Fitch Affirms Peru's FC IDR at 'BBB+'; Outlook Stable

Fitch Ratings has affirmed Peru's sovereign ratings as follows:

--Long-Term Foreign Currency Issuer Default Ratings (IDRs) at 'BBB+', Outlook Stable;

--Local Currency IDRs at 'A-', Outlook Stable;

--Senior unsecured Foreign-Currency bonds at 'BBB+' and 'A-';

--Senior unsecured Local-Currency bonds at 'A-';

--Short-Term Foreign-Currency IDR at 'F2';

--Short-Term Local-Currency IDR at 'F1';

--Country Ceiling at 'A-'.

KEY RATING DRIVERS

Peru's creditworthiness is underpinned by its track record of macro policy credibility, consistency, and flexibility, which has delivered macroeconomic and financial stability. Strong fiscal and external balance sheets balance the country's high commodity dependence, low government revenue base, financial dollarization and structural constrains in terms of income per capita, social indicators and institutional quality.

Peru maintains a strong sovereign balance sheet. At 25.1% of GDP (2016f), general government debt is lower the 'BBB' median, and interest payments are forecasted to average 6.1% of revenue during 2016-2018. Fitch expects the government will be able to source its remaining 2017 financing needs through PEN-denominated issuance and multilateral credits, after pre-financing its 2016 requirements and 2017 debt service.

Fitch expects the new administration of President Pedro Pablo Kuczynski to carry out a pragmatic fiscal strategy. The administration is planning a gradual fiscal consolidation, reaching primary general government balance by 2020, as the economy adjusts to low long-term mining revenues. Fitch expects the general government deficit of 2.8% of GDP in 2016 to narrow to a 2.1% of GDP deficit in 2018. The government plans to sustain infrastructure projects begun by the previous administration as well as to improve basic services in rural communities. Peru has a track record of prudent fiscal policy and effective expenditure controls, which have reduced government debt, built the fiscal stabilization fund estimated by Fitch at 4.2% of GDP, and supported the credibility of its fiscal framework. Revenue and economic underperformance are the main downside risks to the fiscal trajectory.

Lower metals prices are weighing on mining export revenue, economic growth, and fiscal revenues. In response, the administration plans tax reforms to formalize more small businesses, broaden the tax base, and raise business productivity and private investment over the medium term.

Fitch expects Peru's government to receive special authority from congress to cut the VAT (IGV) to 17% in 2017 from 18% (with future reductions toward 15% conditional on revenue performance), to reverse the corporate income tax rate cuts and the dividend tax hike, and measures to deepen the domestic capital market. Passage depends on the support of Keiko Fujimori's Fuerza Popular party, which holds a congressional majority and campaigned on a broadly similar economic platform. The June presidential election results were broadly accepted by Peruvians and the major political parties, despite the narrow decision margin of the ballot.

The macro outlook for 2016-2017 has improved since 2015, due in part to growth in mining. Fitch expects Peru's economic growth to rise to 3.7% in 2016 and 4.2% in 2017. This is driven by a rise in copper production through 2018, higher public investment and improving domestic confidence.

The central bank's exercise of greater exchange rate flexibility, aided by its de-dollarization initiative, support policy credibility. The central bank allowed faster currency depreciation in 2015 and then greater exchange-rate volatility since the beginning of 2016 as the PEN moderately appreciated. Inflation returned to the central bank's 2%+/-1% target band in July and declined further to 2.94% yoy in August. Peru's five-year average inflation rate of 3.4% is in line with the 'BBB' median but higher than the 'A' median of 1.5%. Macro-prudential policies aiming to de-dollarize household and small-business credit have reduced foreign currency-denominated private credit to 29% of the total, although it is still high relative to 'BBB' peers.

The external trade balance narrowed to -1.4% and -0.4% of GDP in Q1 and Q216, respectively, versus -2.4% and -2.2% of GDP in Q1 and Q215. This resulted from import compression. Export revenues were stable, as copper production grew by more than 40% year on year in Q1 and Q216, counterbalancing the effect of lacklustre mineral prices.

Fitch expects the current account deficit (CAD) will narrow to 3.9% of GDP in 2016 and 3.5% of GDP in 2017, down from the average 4.4% of GDP deficit during 2013-2015. Fitch projects the public investment and private-concession infrastructure projects will keep the CAD larger than the 'BBB' median over the forecast horizon and that, although it is forecast to be sustainably financed 75% with net FDI, Peru will rely on increased net external borrowing.

Peru's robust external liquidity is a further credit strength. Large international reserves, USD62 billion or 31.9% of GDP, and its more than 300% international liquidity ratio (double the 'BBB' median) mitigate risks from high commodity dependence, financial dollarization, and non-resident participation at 34.7% of PEN government securities. The sovereign maintains a strong external balance sheet with net foreign assets totalling 20.3% of GDP, greater than the 'BBB' median at 2.6% of GDP.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Peru a score equivalent to a rating of 'BBB-' on the Long-Term FC IDR scale. Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

--Macro: +1 notch: Peru's policy framework is underpinned by the inflation targeting regime and a rules-based fiscal policy. This policy mix has developed a track record for policy coherence and credibility leading to entrenched macroeconomic and financial stability, and generated counter-cyclical policy space.

---Public finances: +1 notch: Peru's fiscal financing flexibility is underpinned by substantial government deposits supporting low net general government debt, in addition to the rules-based Fiscal Stabilization Fund, and proven access to international financing sources.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main risk factors that, individually or collectively, could trigger a negative rating action are:

--Failure to consolidate public finances in line with the fiscal framework resulting in a faster-than-expected rise in the general government debt burden;

--Erosion of policy credibility that results in diminished investment and growth prospects; or

--A negative external shock - such as a sharp decline in the price of Peru's main commodity exports - resulting in weaker macroeconomic performance and deterioration in fiscal and external balance sheets.

Conversely, the main factors that could lead to a positive rating action are:

--Higher growth that reduces Peru's income gap and improves social indicators relative to higher-rated sovereigns;

--Strengthened institutional capacity that improves the effectiveness of economic and social policy implementation;

--Significant improvements in Peru's fiscal and external balance sheets and material reduction of financial dollarization.

KEY ASSUMPTIONS

Fitch expects China's economy, a major mining export partner, to grow 6.5% in 2016 and 6.3% in 2017, respectively.

Fitch assumes copper production will continue to increase over 2016-2017 as expanded and new mines come online. Fitch also assumes copper prices will stabilize at current levels through the end of 2016 and moderately improve in 2017.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Country Ceilings (pub. 16 Aug 2016)
https://www.fitchratings.com/site/re/885997

Sovereign Rating Criteria (pub. 18 Jul 2016)
https://www.fitchratings.com/site/re/885219

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1012390

Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012390

Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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