8.7 20.7 2 0.4 19.5 20.5 21.5 22.0

General government interest paid/general government

revenues

10.3 9.3 8.5 7.4 6.8 5.7 5.1 4.4 3.8 3.3

N et general government debt /GDP 32.4 25.5 19.8 17.9 20.4 15.5 13.1 11.6 10.3 9.0

General government debt/ GDP 36.9 30.1 26.2 25.9 28.8 23.8 20.7 18.6 16.7 15.0


Contingent liabilitiesDomestic credit to GDP is 25%. However, the highlevel of dollarization poses some additional risks.

Monetary Policy: Further Institutionalization Of

Monetary PolicySince December 2010, the central bank has raisedthe policy rate by a cumulative 300 basis points(bps) from a historical low of 1.25%. The CentralBank raised the benchmark policy rate 25 bps in

its May monetary policy meeting. We expect thatthe ination rate will remain at the upper targetof its 1%-3% band in 2011, in large part becauseof an increase in food and oil prices. Furthermore,ination should stay within this range over themedium term.

A still-high, though declining, level of nancialdollarization, the still-low level of nancialintermediation, and the continuing process of greatermonetary institutionalization continue to constrainmonetary policy exibility. The central bank hasimplemented a system of ination targeting and

formally liberalized the exchange rate. The centralbank also began to put in place higher reserverequirements over the course of 2010. It is doingthis to deter short-term capital inows to buffer theination targeting framework and the risks posed tonancial stability posed by large short-term capitalinows.

The current administration reappointed JulioVelarde, a well-respected economist, as Central Bankpresident at the beginning of its term. However,there is room for greater institutionalization of themonetary authority by a constitutional amendmentdelinking the appointment of the central bankpresident and board members from the presidential

cycle.


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Gradualismis a key notion in monetary policy

strengtheningAlthough there is more transparency in theimplementation of monetary policy and thegovernment is deepening the local capital market,major obstacles remain to fully develop monetarypolicy into a stronger anchor with a countercyclical

role. Among the challenges are the still-high level ofdollarization and low nancial intermediation.

The governments strategy of increasing the use ofdomestic currency began to yield favorable results.The share of foreign-currency participation to totalloans decreased signicantly to 45% as of June 2011from 63% at year-end 2006.

Table 5 I Perus Monetary Indicators

Year end ed Dec . 312005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f

CPI grow th 1.6 2.0 1.8 5.8 2.9 1.5 3.0 2.5 2.0 2.0

Effective general overnmentinterest rate (interest/debt)

4.7 5.8 6.5 6.5 5.1 4.5 4.8 4.9 4.9 4.8


Financial intermediation will have to increase ifPeru is to achieve more freedom to pursue a moreactive and effective monetary policy. In tandem withdynamic consumption and domestic investment,lending is growing at higher rates than nominalGDP, showing variations of slightly more than 20%year-over-year. As a result of the high credit growth,

the central bank began to implement policy measuresin an effort to slow growth by tightening prudentialregulations on consumer loan and implementationof new pro-cyclical provisioning rules. Furthermore,reforms to enhance the bank surveillance andintervention regimes and implement enhancedcapitalization requirements in line with Basel II arebeing undertaken. Domestic credit to GDP will likelyreach 26% at year-end 2011, recovering from arecord low of 17.7% in 2006.

Comparative Analysis: Better Economic

Indicators And A Weaker Political StancePerus regional peers in Latin America are Brazil

(BBB-/Positive/A-3), Panama (BBB-/Positive/A-3),and Mexico (BBB/Stable/A-3). (All ratings are long-term foreign currency sovereign credit ratings as ofSept. 15, 2011.) Extra-regional peers include Russia(BBB/Stable/A-3), Thailand (BBB+/Stable/A-2), andIndia (BBB-/Stable/A-3).

Growing consensus on macroeconomics balanced by

still-weak social stabilityAlthough consensus on the direction ofmacroeconomic policies is deepening, Perussocial and ethnic divisions still resemble those ofits Andean neighbors, Bolivia (B+/Positive/B) andEcuador (B-/Positive/C). However, the divisionsin Peruvian society are narrower than those ofits neighbors. Political instability in the otherAndean countries continues to impede economicpolicy despite the regions overall strong economicperformance. Peru is thus situated between the restof the region and higher-rated countries, an unusualposition where the risk of economic policy reversaldiminishes as the entire political class backs thegeneral direction of current economic policies.In Peru, as in other Andean nations, consensus on

the economic policy might weaken if the populationdoes not believe that economic growth is reachingthem. A lack of social progress over time mighterode the political sustainability of current policies,

making them more vulnerable to adverse shocks,whether domestic or external. More diversiedsources of growth have moderated this risk over thepast three years by reducing GDP dependence onthe export of primary products. Therefore, the morediverse economic growth pattern since 2005 has ledto higher employment, helping distribute the benetsmore widely and evenly. The dynamism of domesticconsumption is another indication of this trend.Although there are similar patterns in other LatinAmerican countries, Perus extraordinarily highGDP growth rates reect the importance of such

developments in a country that has long been poorand politically unstable. Greater overall satisfactionwith the current economic model, if conrmed,is a key positive credit factor because it providesadditional political stability.


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Relatively high and sustained economic growth, but

fromstill-low per capita incomePerus GDP has grown higher than the BBB medianin real terms over the last ve years. We expect itto continue to perform at levels signicantly higherthan those of the BBB median for the next threeyears.

However, Perus GDP per capita of $5,596 is stillwell below the BBB medians $10,860 and all ofits peers, with the exceptions of India ($1,618) andThailand ($5,243). A broader indicator of humandevelopment is the UNDP Human DevelopmentIndex. Peru is 63rd on the list, which is better thanmost of its key peers with the exceptions of Panama(54th) and Mexico (56th).

Solid budget performance compensates for Perus still-

limited fiscal revenuesThe scal consolidation strategy implemented by thelast two administrations and expected to continueunder the Humala administration has led to a sharpimprovement in the level of general governmentdebt. Perus scal performance has improved

markedly over the last ve years, with a surplusof 1.0% of GDP expected in 2011, signicantlyoutperforming the BBB medians 2.8% decit. Infact, Peru will likely maintain a small surplus overthe next two years compared with decits of 2%-2.5% of GDP for the BBB median.

