Pedro Castillo and the investment paradox in Peru

On June 6, Peruvians were called to the polls to elect their new president, in a second round where the candidates with the highest number of votes, Pedro Castillo and Keiko Fujimori, competed.

The victory of the Peru Libre candidate has generated great uncertainty in the economic world, and this due to his proposals regarding his program of expropriations of companies.

This 180-degree turn in Peruvian economic policy is defended by Castillo as a necessity to boost growth, but as we will see throughout this article, the results, as Thomas Sowell would say, may differ from those desired. Well, economic policies must be measured by these, and not by the intentionality that led these politicians to apply them; at least that’s how the Chicago School economist defended it.

The importance of investment

“Investment is what allows companies to capitalize, that is, to provide workers with the means to get the most out of their time.”

It may seem obvious, but it is important to remember that any economic growth process is sustainable over time as long as there is at least a minimum level of investment. The reason is that investment is what allows companies to capitalize, that is, to provide workers with the means to get the most out of their time; what we know as productivity.

In agriculture, a sector that also has a lot of weight in the Peruvian economy, we can find a very clear example. A farmer who only has a plow, as we can guess, will be able to work a very limited area of ​​land. On the other hand, another farmer with a tractor, for example, will be able to cover a larger area and in less time. The result is that the owner of the tractor will be able to generate a yield equivalent to that of several farmers with a plow, that is, they will be more productive. And this for that investment made.

As we can imagine, if the other farmers also have tractors, the logical thing is that the production, in their case, also multiplies, so that the wages in the sector will increase. It is a process experienced all over the world and of which we can find numerous examples. The United States, to name one of them, employed 25.90% of the labor force in the agricultural sector in 1920 to feed a population of 106.5 million people. In 2020, and with a more capitalized agriculture, 1.31% was enough to feed 331 million.

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The same can be said of other sectors, where capitalization is essential to raise workers’ productivity and, with it, their real wages. The problem is that, as we will see, capitalization is one of the great absent from Pedro Castillo’s program, giving rise to a strange paradox that we will explain in the next few lines.

The entrepreneurial state

“An excessive eagerness to expropriate, which aims to increase investment in the country, runs the risk of being the factor that ends it.”

If we read the electoral program of the Peru Libre party, we will see that two of the most recurrent themes are economic nationalism and statism.

The result of the combination of these two variables is a message abounding in criticism of private companies – especially foreign companies – for taking their profits outside of Peru. The same reasoning applies to foreign debt, the payment of which requires capital to flow out of the country. And we could not forget those made on free trade agreements, for introducing foreign products at prices with which Peruvian producers cannot compete.

The proposed alternative is to reverse this situation by giving the State the role of entrepreneur, that is, by launching investment projects, creating employment and even industrializing the country. In this way, ambitious public investment projects are proposed, such as the proposed transport infrastructure plan, or the proposal to increase spending on education, from 3% to 10% of gross domestic product (GDP).

On the other hand, to stop the outflow of capital from the country, in its program we find two great proposals. The first consists of raising taxes on concessions of multinational companies, being able to reach 80% of the profits generated. The other, more radical in the opinion of analysts and experts, consists of a plan to nationalize private companies in sectors that the Government considers strategic. Sectors including mining, oil or natural gas.

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The idea is that the resources obtained through these two routes are redirected towards a greater benefit for all Peruvians through greater public investment. For example, according to Castillo’s own electoral program, it is estimated that the taxes applied to the Camisea gas operations would be sufficient to finance the increase in education spending mentioned above. The problem is that, as we will see later, this expropriating desire, whose main objective is to increase investment in the country runs the risk of being the factor that, as if it were a paradox, ends it.

Legal uncertainty and low productivity

«The so-called rule of law can only manifest itself when the behavior of the State is foreseeable. That is, when the consequences of breaking a law are clear to everyone, they are sustained over time and allow companies to compete under the same rules.

