Moody's affirms Peru's A3 rating, maintains stable outlook

"The rating for the sovereign's local currency deposit note was also affirmed at A3 as were the ratings for senior unsecured foreign currency shelf programs at (P)A3. The outlook on the A3 issuer rating remains stable," Moody's stressed.

The decision to affirm the ratings and maintain the stable outlook was driven by the following key rating factors:

1) Strong track record of macroeconomic stability and resilience to multiple shocks.

2) Credible fiscal framework and proactive fiscal management.

3) The continued presence of credit challenges posed by institutional weaknesses.

Peru's long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at A1/P-1 and A3/P-2, respectively. The local currency bond and deposit ceilings remain unchanged at A1.

Moody's decision to affirm Peru's sovereign ratings incorporates its record of macroeconomic stability, which it expects to be maintained following a combination of structural and transitory shocks, including lower commodity prices, and more recently the Odebrecht corruption scandal and extensive flooding from Coastal El Niño weather phenomenon.

Following a robust expansion since 2010, GDP growth in Peru slowed significantly in 2014 to 2.4%, as a cyclical slowdown coincided with the structural decrease in mineral prices and a strong decline in economic sentiment. Growth accelerated in 2015 to 3.3% and further to 3.9% in 2016, supported by the government's counter-cyclical impulse as well as by increased mineral output that offset some of the effects of weak commodity prices.

Although the recovery following the commodity price decline continued into early 2017, the fallout from the Odebrecht corruption scandal had a strong negative impact on public investment that dented economic performance in the first quarter of 2017.

This was followed by Coastal El Niño climate shock in March and April that caused the worst flooding and landslides in over 50 years in the country. The rains from Coastal El Niño abated in late April and the economy is showing signs of recovery again. The impact of the shocks seem to be dissipating and Peruvian economic activity is likely to continue converging toward potential growth rates over the next 12 months.

Moody's forecasts that growth will reach 2.6% in 2017 and then accelerate to 3.9% in 2018 as the recovery firms and public investment picks up, underpinned by the reconstruction of damaged infrastructure from the climate shock.

Over the longer-term, the economy's growth potential is supported by continued convergence with higher-income economies, a favorable demographic profile, recent reform efforts, high relative competitiveness within the mining and extractive sectors, and the absence of major macroeconomic imbalances. These elements support Peru's economic strength and offset the economy's relatively low income levels that are among the lowest compared to 'A'-rated peers.

Fiscal management has been focused on preventing rapid debt accumulation. Successive governments have strictly adhered to fiscal deficit limits over the past decade, reflecting a strong consensus in favor of fiscal responsibility. Following Coastal El Niño related floods this year, fiscal deficit targets have been revised upward to incorporate reconstruction costs.

Nevertheless, the underlying non-financial public sector deficits (excluding reconstruction costs) remain unchanged from the government's medium-term macro-fiscal framework. The 3.2% of GDP reconstruction costs will be spread out over four years. Although the new fiscal trajectory including this spending will run counter to the consolidation path originally envisioned for 2017 and 2018, the sovereign's fiscal rules contain escape clauses in the event of natural disasters that have been triggered in this instance.

The impact of the new fiscal trajectory on the sovereign's debt ratios will be limited. In this regard, the sovereign's financial assets (approximately 16% of GDP) provide a strong buffer that allows fiscal policy ample room for maneuver while limiting the deterioration of debt metrics. About 80% of the reconstruction funds are expected to be sourced from the sovereign's cash assets, specifically from the fiscal stabilization fund that currently holds assets equal to 4.2% of GDP. The remaining 20% of the funds is likely to come from multilateral creditors, and will make use of the technical assistance and project monitoring that comes with these programs.

The sovereign's non-financial public sector debt metrics are likely to stabilize at under 28.5% of GDP in 2018-19 after absorbing the various shocks that include the commodity price decline and the two recent shocks. Despite the uptick, debt metrics will remain stronger than the median for 'A'-rated sovereigns and among the lowest within the category.

The sovereign's track record of fiscal prudence underpins the credibility of the planned fiscal trajectory for the next three-to-four years. Moody's believes that policy measures to ensure a recovery in government revenues will be key to support consolidation going forward, and that increasing the efficiency of public spending by restraining current expenditure should provide the fiscal room to sustain capital expenditures as per the outlined fiscal trajectory.

Moreover, there is recent evidence of a capacity and willingness to adjust fiscal policy in order to prevent material deviations from the authorities' projected path. When deficit levels began to increase beyond the authorities' projections by mid-2016, the authorities implemented adjustment measures to curb spending, particularly focused on current expenditures, that brought fiscal performance well within yearly deficit limits.

Nevertheless, the sovereign's main credit challenges, including corruption, a weak judicial system, a large informal sector and an inefficient bureaucracy at the local and regional government level, constrain the sovereign rating at its current level. These issues affect governance, detract from the efficient allocation of resources, and impose substantial costs to the economy. Current reform proposals seek to address some of these issues, including labor market reform and changes to the country's political governance structure, but tangible progress will take time and continued reform efforts.

The stable outlook on the rating reflects Moody's view that upside and downside risks to Peru's credit profile remain balanced as the economy will continue to recover, fiscal performance will remain sound, and debt ratios will remain relatively stable, even as institutional strength challenges that hinder the efficient allocation of resources in the economy remain.

A substantial increase in income levels or a significant strengthening of governance indicators, especially related to political institutions, corruption and the informal economy, would contribute to improving creditworthiness.

Conversely, downward pressure on the sovereign's rating would develop if government debt ratios deteriorate significantly due to the maintenance of large fiscal imbalances. The absence of structural reforms to preserve the economy's relatively high growth potential that ensures healthy public finances and a convergence in income levels with rating peers, would also pressure creditworthiness.