Consequently, Perus net general government debtat 14% of GDP in 2011has fallen well belowthe BBB medians 35% and well below Brazils42% and Mexicos 35%. We expect that Perusnet general government debt to GDP will graduallydecline further over the next three years, while theBBB medians should rise marginally.

Notwithstanding these achievements, Perus scalexibility remains limited. On the revenue side, itsscal revenue to GDP is still low for an economyat this stage of development, given the high levelsof poverty and infrastructure needs. Perus generalgovernment revenue, at about 20.5% of GDP, is

much lower than that of the BBB median (34%).

Mexico is the only country with a lower level ofrevenues at 18.3%, though Indias 21.2% is low aswell. Despite the low level of government revenue,Perus debt level in terms of revenues is now lowerthan the BBB median and that of all of its peers.Perus debt to revenues ratio lies at the BBB medianof 107%. Perus ratio has improved markedly overthe last three years.


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As in other Latin American countries, favorableinternational conditions led to a strong positiveadjustment in Perus external accounts. The strongaccumulation of international reserves and higherlevels of current account receipts have led toimprovements in its external liquidity, as measuredby the gross nancing requirement over currentaccount receipts and usable reserves. The ratio hasimproved to 73% in 2011 from 85% in 2008 versusthe 106% for the BBB median. Of its peers, onlyThailands at 68% and Brazils at 73% are similar toPerus.

In addition to a dynamic export sector, the lowergovernment borrowing requirements resultingfrom scal consolidation and the replacement ofexternal debt by domestic indebtedness also playeda signicant role in the adjustment. Therefore,Perus narrow net external position has improvedto a creditor position of 27.4% of current account

receipts. Again, only Thailand and Russia havesimilarly strong positions, with 43.6% for Thailandand 38.8% for Russia.

Related Criteria And Research Sovereign Government Rating Methodology and

Assumptions, June 30, 2011

Rating historySovereign Rating And Country T&C AssessmentHistories

Default historySovereign Defaults And Rating Transition Data,2010 Update

Ratings Detail (As Of 15-Sep-2011)*

Republic of Peru

Sovereign Credit Rating

Foreign Currency BBB/ Stable/ A-3

Local Currency BBB+/ Stable/ A-2Certificate Of Deposit

Local Currency A-2

Senior Unsecured (14 Issues) BBB

Senior Unsecured (23 Issues) BBB+

Sovereign Credit Ratings History

30-Aug-2011 Foreign Currency BBB/ Stable/ A-3

23-Aug-2010 BBB-/ Posit ive/ A-3

14-Jul-2008 BBB-/ Stable/ A-3

23-Jul-2007 BB+/ Posit ive/ B

20-N ov-2006 BB+/ Stable/ B

14-Jul-2008 Local Currency BBB+/ Stable/ A-2

23-Jul-2007 BBB-/ Posit ive/ A-3

20-N ov-2006 BBB-/ Stable/ A-3

Current Government

Ollanta Humala of the Peruvian Nationalist Party

Election Schedule

Next Presidential elections: April 2016

*Unless otherwise noted, all ratings in this report are global scale ratings. Standard & Poors credit ratingson the global scale are comparable across countries. Standard & Poors credit rat ings on a national scale arerelative to obligors or obligations within that specific country.


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During the recent global recession, Latin Americashowed unprecedented resilience and recoveredquickly. On a weighted average, real GDP for the

region climbed 6.5% in 2010 after a decline ofonly 1.9% in 2009 (see table 1). Standard & PoorsRatings Services expects a combination of domesticand external demand to continue to support theregions economic growth, with real GDP risingby 4.5% in 2011 and 4.2% in 2012. (Listen tothe related podcast titled, Latin America: CreditQuality Improves As The Region Rebounds FromGlobal Recession, dated June 17, 2011.)

To be sure, the pace of growth differs somewhatwithin the region. Economies in South Americahave expanded faster than those in Central America,and we expect that to continue because of SouthAmericas high share of commodity exports,especially to fast-growing emerging countries inAsia. Mexico and Central America have recoveredmore slowly because of their closer economic linkswith the U.S. Nonetheless, we expect remainingoutput gaps to close during 2011 and economicactivity to moderate going into 2012, consolidatingat a pace consistent with trend rates of growth.

The recovery in domestic demand and narrowing(or already closed) output gaps, coupled with

high commodity prices for both food and energy,have contributed to an uptick in ination. Currentination for the region is about 7.4%, which isgenerally several percentage points higher than at thebeginning of 2010. Two exceptions are Mexico andVenezuela, though the latter still with ination ofmore than 20%. However, ination is still quite lowrelative to the regions inationary past, and to dateis still below 2008s uptick.

The medium-term foundation for domestic demandhas never been stronger given a broadening ofthe middle class, formalization of labor markets,

and deeper credit markets. But external links havepropelled economic growth as well. Supportive termsof trade for commodity exporters and capital inowsin 2010-2011 have contributed to strong domesticdemand in many countries. A decline in commodityprices or a sharp slowing in capital inowspresents downside risk for the region. The strongermacroeconomic foundation that helped LatinAmerica withstand the 2008-2009 recession shouldhelp mitigate future economic shocks. The buoyancyof external and domestic demand, however, poses

Latin Americas Resilience, Recovery, And ConsolidationLisa M Schineller, New York (1) 212-438-7352; lisa_schi neller@ standardandpoors.com

risks. One is the potential build-up of excesses, orbubbles, which could make an eventual economicslowdown a hard landing. In fact, some governments

are taking pre-emptive steps to avert these risks,including managing currency appreciation, capitalinows, and growth in domestic credit, and to alesser extent, tightening scal spending.

