Publish in Perspectives - Wednesday, August 26, 2015
Peru’s open trade and investment policy is an integral part of a broader economic formula that is centered on creating an environment that encourages business activity. Here capital Lima. (Photo: Federico)
How free trade turned a once-struggling economy into a global player.
BY LUIS MIGUEL CASTILLA
Trade and investment are vital for a middle-income economy like Peru, which requires access to export markets and a steady supply of external capital flows in order to thrive. Peru’s foreign trade of goods and services measured by value is equivalent to 48 percent of its GDP.
For over a decade, Peru has sustained an open trade and investment policy aimed at integrating its economy into global markets, with a network of 17 fully fledged free trade agreements (FTAs) that currently cover 95 percent of merchandise trade and account for nearly $80 billion in annual exports and imports.
These agreements have contributed to making Peru one of Latin America’s great success stories. Its economy grew at an average rate of 6.1 percent between 2002 and 2013. Despite slowed region-wide growth, Peru continues to outpace its neighbors, with 2.4 percent growth in 2014, compared to 0.8 percent for the rest of the region. This economic growth has brought important social gains: the number of Peruvians living in poverty fell by more than half between 2005 and 2014.
Free trade has become a cornerstone of Peru’s economic policy. The Peruvian government is in the process of expanding its trading network through negotiations within and outside the region that will eventually cover nearly all of Peru’s global trade. Each round of negotiations, including the present one, has been supported by several governments from different political parties over the past decade and a half.
There’s no mystery about why Peru’s ambitious trade policy has received such broad domestic political support. It is a crucial element of an economic and social agenda aimed at enhancing the welfare and social inclusion of all Peruvians.
FTAs have worked in three key ways: by boosting Peruvian exports and reducing the costs of imports; by encouraging confidence in Peru as a reliable trade partner; and by helping transform inefficient domestic structures and institutions.
THE FREE TRADE PAYOFF: GREATER DIVERSIFICATION, GREATER COMPETITIVENESS
Enhanced trade access increases Peru’s competitiveness vis-à-vis countries that do not have such trade preferences in place. The figures tell the story. Exports rose from $17.1 billion a year in 2005 to $46.4 billion in 2012 (before slowing in the past two years due to a drop in international commodity prices).
Trade preferences have also helped Peru diversify export markets and increase exports of nontraditional value-added goods, which nearly tripled in the past 10 years to $11.6 billion in 2014.
Successful nontraditional export industries include textiles, high-quality fruits and vegetables (as opposed to bulk agriculture commodities), fisheries, jewelry, crafts, and metal- and wood-based products. Peruvian trade policy aims to make these products constitute a greater share of overall exports.
FTAs create opportunities for new export products and they consolidate existing unilateral and temporary trade preferences, such as the U.S. Andean Trade Preferences Drug Eradication Act (ATPDEA) and the European Union’s Generalized Scheme of Preferences (GSP+). For example, the 2009 Peru-U.S. Trade Promotion Agreement (PTPA) phases out all duties on 99.5 percent of U.S. tariff lines, including on all Peruvian agro-exports to the United States.
As a result, Peruvian exports to the U.S. grew by 26 percent during the first six years of the agreement. During this period, nontraditional industries in Peru also grew by 80 percent, and Peru exported more than 900 new products, valued at nearly $1 billion, to the United States.
For Peruvian businesses and households, the welfare gains from trade liberalization are equally significant. FTAs generate new export opportunities, leading to the creation of new businesses. In the past 10 years, the number of exporting businesses operating in the country nearly doubled to over 8,000. The effect on employment is also significant: an estimated 15 of every 100 jobs in Peru are sustained by exports. On the import side, Peruvian manufacturers have better access to capital goods and cheaper foreign inputs for domestic production, which, in turn, enhances their export competitiveness.
Lower import duties—combined with rising wages and low inflation—have also led consumers to enjoy a significantly expanded and more affordable basket of goods. Cheaper imports contribute to greater disposable income, leading to increased and more sophisticated consumption, which also fuels economic growth.
FTAs CREATE A BUSINESS FRIENDLY ENVIRONMENT
Peru’s open trade and investment policy is an integral part of a broader economic formula that is centered on creating an environment that encourages business activity. Sound macroeconomic policies, a stable legal framework and respect for the rule of law are part of this equation. Peru’s comprehensive FTAs reinforce this policy, helping businesses take full advantage of the market opportunities created.
