GoldMau your source for reliable precious metals information

Many precious metals equity investors have exposure to Peru through companies like Newmont, Pan American Silver, and Southwestern Resources, yet most don’t know much about Peru. In this report, we share our findings on Peru, as well as our first hand experience from a recent visit to a property in the country.

Peru is a country with an abundance of geological resources and promising economic conditions. In 2005, the country boasted its best real GDP growth rate in eight years, growing 6.7%. Inflation, which was a serious problem for the country in the 1980s has been at OECD levels since 1999 and looks poised to remain at such levels in the future.

This mixture of strong economic growth and low rates of inflation has enabled the government to strengthen and develop local capital markets, reduce external debt, and build up reserves; all while running record current account surpluses. Peru is an economy on the rise.

Sources: Central Reserve Bank of Peru and Ministry of Economy and Finance of Peru, 2005

Much of Peru’s current economic success can be attributed to the country’s geologic wealth. Both within Latin America and on a world scale, Peru is a leader in the production of commodities such as: gold, copper, silver, tin, zinc, lead, and moly.

Peru’s International and Latin American Ranking in Mine Output of Selected Metals

How important is mining to the Peruvian economy? Fifteen percent of the foreign direct investment that enters Peru can be directly attributed to mining. Since the 1990s mining (including refining and smelting) has accounted for about 11% of Peru’s GDP, over 45% of the economy’s total exports, and contributed about 13% of the government’s tax revenues.

	2002	2003	2004
Total	7,723	8,986	12,547
Mining Sector	3,809	4,597	6,881
Gold	1,501	2,045	2,362
Copper	1,187	1,261	2,446
Zinc	429	529	577
Lead	211	201	398
Silver	174	191	260
Iron	83	94	129
Tin	155	175	299
Other Metals	69	102	410
Other Sectors	3,914	4,389	5,667

Copper, gold, silver, zinc, iron ore, and tin are the main metals produced in Peru; altogether they account for about 95% of the country’s mineral exports.

Many of the world’s largest mining companies have major stakes in Peru including: BHP-Billiton, Newmont, Phelps Dodge, Teck-Cominco, and Barrick. These companies are not primarily attracted to Peru in the hopes of discovering and developing high-grade deposits. Rather, the main asset that Peru has for mining companies is its wealth of large, low-grade deposits; many of which have yet to be discovered or exploited. These deposits can be mined at a discount to other regions. For example, at Newmont’s Yanacocha gold project in Northern Peru production costs are believed to be as low as US$100 per ounce. This is significantly less than the production costs at Newmont’s other operations in the United States (US$225/oz), Eastern Europe (US$225/oz ounce) and Indonesia (US$224/oz).

If you looked at the Peruvian economy twenty years ago you would have seen a vastly different situation. In the 1980s the Peruvian economy was suffering from economic mismanagement. The economy was plagued by hyperinflation, the government was carrying a huge deficit, and the state had monopolized most of the country’s mining operations. The mines controlled by the state were not receiving inflows of new investment and were reporting annual losses of around US$100 million. Production at the mines had stagnated and labour productivity was rapidly declining. The situation was bad.

At the start of the 1990s Peru had amassed a massive foreign debt. In a desperate attempt to attract foreign investment the government began to implement liberalization reforms. The goal of the reforms was to create stable and profitable conditions for foreign investment. Mining was a sector that was targeted directly by the reforms.

As part of the reforms, Peru enacted a privatization law in 1991. This led to the privatization of about 220 state-owned corporations, netting the government US$10.5 billon or about 17% of Peru’s GDP. During the process most of the states mining assets were privatized. The last state owned mining operation was privatized in 2003, and only a few projects and concessions remain under state control.

In addition to the privatization program, since 1990 the government has created an attractive environment for new mining investments. Since the 1990s, foreign investors have viewed Peru as an attractive investment opportunity because the State has guaranteed property ownership, free remittance of profits, and capital repatriation. The Peruvian government has also cut subsidies and tariffs, freed foreign exchange and interests rates, liberalized international investment rules, simplified the tax code, and repaired its fiscal situation.