A Greater Resiliency To External ShocksOver the last decade, Latin America governmentsimplemented various policies that have strengthened

Table 1

Latin America---Growth And Inflation Outlook

(Year-over-year % change)

2006 2007 2008 2009 2010 2011f 2012f

Latin

American

Weighted

Average

Rea l GDP 5 .6 5 .8 4 .4 (1 .9 ) 6 .5 4 .5 4 .2

Consumer

Prices

4.7 5.5 8.3 6.5 6.6 7.4 6.6

Argentina* Real GDP 8.5 8.7 6.8 0.9 9.1 6.5 4.0

Consumer

Prices*

5.4 8.8 8.6 6.3 10.0 28.0 30.0

Brazil Rea l GDP 4 .0 6 .1 5 .1 (0 .6 ) 7 .5 4 .0 4 .3

Consumer

Prices

4.1 3.7 5.8 4.3 5.8 6.3 4.9

Chile Rea l GDP 4 .6 4 .6 3 .7 (1 .7 ) 5 .2 6 .0 5 .0

Consumer

Prices

3.4 4.4 8.8 1.4 2.7 4.0 2.9

Colombia Real GDP 6.7 6.9 3.5 0.4 4.3 5.4 4.8

Consumer

Prices

4.3 5.6 7.0 4.2 3.3 3.8 3.7

Mexico Rea l GDP 5 .2 3 .3 1 .5 (6 .1 ) 5 .5 4 .5 3 .5

Consumer

Prices

3.6 4.0 5.1 5.3 4.2 3.8 3.6

Panama Real GDP 8.5 1 2.1 10.8 3.2 7.5 7.5 5.5

Consumer

Prices

2.5 4.3 8.7 2.4 3.0 7.5 5.0

Peru Real GDP 7.7 8.9 9.8 0.9 8.8 6.0 6.5

Consumer

Prices

2.0 1.8 5.8 2.9 1.5 2.5 2.0

Venezuela** Re al GDP 9 .9 8 .2 4 .8 (3 .3 ) (1 .4 ) 1 .5 3 .5

Consumer

Prices**

13.6 18.7 31.0 26.9 28.5 30.0 30.0

* Historical figures are based on official data, and forecasts are market estimations.

* * Venezuela CPI is national. f--forecast.


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their underlying economic fundamentals. Theregions external position improved, including adecline in net debt and nancing needs (see charts 1and 2). The accumulation of international reservesto more than US$620 billion in 2010 from aboutUS$150 billion in 2002 played an important role inthe improvement of these external indicators.This much lower external vulnerability was a keycomponent enabling governments to secure nancingfrom ofcial and multilateral creditors duringthe global crisis until capital markets reopened.Healthier scal positions include lower debt anddecits (see charts 3 and 4). In addition, betterterms for government borrowing, such as the abilityto issue local currency debt in domestic marketsat xed rates, and with longer maturities, furtherreduces scal vulnerability.

Flexible monetary and exchange rate regimesand a successful track record of containing

ination enabled central banks to cut interestrates during the crisis in contrast with previouscrises. Latin Americas banking systems, whosestrength improved signicantly as a result of moreconservative policies following the regions ownbanking crises in the 1980s, 1990s, and early 2000s,also provided a foundation to weather the globalrecession. Comparatively high capitalization levelsabove the minimum Basle standards, predominantlydomestic currency, local deposit nancing, strongerregulation, and consolidated supervision characterizethe prominent banking systems in the region. Deeperlocal capital markets that developed alongside these

sounder fundamentals provide more exibilityfor companies to fund themselves locally and indomestic currency. In our view, these factors shouldalso help the region manage future negative globalshocks.

Chart 1

Chart 2

Chart 3

Chart 4


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Strong Domestic And External DemandStronger economies in the region have createdhigher, and healthy, domestic demand growth. Webelieve that robust labor and credit markets willcontinue to support demand growth in the nextseveral years. In fact, the regions resilience duringthe recession and its quick recovery reect thisstronger dynamic (see chart 5). This is true eventhough policy distortions in some countries, such asArgentina and Venezuela, undermine the medium-term domestic investment outlook, in our view.

Greater macroeconomic stability and lowerination, in particular, have supported expansion ofthe middle class and reduced poverty. Approximatelyone-third of the regions population, on average,

lived in poverty in 2010, down from more than40% in 2002--and from approximately 50% in1990. This improved standard of living for a largersegment of the population translates into strongerlocal consumption as well as investments in productsand services to attend to those consumers needs.

The combination of low ination, better growthprospects, and well-capitalized banking systems thatrely primarily on local funding led to the deepeningof Latin Americas credit markets, namely morelending to consumers and businesses. This in turnalso supports more solid domestic demand. The

ratio of (weighted) average domestic credit to GDProse to 38% in 2010 from 22% in 2004 (see chart6). Although this is a signicant increase for theregion, nancial sector intermediation is still lowerthan that in Asian emerging markets (with domesticcredit to GDP of about 80% on average) and theadvanced economies (more than 100%).

Growing global demand for commodities, largelyfrom Asia, has also supported growth in Latin

America, and in South American countries inparticular. Commodities account for 60% to 90%of South Americas total exports, in contrast withMexico where manufactured goods represent 80%

of total exports. South America has established tradelinks with fast growing Asian countries, in particularChina (see chart 7). As a result, commodities orraw materials as a share of total exports rose 10percentage points over the past 10 years, accordingto data from the Economic Commission for LatinAmerica and the Caribbean (CEPAL). China is nowthe single-largest export market for Brazil (15.2%of total exports in 2010) and Chile (23.8%), andthe second largest for Peru (18.3%). The growthtrajectory and demographics in emerging Asiashould continue to generate strong medium-termdemand and prices for commodities, in our opinion,

including food, metals, and oil, all of which SouthAmerica produces on a globally competitive basis.

Favorable terms of trade for commodity exportersimplies that a given basket of exports buys moreimports, in turn strengthening local purchasingpower and domestic demand (see chart 8).