The first and most obvious reason for what is happening in the country is the lack of legal security, which is known as legal insecurity. As we know, a business project can only be launched, with guarantees, if a long-term cost-benefit calculation has been previously studied and a positive result has been observed. For this reason, any unforeseen event that alters the possibility of making these forecasts with some reliability generates, de facto, more caution in entrepreneurs when investing.

This dynamic has already been explained by Friedrich von Hayek in his studies on the importance of a stable legal framework for economic growth. According to the Austrian economist, the so-called rule of law (rule of law) can only manifest itself when the behavior of the State is foreseeable. In other words, when the consequences of respecting or breaking a law are clear to everyone, they are sustained over time and allow companies to compete under the same rules and conditions.

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Logically, an expropriation can break this dynamic and generate uncertainty in the markets, both on the business side and on the consumer side. If a company fears being nationalized by the Government, and does not have guarantees to protect its investment, what is the point of investing? If a worker sees signs that the government may implement an inflationary policy, why should the government save?

Second, expropriation can also be a serious drag on productivity. Let us remember that in many of the sectors that seem to be in the spotlight, activity is only possible if, simultaneously, there are very high levels of initial investment that, perhaps, may be out of the reach of a State with a deficit of 8, 9% of GDP. This may not be a problem when nationalizing existing farms, but it could be a brake for those who want to start up in the country, both by citizens and through foreign direct investment (FDI).

Lastly, we must remember that these economic activities usually require a very high level of replacement investment. In other words, repairing machines that break down, renovating equipment when it becomes obsolete, as well as other expenses that allow the operation to continue to develop efficiently.

The Argentine case

“In Argentina, for example, many companies were privatized in the 1990s.”

The recent history of South America can give us some examples of the risks involved in applying policies such as those proposed by Castillo.

In Argentina, for example, many companies were privatized in the 1990s, receiving large volumes of foreign investment. This endowed them with a renewed capital stock, which made it possible to expand production as long as conditions were conducive and permitted. The result, as we can see in the graph below, is strong growth in per capita income over the next decade.

Peru1
Evolution of GDP per capita (at purchasing power parity, expressed at constant prices in 2011 USD dollars) and net foreign direct investment (FDI, net capital inflows as a percentage of GDP) in Argentina in the period 1990-2019. Source: World Bank.

However, the relatively low levels of investment in the 21st century do not appear to have slowed growth until 2011. The reason is that the effects of investment on GDP are often seen in the long term, and when there is a very strong initial investment, the lack of replacement investment seems to be more blurred. However, as we can see, this lack does seem to have had a negative effect on per capita income, which, as can be seen in the indicators, has stagnated in the last 10 years.

What future awaits Peru?

“It is a path already undertaken by other neighboring countries, the consequences of which, at the very least, should be considered, and very closely.”

The experience of Argentina, perhaps, could serve as an example to analyze what could happen in Peru if the country, finally, bets on closing its economy to the world, as well as putting obstacles to investment.

In fact, we can find two closer cases in the graph that we expose below, such as the cases of Bolivia and Ecuador. Both countries, proposed as a model to be followed by Pedro Castillo in his nationalization policy, which are, in the same way, those that, as shown in the indicators, have ended up with lower levels in terms of the arrival of flows of foreign investment.

Peru2
Foreign direct investment (net capital inflows) as a percentage of GDP in Peru and its neighbors in the Andean region. Source: World Bank.

In this way, the promises of the new president could end up causing the opposite effect to the desired one, as Sowell said and as we see, by not considering some risks, visible in other countries that have made similar decisions.

It is possible that for a few years, and taking advantage of the capital invested by the private sector, nationalized companies will generate resources to improve education or transportation. The problem is that if you do not continue to invest in capitalizing these companies and foreign investment flows stagnate, over time, their growth capacity could be reduced, just as we could observe a stagnation in the wages of their workers.

These errors could lead to irrational situations, such as building roads to farms that may end up closing because they are not profitable, or creating universities whose students have to emigrate because the economy does not offer the jobs for which they have been prepared. It is a path already undertaken by other neighboring countries, the consequences of which, at the very least, should be considered, and very closely.

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