Peru has emerged as a star performer in Latin America. The economy is on a tear, expanding by an average of over 7% per year since 2006. In comparison, the region as a whole grew by an annual average of only 4% per year. Peru even managed to eke out positive growth in 2009 during the global financial crisis.

However, a continuation of this performance is unlikely. Peru has achieved impressive growth, at least in part, by riding on China’s coattails. This contrasts with Colombia, whose direct ties to China remain very limited. (See: How Exposed is Colombia to a China Slowdown?)

Going forward, Peru’s economic fortunes largely rest on the outlook for China and on how global commodity demand shapes up.  As China’s growth looks set to moderate, so will Peru’s. (See: IMF’s Latest Growth Forecasts for China Look Overly Rosy) Moreover, Peru could really hit the skids if the Middle Kingdom’s hearty appetite for copper and other metals substantially diminishes.

Trade with China

Exports to China have risen steadily and helped propel the economy’s fast growth. The two countries signed a bilateral free trade agreement that entered into effect in March 2010, further strengthening their trade ties. In 2011, the Asian giant became Peru’s biggest market. China now accounts for 16% of the country’s total exports, as seen in Figure 1 below. This is not an incredibly high percentage, but it’s still significant.

Peru’s export markets are pretty diversified relative to others in the region. For example, over 40% of Colombia’s exports go to a single market, the US. (See: How Exposed is Colombia to a China Slowdown?) Nevertheless, Peru’s growing trade dependence on China means its economic fortunes are increasingly tied to Chinese demand.

Figure 1: China has surpassed the US as Peru’s top trade partner

Source: Promperu

Investment from China

China’s direct investment in Peru is among the highest in Latin America, as shown in Figure 2. Almost all of this investment has gone into the country’s mining sector. According to data from Peru’s investment promotion agency, Proinversion, Spain and the US remain the biggest direct investors in the country, but that could change.

Peru’s Prime Minister Salomon Lerner expects Chinese direct investment in Peru to increase by 30-40% in 2012-13 (See related article from Andina). Of course, that assumes strong Chinese demand for the country’s resources continues.

Figure 2: Peru received more Chinese investment in 1990-2009 than any other Latam country

Source: ECLAC*

*ECLAC’s analysis of Chinese FDI is based on data collected from companies and on data provided in announcements of investments and M&A activity, more than on official BOP data.

Global Commodity Demand

Mining is an important economic driver in Peru, and China’s seemingly insatiable demand for commodities has propelled metal prices upward. But will it last?

Liam Peven of the WSJ outlines three potential scenarios for commodities based on: 1) continued robust growth in China, 2) a soft landing (mild slowdown), 3) a hard landing. (Note: I don’t see scenario 1 happening, but clearly the WSJ is more optimistic than I am).

Peven does warn, “Demand for steel, copper and other industrial metals could drop significantly if China does stall, because those materials are heavily used in construction—which would be at risk from weakness in the Chinese real-estate market—and because China often accounts for some 40% of global demand for those materials.” (See WSJ article: As China Goes, So Go Commodities)

Metals – led by copper and gold – generated 60% of Peru’s export revenue in 2010, as shown in Figure 3. Not only does mining drive the country’s exports, it also feeds into domestic demand in the form of job creation and investment. As a result, a downturn in China would have far-reaching effects on Peru’s economy. Notably, gold prices tend to move differently than those of other metals given gold’s perception as a safe haven, which could provide Peru some comfort.

Figure 3: Copper and Gold dominate Peru’s exports

Source: PromPeru

On the Bright Side

Clearly Peru is vulnerable to a slowdown in China, but there is some good news. Policymakers have taken advantage of the boom times to lower the country’s public debt-to-GDP ratio and to bolster the country’s competitiveness through growth-enhancing reforms.

As seen in Figure 4, public debt has fallen from 47% of GDP in 2003 to 25% in 2010. Notably, the debt ratio fell even amid the global downturn in 2008-09. Meanwhile, Peru ranked 36th out of 183 countries in the World Bank’s 2011 Doing Business Survey, which is ten places higher than last year’s ranking. Among the many reforms, the government made it easier to start a business and simplified the process to register property. This is very positive and will boost Peru’s longer-term growth potential.

Figure 4: Peru’s public debt ratio has steadily declined from a peak in 2003

Source: IMF

Bottom Line

Despite the positives mentioned above, Peru is among the most vulnerable of Latin America’s economies to a downturn in China. It would directly affect the Andean country through its strong trade and investment ties to the Asian giant and more broadly affect Peru through a fall in global commodity prices.