Chart 5

Chart 7

Chart 6


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Another external factor supporting domestic demandis the robust recovery in foreign capital inows aftera retrenchment in 2008-2009. Non-residents haveincreased their investments in local capital markets,and Latin America issuance in foreign markets has

also risen. For example, in 2010, foreign directinvestment (FDI) and portfolio inows totaledUS$230 billion for Argentina, Brazil, Colombia,Chile, Mexico, and Peru, up from US$136 billion in2009 and US$111 million in 2008 (see chart 9).The rise in portfolio inows alone to this group ofLatin American countries is even more impressive.It almost doubled to an estimated US$128.1 billionin 2010 from US$66.1 billion in 2009. Portfolioinows began to recover in the second half of2009, after outows of US$2.4 billion in 2008. Thethree-largest recipients were Brazil, Mexico, andChile. Brazil received US$67.8 billion, split almost

evenly between debt and equity. Mexico receivedUS$37.1 billion, consisting mostly of purchases ofgovernment securities. Chile received US$9.3 billionof portfolio inows, with more than 50% goingto the nonbank private sector. Peru and Colombiareceived much smaller amounts, about US$3.3billion each in 2010. And Argentina received US$7.4billion, after several years of outows.

Since 2009, net portfolio inows have represented alarger share of total net foreign investment (48%) inLatin America compared with FDI and other/banknancing than in previous cycles of strong capital

inows. During the 1990s and 2000s, the share ofnet portfolio ows was 30%-40%, according to theIMF. Moreover, much of the growth in portfolioows has been in the form of debt, or xed-incomesecurities, rather than in equity. Increased reliance onxed-income portfolio investment is somewhat morerisky than FDI, with a greater potential to reverse,for example, when returns in advanced economiesbecome more favorable as monetary conditionsreturn to normal.

Credit And More CreditBuoyant capital ows and high rates of growth indomestic credit have contributed to worries that acredit bubble could be emerging in Latin America.

Despite a general slowdown in credit growth by theend of 2008 and in 2009, annual credit growth stillaveraged about 20% in the region during 2004-2010. Much of this reects a healthy, deepeningof credit markets: growth from a small base in theratio of domestic credit to GDP amid low inationand prospering economies. It also reects betteraccess to collateral thanks to revised legislationand bankruptcy codes since 2000 in a numberof countries. The growth in mortgage lending, inBrazil for example, reects this combination ofmacroeconomic and microeconomic factors thatfacilitated increased lending after 2003. Although

mortgage lending accounts for less than 4% of GDP,growth rates of 40% to 50% during the past severalyears have fueled discussion of a possible credit andreal estate bubble.

In our view, the growth in consumer credit, albeitmuch of it with better access to collateral, warrantsscrutiny more so than the housing market. InBrazil, for example, a large portion of nancing isin the form of cash, and there are limits on the sizeof mortgages that banks will nance via directedlending (which comprises the market). A rapidgrowth in consumer credit has occurred not just in

Brazil, but elsewhere, including Colombia and Peru.Much of the increased lending is to new borrowerswho dont have any established credit track record,which would include one of making their paymentsduring a prolonged economic downturn. The useof positive credit bureaus such as in Mexicoand Brazil (legislation pending in Congress), isimportant, but their credibility must be proven overtime.

Chart 8 Chart 9


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When considering the possibility of a Latin Americabubble in credit or capital markets, it is important toanalyze the differences between the region and moreadvanced economies. We need to consider the realgrowth in mortgage credit, which has averaged some15% during 2007-2010 for key Latin Americaneconomies, in a broader context. Total mortgageand household debt in Latin America is a fraction of

that in advanced economies--as is overall credit toGDP. Mortgages account for less than 5% of GDP inBrazil, Colombia, and Peru; and about 10% of GDPin Mexico, 20% in Chile, and 25% in Panama.Total household indebtedness (consumer andmortgage) is 21% of GDP in Brazil, 13% in Mexico,and about 8% in Colombia and Peru. As a percentof household disposable income, it is 41% in Braziland 19% in Mexico. The corresponding gures foradvanced economies are 80% and above. As to therisk to the capital markets, the use of securitizationsto nance the mortgage sector ranges from non-existent (such as in Brazil) to limited (as in Mexico,where it took a hit in 2008-2009 and has notrecovered). In Brazil and Panama, there are limits onthe size of the mortgage that banks can nance withlower cost funding (directed credit or subsidies), andvia government funded programs in Mexico. Theseprograms are key for granting mortgages.

Despite the benign comparison with other regions,growth in overall consumer lending, which hasranged from 8% to 24% in Latin America, bearsmonitoring. Debt service burdens have risen alongwith the increase in debt. In Brazil, debt service

consumes 25% of household disposable income, upfrom 21% in mid-2006. These gures do not includerent; mortgages are only 17% of total consumerdebt. The rise in the debt service burden has been ata much slower pace than the accumulation of debtbecause of lengthening loan maturities and lowerinterest rates. In Colombia, debt service is about17% of wages, up from 12% in 2005, but still wellbelow the 25% peak in 1995 before Colombiasbanking crisis. In comparison, the debt- servicingratio for U.S. households has ranged between 15%and 17% of personal disposable income during1995-2010.

Although debt-servicing data for Mexico areunavailable, the majority would be for mortgages,which account for 70% of household debt. Credit toMexican households increased 14% (on a nominalbasis) annually from 2003-2010 with mortgagesrising 12% and other credit 23%. In Mexico, therapid expansion of credit card lending that beganin 2005 and peaked in mid 2008 is an exampleof excesses--fast growth from a low base, lendingto new (riskier) borrowers, and weak origination

practices (multiple cards to the same household).Nonperforming loans (NPLs) for consumer creditrose markedly, peaking at almost 10% in the rstquarter 2009. Now theyre a little more than 4%.Consumer credit contracted (in nominal terms) frommid-2008 through the rst quarter of 2010.

This experience provides a warning for fast growthof credit elsewhere. The use of automatic payrolldeductions (as in Brazil and Mexico) and leasingmechanisms somewhat mitigates lenders risk ofaccess to collateral. Barring a change in the rules-of-the-game amid a stress scenario (i.e., courts limitingbank access to collateral), the key risks stem fromprolonged unemployment or high ination thaterodes real incomes and implies higher interest rates.

Some of the risks inherent in the regions creditgrowth relate to the resurgence of capital inows toLatin America (and emerging markets).

Although the regions banking systems relypredominately on local funding, there has beena slight rise in the share of foreign funding to10% in 2010, from 6% of bank liabilities in mid-2009, according to IMF calculations. Smaller, orniche, banks in the region tend to rely more onwholesale or external funding, rendering them morevulnerable. Typically, they arent as systemicallyimportant, but small banks with signs of distresscould foretell emerging weakness.