The impact that Peru’s economic transformation has had on mining is astounding. From 1991 to 1997, mining concessions increased from 2,258,000 hectares to 15,597,000 hectares, or 700%. Over the same period metal mine production had an average annual growth rate of more than 8%. Between 1990 and 2000 mining exports more than doubled, rising from US$1.5 billion to US$3.2 billion. Over the period of 1992-2004, some US$1.9 billion of private investment capital was injected into the mineral sector for exploration, and about US$ 5.5 billion was invested for the establishment of new mines as well as for the expansion and enhancement of existing ones.

With the economic transformation of the 1990s largely completed and commodity prices soaring, Peru’s economy is in excellent shape. Largely due to record mineral shipments, last year Peru’s exports increased 37%. In addition, in 2005 the government posted its smallest deficit (0.4% of GDP) in eight years.

More than 100 foreign mining companies have established themselves in Peru since 1990. Whereas in the 1980s foreign mining companies were repelled from the country, now they have been welcomed with open arms.

On April 9th an election was held in Peru. No candidate received more than 50% of the vote and a run-off vote will occur in May or early June. Ollanta Humala, a former army officer and leader of the nationalist party, will face Alan Garcia in the run-off.

Polls have suggested that when the run-off vote occurs, Garcia will win. Many of the people that supported Lourdes Flores, a right-wing candidate that placed 3rd in the April 9th vote, will place their support behind Garcia in the run-off vote. Although Flores’ supporters have little love for Garcia, he is seen as the lesser of two evils when compared with Humala. In addition, the majority of the people that voted for the many splinter parties in the April 9th election will most likely place their support behind Garcia.
Alan Garcia is a well known political figure in Peru. In 1985, at the age of 36, he became the youngest President of Peru. His term lasted until 1990 and was marred by hyperinflation, social turmoil, human rights violations, increasing violence, power blackouts in Lima, and international financial isolation. Throughout his term the inflation rate rose from 87.7% in 1985 to astounding 7,649% in 1990. When he left office, the government was drained of its income sources and foreign reserves. This left the next government, lead by Alberto Fujimori, no choice but to seek the economic support of the International Monetary Fund, World Bank, and the international financial community.

In spite of his early political troubles, Garcia remains a popular public figure in Peru. He is known for his charisma, charm and oratory skills and has been referred to as “Latin America’s best orator with a power to convice.” Many of Garcia’s supporters aknowledge that he made mistakes during his previous presidential term, but argue that he has valuable experience and solid new policies. They believe that he has matured and that he deserves a second chance. Garcia has also gained the support of younger voters who did not experience the disastrous effects of his previous presidency.

Garcia is a populist with a political outlook that steers a course between the extremes of raw capitalism and extreme nationalism. He is a moderate leftist that is not hostile to Washington. He has promised to reduce telephone and electricity rates, provide loans to farmers, maintain macroeconomic stability, promote workers rights, leavy a windfall profit tax on mining companies, and to oppose the ratification of the free trade agreement with the United States until a full public debate has occurred. He has also claimed that he is the only candidate that is prepared to represent the poor without a takeover of private property. Whereas Humala has gained the support of those in rural areas, and Flores gained the support of those in urban areas, Garcia’s middle-left policies have allowed him to gain the support of a diverse voter base.

The other candidate, Ollanta Humala, is a retired Peruvian Lieutenant Colonel. During his military career, Humala was involved in the two major Peruvian conflicts of the past 20 years: the battle against the terrorist organization the Shining Path and the 1995 Cenepa War with Ecuador.

In 2005, Humala became the leader of the Peruvian Nationalist Party (PNP). For the current election campaign he is running under the Union for Peru (UPP) ticket, with the support of his own PNP party.