The terms of Peru’s FTAs extend beyond merchandise trade, applying to services, investment, government procurement, and a range of regulatory areas through which Peru’s domestic procedures are streamlined with those of its trading partners and made more efficient. These include customs and trade facilitation, technical import requirements and food safety measures, among others. Peru’s FTAs also include the latest generation of labor, environmental and intellectual property standards.
All these provisions make Peruvian businesses competitive. Moreover, most of Peru’s FTAs contain investment chapters that build further investor confidence and make the country a more attractive destination for foreign investment. Annual flows of foreign direct investment in Peru grew from $2.6 billion in 2005 to more than $9 billion in 2013.
FREE TRADE TRANSFORMS INFRASTRUCTURE
The Peru-U.S. FTA represented a watershed for Peru’s economic policies and institutions. The PTPA required nearly 100 new laws in order to be implemented— significantly strengthening its domestic infrastructure and institutions in the process.
It both reinforced Peru’s legal stability and contributed to an enhanced country risk classification. As of May 2015, Peru tied with Mexico for the second-highest investment rating in Latin America, behind only Chile. The PTPA also led to a greater degree of economic specialization and greater efficiency in the allocation of capital and labor. Moreover, the integration of previously informal economic sectors into the mainstream led to further structural benefits.
As a result of the Peru-U.S. agreement and other FTAs, public support for free trade in Peru is high. But perhaps the most notable result is the strengthening of Peru’s entrepreneurial culture. The agreements have generated complex supply chains that serve major enterprises, leading to the rise of small- and medium enterprises (SMEs). Of the 8,032 businesses that exported abroad in 2014, 6,200 were SMEs.
This is a significant development, given that 99.8 percent of Peruvian businesses are SMEs and that SMEs account for nearly 81 percent of employment in Peru.12 In this regard, FTAs help strengthen supply chains by streamlining SME business practices. They also spur innovation and entrepreneurship.
However, Peruvians know that in today’s fast-paced global environment, the country cannot rest on its achievements. Significant reforms remain necessary for Peru to increase its competitiveness and fully take advantage of the many opportunities created by its FTAs.
Perhaps the most pressing challenge is tackling inefficient bureaucratic structures that reduce labor market efficiency. Some 80 percent of Peru’s SMEs remain unregistered—representing an informal economy that continues to cost in efficiency and productivity and is a drag on the potential growth rate. Addressing these challenges will help Peru take the next major step in its international trade policy, exploiting the advantages represented by the Pacific Alliance.
Established in 2011, the Pacific Alliance is the most dynamic integration initiative in the region. Linking Peru, Chile, Colombia, and Mexico (as of this writing), it aims to foster an open and nonexclusive integration process among countries that share a common vision of trade-led development. The alliance is a cornerstone of Peru’s inclusive foreign policy of open regionalism. It is non-ideological and complementary to—rather than competitive with—other regional bodies.
The Pacific Alliance is intended to create an area of deep economic integration that will progressively establish the free circulation of goods, services, capital, and persons. As a platform for economic and trade integration with the rest of the world, particularly the Asia-Pacific region, it will not only promote the growth, development and competitiveness of its four member countries, but allow each to reduce socioeconomic inequality and achieve greater social inclusion.
In 2012, a year after its launch, Pacific Alliance members concluded a Framework Agreement. Two years later, following extensive and successful negotiations, the presidents of Pacific Alliance countries signed an additional protocol, which, upon entry into force, will immediately eliminate 92 percent of tariffs among the four member countries. The remaining 8 percent of tariffs will be progressively phased out in the medium term.
The Pacific Alliance represents a significant opportunity for businesses throughout the Americas. Together, Peru, Chile, Colombia, and Mexico form the eighth largest economy in the world, with a combined GDP of roughly $2.2 trillion and a population of 214 million (Latin America’s overall combined GDP was an estimated $5.6 trillion in 2014). In recent years, alliance members have greatly outperformed many other countries in the region. Even with deceleration in 2014, the bloc’s 2.9 percent average annual economic growth was the third most dynamic in the world among large economies, falling behind only China and India.