Some Policy Makers Are Taking Proactive MeasuresA reversal of fortunes, such as a deterioration

in the favorable terms of trade or a reversal ofcapital inows, in our view, would likely slowdomestic demand in Latin America. Indeed, whenglobal conditions reversed most recently in 2008-2009, retrenchment followed. It is important, inour view, that Latin American policies are notcomplacent in the face of such risks. This entailstimely withdrawal of the countercyclical scal,monetary, and credit policies that limited the depthof economic contraction and provided an importantfoundation for rebound in 2010. This shift to greaterexibility in setting policy during a global crisisis new to Latin policy makers; the region hadntexecuted countercyclical policy ever before duringa recession. Another challenge includes combatingrising ination and avoiding overheating whilesimultaneously managing currency appreciationand capital inows. In effect, this implies achievingcompeting policy objectives. Persistent, fast creditgrowth in a number of countries and the possibleemergence of excesses or bubbles heighten thepotential for an even harder landing following anexternal shock.


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Policy makers in Brazil, Chile, Colombia, Mexico,and Peru are aware of the risks associated withfast-growing credit, even from a low base, and howthe persistent capital inows to Latin America mayexacerbate a credit bubble. To varying degrees, theyare taking steps to moderate this risk. Their actionsinclude modest scal tightening, more restrictivemonetary policy, and direct efforts to manage capital

inows and slow domestic credit growth. Thelatter are generally considered part of the so-calledmacro-prudential toolkit.

Following the strong recovery in 2010, manygovernments are in the process of withdrawingcountercyclical policy stimulus. As such, we expectscal decits to decline again to an average of 1.9%this year, from 3.2% and 2.2% in 2009 and 2010respectively (see chart 4). Government budget plansin Latin America generally call for slower growth inspending. Chile, for example, announced cuts this

year that reduce growth in spending to take pressureoff domestic demand. Brazil also made spendingadjustments this year. Mexicos budget trajectoryalready included a phasing out of policy stimulusover several years (and Mexico does not have anoverheated economy).

Governments have also been tightening their

monetary policies since the second quarter of 2010.Initially, this was undertaken to normalize the loosemonetary conditions put in place in 2008-2009(see chart 10). Central banks also raised reserverequirements, reversing the cuts done during thecrisis. During 2010, monetary policy decisionstransitioned to combating rising ination andengineering a slowdown in activity amid signs ofbuoyant domestic demand and closing output gaps(see table 2). The Central Bank of Chile has raisedpolicy rates a total of 450 basis points (bps) sincelast year. In Brazil, the increase has been 325 bps, inPeru 300 bps, and Colombia 100 bps. The Mexican

central bank is the only central bank that has notraised interest rates. This is not a surprise since thecountrys estimated output gap is still negative.While we expect Mexicos ination to slow in 2011,the central bank of Mexico is likely to act quicklyshould food and energy prices push up the inationrate. In general, we expect that central banks willraise interest rates in 2011, as needed, to limit theination effects of food and energy price increases.While higher, ination is still broadly consistent withination targets in these economies.Central banks and governments are also taking

preventive macro-prudential measures, since raisinginterest rates to slow the economy and inationpotentially attracts further capital inows. This is

Chart 10

Table 2

Monthly Inflation

Year-over-year change (%)

2010 2011

Nov. Dec. Jan. Feb. March April Inflation Target Current

Policy

Rate

Argent ina (off icial) 11.0 10.9 10.6 10.0 9.7 9.7 -- --

Brazil 5.6 5.9 6.0 6.0 6.3 6.5 4.5 (+/ -2) 12

Chile 2.5 3.0 2.7 2.7 3.4 3.2 3 (+/ -1) 5

Colombia 2.6 3.2 3.4 3.2 3.2 2.8 3 (+/ -1) 3.75

M exico 4.3 4.4 3.8 3.6 3.0 3.4 3 (+/ -1) 4.5

Panama 4.3 4.9 4.8 5.0 5.5 6.3 -- --

Peru 2.2 2.1 2.2 2.2 2.7 3.3 2 (+/ -1) 4.25

Venezuela (Caracas) 26.9 27.4 28.9 29.8 28.7 24.0 -- --

Sources: Central Banks of Brazil, Chile, Colombia, Mexico, and Peru, respectively, and INDEC (Argentina). Data as of June 1, 2011.


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especially true because of the low policy rates inadvanced economies. To manage capital inows andcurrency appreciation, central banks in Brazil, Chile,Colombia, Mexico, and Peru are accumulatinginternational reserves. The banks methods varyfrom discretionary purchases in the spot andderivatives foreign exchange markets (Brazil andPeru) to more rules-based mechanisms via monthlyor daily preannounced spot or options purchases(Chile, Colombia, and Mexico). In addition, in late2010, Peru eased limits on pension funds investingabroad, while Colombia lowered the amount offoreign currency the Ministry of Finance and thestate-owned oil company Ecopetrol could bring intothe country. Peru and Brazil have also taken moredirect and aggressive steps to discourage short-terminows. Peru increased the reserve requirementson nonresidents deposits and holdings of centralbank certicates of deposit and limited nancialinstitutions foreign currency derivative positions.

In early 2011, the Brazilian central bank limitedthe size of any banks short foreign exchangeposition that is not subject to unremunerated reserverequirements. Brazil took its most noteworthy actionin October 2010, when, in the span of weeks, thegovernment raised the nancial transaction (IOF)tax on nonresidents xed income portfolios twice to6%. As a result, theres intermittent recurrent marketconcern that the government could raise the IOF taxyet again or extend it to cover nonresident equityinvestments. The government also applied the IOF toexternal debt issued for less than two years.

Brazil has also been the most active in deployingmacro-prudential measures aimed specically atslowing credit growth via tighter lending standards.In December 2010, for example, the Braziliancentral bank raised reserve requirements, imposedhigher capital requirements on longer-term consumerand auto loans, and raised the minimum requiredpayment on credit cards. In 2011, it increased theIOF tax on consumer credit to 3% from 1.5%.These measures have not been aimed at, and haventslowed, the pace of lending from state-owned banks,whose lending has grown at a faster rate thanlending from private banks.

