MEMORANDUM

TO: President of Peru Ollanta Humala, Finance Minister Luis Miguel Castilla Rubio

FROM: Erick Soto IADB Advisor, Country Capital Market Development Program

SUBJECT: Developing and Diversifying the Peruvian Capital Market

EXECUTIVE SUMMARY: Peru’s economy is currently considered one of the rising stars of Latin America. GDP has grown over 5% since 2011 (see Graph 1) buoyed by stable macroeconomic policies and a booming extractive sector. Peru’s macroeconomic policy has remained one of the most resilient in the region by sustaining single digit inflation rates, low unemployment, and keeping fiscal spending to a minimum. Peru has followed in the footsteps of other countries within the region like Colombia, Brazil and Chile in developing its financial system since the late 1980s through improved banking policies and capital market development. For example, pension funds were privatized in 1992 creating a role for institutional investors to invest in local capital markets. Despite the government’s efforts to deepen capital markets instead of relying on the banking system, capital markets have not developed to the extent of some other emerging markets, and still far behind developed economics. Investor participation remains low as pension funds remain the major institutional investors in capital markets in Peru, followed by mutual funds, and insurance companies. Additionally, pension funds continue to invest on safer and short-term assets such as public sector bonds as opposed to taking on riskier and long term positions. In order to deepen capital market participation and attract risk-taking investments, the government must reduce restrictive capital gains taxes on financial sector investors and reduce the red tape, promote greater corporate governance, and see through the necessary regulations to access greater capital market liquidity (see Graphs 2 &3) with the use of the integrated stock exchange system called the Mercado Integrado de Latinoamericano (MILA). Additionally, the government can participate in a co-marketing campaign with market exchange and brokerage agencies to educate and promote the benefits of opportunities offered by the Peruvian capital market.

BACKGROUND: Latin America has made great strides in reforming its economies by liberalizing trade, capital accounts, privatizing industries, reducing and sustaining inflation rates to single digits, and attracting investments from both foreign and domestic investors since the Lost Decade of the 1980s. Governments in the region implemented neo-liberal policies beginning around the mid-1980s in an effort to rectify years of fiscal overspending, monetary policy mismanagement, and persistent financial uncertainty in the form of currency volatility. The global credit crisis in 2008-2009 exposed the degree of improvements in economic and financial development across Latin America provided by these reforms as investments flocked to stable Latin American derived assets, while developed countries crumbled under the credit crisis.
While developed economies in Europe and the Unites States faltered, investors flocked to the south for safety and greater opportunity illustrated through years of macroeconomic stability and policy soundness, which allowed the region to outperform and economically grow without being exposed to financial risks compared to its earlier history. In particular, Latin American capital markets served as attractive havens for investors in countries like Mexico, Brazil, and Chile, as investors positioned their portfolios in government bonds and equity trades. Governments of these countries had long before recovered from their domestic capital market afflictions by developing liquidity, debt markets, sound policies, and ensuring stability through reforms stemming as far back as the 1980s. Despite the reform efforts, economists and analysts argue that Latin America’s economy has not developed to levels similar to that of other