Furthermore, Pacific Alliance countries attracted 45 percent of foreign direct investment flows to Latin America. While the bloc accounts for 36 percent of Latin America’s population and 38 percent of its total GDP, it accounts for nearly half of the region’s imports and exports. In the next decades, the Pacific Alliance is expected to be among the four economies that will most contribute to global GDP growth, following China, India and the United States.
THE NEXT STEPS: BUILDING A GLOBAL PLATFORM
The Pacific Alliance is also an attractive production and export platform. The combined exports of these four countries, nearly $560 billion in 2013, made it the world’s eighth largest exporter. The bloc serves to connect Latin America to the rest of the world, particularly the Asia-Pacific region. Member countries are promoting reforms to increase investment and business competitiveness. In the World Bank’s 2015 Doing Business report, they ranked as the top four countries in Latin America.
The Pacific Alliance is also distinguished by strong support at the highest levels. The heads of state have regularly met at summits—there have been 10 so far—to provide momentum to the ongoing trade negotiations.
The bloc is now moving beyond trade issues and on to financial integration, infrastructure investment and public finances. Its work in this area has been complemented by private initiative, which established the Mercado Integrado Latinoamericano (Latin American Integrated Financial Market—MILA) comprising the four countries’ stock exchanges. With a market capitalization of $902 billion, MILA has already surpassed Brazil’s stock exchange to become the largest financial trading platform in Latin America. MILA will allow Pacific Alliance businesses to develop their financial growth potential by issuing joint initial public offerings (IPOs) of stocks and bonds, expanding investment alternatives and deepening the financial market.
The alliance also has an agenda of joint export promotion and standardized regulations for pharmaceutical and cosmetic products, tourism, and academic and student mobility. The Pacific Alliance Business Council, created in 2012, engages private enterprise. And Pacific Alliance members plan to pilot joint embassies and trade offices. The bloc’s future agenda will largely center on developing strategic alliances and increasing supplier capacity and production and supply chain linkages.
Interest in the Pacific Alliance extends beyond Latin America. The bloc has 42 observer nations, including the U.S., China, Japan, and several European nations.
The Trans-Pacific Partnership (TPP) is another illustration of Peru’s commitment to consolidating its strategic presence in the Asia-Pacific region. The TPP is an ambitious undertaking. It aims to build an area of free movement of goods, services and capital between 12 countries, accounting for nearly 40 percent of world GDP, 25 percent of world exports, and 28 percent of world imports. The TPP seeks to lay the groundwork for the Free Trade Area of Asia-Pacific (FTAAP), which would build on TPP and Association of Southeast Asian Nations (ASEAN)-led trade agreements to create the world’s largest open trade and investment area, involving all 21 Asia-Pacific Economic Cooperation (APEC) member economies. As such, TPP is expected to include the latest generation of high standard rules and disciplines in 29 different chapters.
Peru, along with Mexico and Chile, has actively participated in the past four years of TPP negotiations and is fully committed to reaching an ambitious, comprehensive and balanced agreement.
The TPP would spur economic growth and generate employment; build on Peru’s privileged geographic position as a hub for trade with the Asia-Pacific region; bring preferential trade access to five new markets and enhance existing FTAs; boost demand for Peruvian products by an estimated $2.5 billion; enhance service-sector trade and participation of Peruvian businesses in public procurement opportunities; and further integrate Peruvian businesses into Asia-Pacific value chains, significantly boosting Peru’s competitiveness.
Mercosur is yet another economic grouping that complements the Peruvian economy. Peru is an associate member of Mercosur and, since January of 2006, has an Economic Complementation Agreement in force that provides a preferential economic and trade framework with Brazil, Argentina, Paraguay, and Uruguay. Peru is seeking to cooperate with Mercosur countries to further enhance trade and investment.
Peru’s positive experience with FTAs, as well as that of its regional partners, is helping foster a better understanding throughout Latin America that trade is not a zero-sum game. An open trade policy can yield tangible development benefits underpinning employment, enhanced competitiveness and poverty alleviation. There will be trade-offs and adjustment costs that must be addressed through the appropriate complementary economic and social policies, yet the overall positive impact from free trade far outweighs any such costs.
Miguel Castilla is Peru’s ambassador to the United States
and former minister of economy and finance.
This article was originally published in the Summer 2015 issue of Americas Quarterly (www.americasquarterly.org)