Latin America Could Likely Withstand Another Global

CrisisThe economic outlook for Latin America includesboth risks and opportunities. In terms of externalor global risks, oil price volatility amid politicalinstability in the Middle East risks increasing LatinAmericas ination rates and, depending on theseverity of a price shock, could hurt the regionseconomic growth. In general, a downside scenario

for the region includes reversal of capital inowsamid higher risk aversion, with a detrimentalimpact on the cost and the availability of fundingfor the public and private sectors. In a more benignscenario, this could stem from central banks inadvanced economies returning monetary policies tonormal. A more severe scenario is one of sovereignscal distress in Europe or market concern overfuture U.S. scal policy, which could raise long-termbond yields.

Growth dynamics in China also play an importantrole in commodity prices and exports from manycountries in Latin America. The region facesdownside risk from a fall in commodity pricesand an economic slowdown in China. Strongglobal commodity demand and prices are helpingto moderate deterioration in the regions currentaccount decits. Current account surpluses during2003-2007 moved into decit in 2008, owing to

strong domestic demand-led growth of imports.After moderating in 2009 as GDP slowed ordeclined, current account decits are widening onceagain, albeit modestly. We expect the average currentaccount decit (weighted average) to increase to1.5% of GDP in 2011 and 2012 from 1.1% in2010. The IMF has underscored the fact that basedon 2005 terms of trade, these decits would bemuch larger--possibly by four-percentage points forsome countries--highlighting the risk for adjustmentshould commodity prices fall.

Latin Americas current ability to manage these

global downside risks is similar to its abilityduring the recent global recession, though perhapssomewhat weaker until governments fully withdrawtheir policy stimulus. The failure to withdraw thestimulus at a sufciently rapid pace presents riskof overheating, resulting in even higher inationand eventually, perhaps, a hard landing. In ourview, Latin American governments should continueto monitor the evolution of their local nancialmarkets to mitigate the possibility of asset or creditbubbles, since any persistent and fast rate of creditgrowth warrants caution.

Kelli Bissett and M atthew Walter pr ovided research

assistance to th is report .

Related Research

Special Report: L atin America Capitali zes O n I ts

Resistance, June 13, 2011


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also with signicant volume declines. Domesticdemand did not fall as steeply as it did in other partsof the world, but a complete freeze of international

credit and trade put commodity exports at a virtualstandstill late in 2008 and most of 2009. Withexport customers in Asia or Western Europe andelsewhere unable to nance their own workingcapital, commodity demand and prices tumbled.Financial prudence paid off during the crisis. Aftera big initial hit to their operating margins, mostcompanies survived (with some notable exceptions)because of their ability to quickly cut xed costs,improve productivity, and aggressively adjustworking capital needs.

The sectors that suffered the most during the 2008-2009 commodity crisis, relative to EBITDA margindeclines, were agricultural commodities, metals andmining (with steel suffering the most because ofsignicant demand slowdown), and forest productscompanies (also because of volume declines);building materials performance was close to neutral,and chemicals and oil and gas companies actuallyimproved. The average EBITDA margin expansionof oil companies in 2008-2009 reected resiliencefor the exploration and production (E&P) businessin the region and some margin expansion forPetrobras. That companys protability is strongly

inuenced by its domestic fuel realization pricepolicy, which does not correlate with volatile, short-term oil prices.

Companies that fared well during the downturnwere the ones that had either secured liquidity bybuilding cash reserves and renancing before creditfroze or expanded more cautiously. SteelmakersUsiminas, CSN, Gerdau, and CAP, for example,faced steep margin declines in 2008-2009 butmanaged through the downcycle because of their

strong pre-crisis capital structures. We downgradedpulp producers Arauco and CMPC by one notcheach in 2009, but the main reason was theiraggressive debt-funded capacity expansion projectsand mergers and acquisitions (M&A). Theirprotability weakened in the period but remainedhigh compared with global peers, and their creditproles remained strong enough in our view topreserve their investment-grade status.

Two characteristics were common among issuerswhose credit weakened more steeply in 2009. Therst was a bet on market growth using heavy capitalexpenditures, M&A, or working capital build-upnanced with debt. The second was signicantleverage, either with debt or derivatives. Whenmarket conditions reversed course, companies inthese situations found it much more difcult togenerate enough cash to service debt while facing avirtual shutdown in renancing.

Indeed, some rated entities in the region wentthrough nancial trouble as the 2008-2009 crisisunfolded, including (but not limited to) meatproducer Independencia S.A. and soybean producerImcopa Importacao, Exportacao e Industria deOleos S.A., both of which defaulted in 2009.Similarly, Bracol Holding Ltda. (the holdingcompany of Bertin Group, now part of JBS) alsofaced a strong deterioration of its credit prolewhile burning cash reserves very quickly. The crisisalso caught poultry company Sadia S.A. (now partof BRF Brasil Foods) and pulp company Aracruz

Celulose S.A. (now part of Fibria), but less sobecause of the cash ow deterioration than becauseof their bets on leveraged derivatives that triggeredgiant losses when the Brazilian real weakened bythe end of 2008. The sudden and steep decline inprices also caused some companies to face priceand cost mismatches that were difcult to handle.Chiles Empresa Nacional de Petroleo S.A. (ENAP),for instance, reported large losses (actually negativeEBITDA) in 2008 because it had to rene veryexpensive imported crude oil and sell it at muchlower prices.

Although the 2008-2009 crisis did not cause manydefaults in our universe of rated entities, even thecompanies that came through relatively unscathedmight not fare so well when facing a more severestress environment. Commodity prices recoveredquickly after their trough in 2010, and they never hitrecord lows, even in 2009. This made it possible forcompanies to return to reporting strong cash owsvery fast, but that might not be the case if pricestumble again in the future.