Humala has considerable support from the Peruvian populace outside of Lima. In particular he has a stronghold in Peru’s second-largest city, Arequipa. He has maintained a strong nationalist, left wing stance that is popular with those that have remained impoverished and disenfranchised while the Peruvian economy has expanded over the last decade. Humala’s supporters are fed up with recent political corruption and believe that Humala is “not of the corrupt bunch.” Humala has also gained the support of those who believe he is a fearless warrior that has the ability to combat crime, discipline foreign corporations, and redress grievances against neighboring countries. Humala has stated his intentions to legalize the production of coca, renegotiate contracts with foreign mineral and hydrocarbon companies, end military co-operation with America, and void the recently negotiated free trade agreement with the United States until a referendum on the issue is conducted. He has also promised to improve health services, spend $3 billion on education, invest $1.5 billion in agriculture, and embrace economic regionalism.

Nonetheless, in meetings with business groups Humala has promised to respect private property, battle drug trafficking, and push for equitable trade pacts with the U.S and Europe.

Many people in the resource investment community have warned of dire consequences for mining companies if Humala wins the run-off in May. Humala has promised to create a nationalist economic policy, impose more taxes on mining operations, and assume state control over “strategic sectors.” Humala, however, has not indicated exactly what sectors he means or how this is to be accomplished.

With mining accounting for more than half of Peru’s export revenue and 13% of the government’s tax base it has become an easy target for politicians that want to feed off the discontent of impoverished Peruvians. Throughout the election Humala has been strongly advocating economic nationalization in order to gain the support of the impoverished and disenfranchised. If elected, it is almost certain that his policies will be considerably tamer than what many people believe are his intensions now.

Humala may be spouting strong leftist discourse, but he is not going to return the economy to a situation like that of the 1980s. At most we can expect that his government would increase taxes or impose royalties on the mining industry. This would not have a drastic impact on the industry as Peru already imposes one of the lowest tax rates in Latin America – taxes paid in Peru represent 12.5 per cent of GNP, while other governments in the region demand, on average, 18 per cent of GNP. Although the potential election of Humala may spook the financial markets in the short term, in the long term his impact on the mining sector will be minimal.

Major mining companies with operations in Peru remain optimistic about the current political situation. Pete Faur, a spokesman for Phelps Dodge, is optimistic that the company would be able to work with whichever candidate wins. He was quoted as saying “we’ve always been able to find the common ground in the past.” Even in the midst of political uncertainty the company is considering increasing its holdings in Peru through the purchase of BHP Billiton’s Tinaya mine.

Raul Jacob, head of investor relations at Southern Copper, has remained confident that Garcia will defeat Humala in the run-off vote. Jacob’s said, “we’re watching the situation but, at present, we are not too worried.”

Ultimately, mining in Peru will remain strong whomever is elected in the May run-off vote on June 4. In the worst case scenario, Humala will be elected, the financial markets may be spooked in the short term, and in the long term mining companies will be forced to pay higher taxes. Mining companies in Peru, which are currently under taxed according to Latin American standards and making boat loads of profits from increasing commodity prices will not find the increased taxes to be overly constraining. Calm will eventually return after the new administration takes office. Peru will continue to enjoy the abundance that has been provided by its mineral wealth.

Currently the stocks of mining companies that operate in Peru are trading at a discount to those of other regions. Much of this discount can be explained by investor uncertainty about the country’s political climate. We believe that after the June election, much of the uncertainty will be removed and alongside buoyant metal prices companies operating in Peru should reward their investors through share price appreciation

I like Peru. It’s a friendly country with a GDP per capita that is 1/10th of Canada’s and a lot of room for growth. With metal exports driving Peru’s ballooning annual trade surplus (likely to top $5 billion in 2006 which would be outstanding for a $70 billion economy), I see Peru as a country that is moving forward. While I am not an expert in local politics, I think eventually the surplus wealth from mineral exports will benefit the local communities through infrastructure development such as housing, transportation, and communications. Ultimately, only time will answer the question, but I am in the optimistic camp.