Chart 2


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Operating Profitability And Financial Leverage Are Key

Variables In Our Sensitivity AnalysisStandard & Poors sensitivity analysis focused oncompanies operating protability (measured byEBITDA margin) and nancial leverage (measuredby total debt to EBITDA). We estimated the levelof commodity reliance and the percentage of costs

that moves in tandem with commodity prices (forinstance, feedstock and energy), based on our viewsof each sector and entity. We used our 2011 base-case projections for revenues, EBITDA, and totaldebt, as our reference to compute how much theseindicators would weaken if commodity prices fell.

Companies with more-rigid cost structures--highxed costs or an inability to raise prices in responseto variable-cost increases--generally take a harderhit when commodity prices decline. Companieswith low operating protability also suffer becausethey have limited ability to deal with unexpected

events. Higher nancial leverage makes the effect ofprotability variability on credit quality even moresevere. On the other hand, companies that tradecommodities (buy and sell them with a spread, as inthe case of Ceagro, or fuel distribution businessessuch as Cosans, Ultrapars, and Copecs) basicallypass through costs and are almost commodity-priceneutral (We assume spreads compress when pricingweakens, though.) Similarly, for companies thathave high variable feedstock costs (the case of BRFBrasil Foods, Camil, Braskem, and Petrotemex), weassumed some cost reduction in tandem with end-product price declines.

Operating margin is another importantconsideration because it denes how much room acompany has to absorb the commodity price shock.Typically, capital-intensive sectors such as metalsand mining, forest products, and oil and gas arethe ones with stronger EBITDA margins (in excessof 35%-40%; see chart 3). The recent crisis hitcompanies in the metals and forest products sectorswith a steep decline in margins in 2009, but theyquickly recovered in 2010. Others that report aheavy component of feedstock costs and are heavilyinvested in working capital, such as petrochemicalsand agricultural commodities, report lowerprotability (EBITDA margins of 10%-15%, andsometimes less.)Agricultural commodities and forest productscompanies, meanwhile, have the highest leverage(total debt to EBITDA; see chart 4). The latter wasstrongly affected by both nancing for heavy capitalexpenditures in 2007 and 2008 and leading pulp

producer Fibrias huge derivatives losses. Oil andgas and metals and mining companies came in at thelower end of the leverage range, reecting generallyconservative nancial policies and deleveragingundertaken thanks to their cash windfalls inprevious years.

Higher-Rated Companies Have Been More ResilientMost companies report margin deterioration inthe 10%-30% range for every 10% price decline(see chart 5). Generally speaking, companies withhigher ratings benet from lower sensitivity in boththeir protability and leverage due to a change intheir end-product commodity prices. Despite their

heavy dependence on low value-added commodities,Codelco, Vale, and Minera Escondida should be,in our opinion, among the least sensitive to pricedeclines because of their world-class cost positionand very high protability. We also considerCSN, Grupo Mexico, and Fibria to be in thiscategory because of their stronger cost positions

Chart 3

Chart 4


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and low margin volatility relative to our base-caseprojections.

Companies whose feedstock makes up the bulkof their costs and is correlated with end-productsare not that sensitive to weaker commodity prices(Camil, Copec, Braskem, and Petrotemex fall in thatcategory), but they are affected by our assumption of

lower spreads (see chart 5). Indeed, these companiestypically report tight EBITDA margins, which makethem vulnerable to spread revenue-cost compression(Ceagro, for example).

As can be expected, the percent weakening of theleverage ratio is more severe in the lower ratingcategories, if we exclude Usiminas as an investment-grade outlier. That company stands out because

it wasnt able to recover as quickly as did othersteelmakers, who streamlined their operations inresponse to the 2008-2009 crisis. Most companiesleverage weakens by 20% to 50% for every 10%price decline in commodity prices (see chart 6). Thelarger dispersion among the speculative-grade ranksmay stem from the myriad other factors that affectsuch companies, such as concentration, size, lowmarket share, externalities and diseconomies of scaleand scope, and sovereign risks.

Chart 6

If commodity prices were to drop, we wouldexpect the agricultural products sector to performthe weakest, followed by metals and mining andchemicals. Oil and gas and forest products areless sensitive, on average, to price changes, in oursensitivity analysis. The 2008-2009 experienceshows a similar picture, with forest productsstruggling more because of volume effects in 2009(see chart 7). During the crisis, the performance ofthe oil and gas industry was distorted by PetrobrasEBITDA margin improvement due to its local fuelrealization price policies, which is barely correlatedwith short-term oil prices.

Chart 7

The differences between our sensitivity analysisand actual 2008-2009 results are greater when

considering the percent change in total debt toEBITDA. Thats because our test only takes intoaccount additional debt emerging from EBITDA losswhile each companys capital strategy affected itshistorical leverage. For example, many investment-grade companies in cash-rich sectors, such as Vale,Petrobras, Copec, Arauco, and CMPC, increasedtheir debt (worsening their debt ratio) even duringthe 2008-2009 crisis to fund increasing capitalexpenditures in capacity expansion or acquisitions.On the other hand, most companies in the B ratingcategory actually reduced their debt position andimproved their debt leverage ratios during the 2008-2009 credit crunch--Marfrig was an exception withits many acquisitions in the period. The increasein leverage in the 2008-2009 period, in the case ofagricultural commodity companies, came from bothadditional debt to nance acquisitions and capitalexpenditures (such as in the case of JBS and Marfrig,two of the largest companies analyzed), as well asfrom weakening cash ows. The improvement inthe leverage ratio for building material companiesin 2008-2009 come from deleveraging initiatives

Chart 5


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by virtually most companies in the sector, especiallyVotorantim and Cimento Tupi.

Chart 8

Many Other Factors Influence Actual ResultsOur sensitivity analysis does not take into accountall the factors that can affect the performance ofLatin American corporate issuers during a period ofcommodity price declines. First, as mentioned above,companies in Latin America rapidly adapted to thenew, weaker operating environment in 2008-2009by adjusting for the new volume-price level. Thisallowed them to resume better operating marginsand protability, which further improved oncedemand recovered. Although some companies maynot have much left to cut, this ability could helpcompanies again in the future.

We also used a simplistic and generic estimateof commodity dependence and cost exibilityin our sensitivity analysis, which ignores thespecicities of each entity. (However, we do fullyfactor these specicities into our individual ratinganalyses.) Many companies in the region are ableto sustain prices for some time after a price dropin international markets because of their domesticmarket power or because their products aresomewhat differentiated. Although working capitalneeds can become a signicant burden soon aftera price decline, companies may also reduce them

gradually when volumes and feedstock costs aredeclining, which could produce some cash inowsthat would help them withstand the slowdown.

Finally, commodity prices (quoted in U.S. dollars)historically have shown a strong negative correlationwith foreign exchange rates in the region, suchthat a wide uctuation of commodity prices hastypically been offset by an opposite move in theexchange rate. This helps preserve cash owswhen denominated in local currencies, a benet

for companies whose cost structures are primarilyin local currency, such as mining and forestproducts companies (and steelmakers, to a lesserextent, depending on the level of integration withfeedstock). On the other hand, currency effectsare less relevant for companies that sell a lot inthe domestic market (in these cases, a depreciation

of the currency is also typically associated witha slowdown of the domestic demand) or in caseswhere the difference between feedstock cost and end-product prices (for instance, petrochemical spreads)tightens as a result of weaker domestic demand.

Many of these factors played a role in causing thedistinction between our sensitivity analysis andactual results. Several companies in the B ratingcategory, for instance, performed better because theywere efcient in dealing with the weak operatingenvironment, while others beneted from the localmarket. On the other hand, some companies in

higher rating categories took severe hits both inprices and volumes.

Between 2008 and 2009, some lower-rated entitiesimproved leverage ratios. However, the fact thatinvestment-grade companies signicantly increasedtheir total debt to EBITDA ratios during 2008-2009did not necessarily leave them with worse creditmetrics than those lower-rated entities that improvedthat ratio because they started from stronger levels.Investment-grade companies faced relatively modestcredit deterioration, with one-notch downgrades ornegative outlook revisions. Ratings on companies

with more aggressive nancial proles performedrather differently, sometimes with multiple-notchdowngrades, and some entities defaulted on theirdebt. Again, conservative nancial policies helped.

Chart 9


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This is indeed our most relevant conclusion: Becauseprice declines hurt operating protability for allentities (at about 10% to 30% for every 10% pricedecline, though at the lower end of this range inthe case of higher-rated entities), a strong nancialprole will make the difference for credit quality ifcommodity markets suddenly weaken. The 2008-2009 global slowdown gives us a glimpse of whatcould happen again with Latin American companiesin these sectors, because the price and volumechange then was abrupt and intense. However, pricesrecovered just as quickly in the second half of 2009for most sectors. Therefore, the effects of a potentialcommodity price drop may be much harsher if thetrough were to last longer.

Chart 10


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Issuer RatingsLatin American Commodities Companies

Company name Sector Country Foreign currency rating Outlook/CreditWatch

Corporacion Nacional del Cobre de Chi le M etals Chi le A Stable

Vale S.A. M etals Brazil BBB+ Stable

Compania de Petroleos de Chile COPEC S.A. Oi l Chi le BBB+ Stable

Empresas CM PC S.A. Forest Chi le BBB+ StableM inera Escondida Ltda. M etals Chi le BBB+ Stable

Votorant im Part icipacoes S.A. Bui lding Brazil BBB Stable

Celulosa Arauco y Const itucion, S.A. (ARAUCO) Forest Chi le BBB Stable

Sociedad Quimica y M inera de Chi le, S.A. Chemicals Chi le BBB Stable

Petroleos M exicanos (PEM EX) Oi l M exico BBB Stable

Companhia Siderurgica Nacional (CSN ) M etals Brazil BBB- Stable

Braskem S.A. Chemicals Brazil BBB- Stable

Ult rapar Part icipacoes S.A. Chemicals Brazil BBB- Stable

Petroleo Brasi leiro S.A. - Petrobras Oi l Brazil BBB- Posit ive

CAP S.A. M etals Chi le BBB- Stable

Grupo M exico, S.A.B. de C.V. M etals M exico BBB- Posit ive

Indust rias Peoles, S. A . B. de C. V. M etals M exico BBB Stable

Ecopetrol S.A. Oi l Colombia BBB- Stable

Usinas Siderurgicas de M inas Gerais S.A. (Usiminas) M etals Brazil BBB- N egat ive

Gerdau S.A. M etals Brazil BBB- N egat ive

BRF Brasi l Foods S.A. Agro Brazil BB+ Posit ive

Klabin S.A. Forest Brazil BB+ Stable

Suzano Papel e Celulose S.A. Forest Brazil BB+ Stable

Fibria Celulose S.A. Forest Brazil BB Posit ive

JBS S.A. Agro Brazil BB Posit ive

Cosan S.A. Industria e Comercio Agro Brazil BB Stable

Grupo Petrotemex S.A. de C.V. Chemicals M exico BB Credi tW atch Neg

Alto Parana S.A. Forest Argent ina BB- Stable

Camil A l imentos S.A. Agro Brazil BB- Stable

M agnesita Refratarios S.A. M etals Brazil BB- Posit ive

Petrobras Argent ina S.A. Oi l Argent ina BB- Stable

M arf rig Al imentos S.A. Agro Brazil B+ Stable

Loma Negra C.I.A .S.A. Bui lding Argent ina B+ Stable

Cimento Tupi S.A. Bui lding Brazil B Stable

Virgol ino de Olivei ra S.A. - Acucar e A lcool Agro Brazil B Stable

M inerva S.A. Agro Brazil B Posit ive

Ceagro Agricola Agro Brazil B Stable

Grupo Fert inal, S.A. de C.V. Chemicals M exico B+ Stable

Cemex S.A.B. de C.V. Bui lding M exico B Credi tW atch Neg

Siderurgica del Turbio S.A. M etals Venezuela B Credi tW atch Neg

Related Criteria And Research Special Report: Latin America Capitalizes On ItsResistance, June 13, 2011 The Potential Risk Of Chinas Large AndGrowing Presence In Commodities Markets, June1, 2011 Latin America Is Enjoying A Strong EconomicRecovery, But Ination Is Rising, March 2, 2011

Assumptions: Revised Oil and Natural Gas PriceAssumption For 2011, 2012, and 2013, Feb. 25,2011 Standa

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