Geopolitical Briefing Economics and Strategy

July 19, 2021 Will the leftward tilt of Chile and hurt copper production? By Angelo Katsoras

Introduction The massive economic and social damage inflicted by COVID-19 has not only exacerbated long-standing issues, such as unequal access to healthcare and education, it has also transformed the geopolitical landscape of Chile and Peru, the first- and second-largest copper producers. Together, they account for about 36% of the world’s copper production,1 which was estimated to be at 20.1 million tonnes in 2020.2

World: Top copper producing nations Data in million tonnes (2020)

1.2

Chile 2.2 Congo 5.7 China Peru U.S. 1.7

1.3

NBF Economics and Strategy (data via USGS)

Source: “Peru copper output at risk as leftist Castillo leads in presidential election,” Mining.com, June 11, 2021

Because the right was in power in both countries when the pandemic hit, rising discontent has benefited political forces on the left. In Peru, voters elected the head of a Marxist party as president. In Chile, leftist groups are in control of drafting a new constitution. The combination of generally higher mineral prices and the demand for greater social spending to help recover from COVID-19 makes higher taxes on copper production a virtual certainty. The shifting political climate only reinforces this likelihood.

1 “Turmoil casts doubt on Latin America's mining of energy-transition minerals,” S&P, May 2, 2021 2 Fitch Solutions, 2021 1 Geopolitical Briefing Economics and Strategy

Peru is particularly hard hit by COVID-19 For much of this century, Peru has been one of Latin America’s best-performing economies. From 2001 to 2016, it saw GDP grow at an average annual rate of 5.6%.3 Recently, however, Peru has been facing growing headwinds. First, political infighting saw the country go through four presidents in five years. Then, in 2020, came the economic and social devastation of COVID-19: The country registered an 11% economic contraction and the world’s highest number of deaths from the virus per capita.

World: Perspective on Covid-19 deaths per million population As of July 5, 2021

Peru 5784

Brazil 2453

Argentina 2166

Columbia 2128

U.S. 1866

Paraguay 1862

Mexico 1793

Chile 1724

Ukraine 1208

Germany 1090 Deaths per million 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

NBF Economics and Strategy (data via Worldometers)

Political earthquake in Peru All this culminated in the June 6 election of , the head of a Marxist party called , by a mere 49,000 votes over his opponent, , daughter of the former . Castillo is awaiting to be officially confirmed president after a review of the ballots. During the campaign, he stoked fear in the hearts of investors and businesses by expressing support for rewriting the constitution, keeping 70% of mining profits, and nationalizing certain resource projects.4 The mining sector accounts for 25% of Peru’s foreign direct investment and 60% of exports.5 However, the ability to follow through on these campaign pledges will be very limited For starters, upon taking office, Castillo will face a very divided parliament, where the majority of the 11 political parties are either centrist or conservative. Given that his party holds only 37 of the 130 seats in Congress, he will need the support of more moderate parties to pass any legislation.

3 “A failure to reform Peru is poised to produce a lurch to the far left,” The Economist, June 12, 2021 4 “Peru's Castillo expects mining firms to accept 'prudent' tax changes, adviser says,” , July 6, 2021 5 “In Peru, Uncertainty at Home, Consistency Abroad,” Geopolitical Futures, June 16, 2021 2 Geopolitical Briefing Economics and Strategy

Source: “In Peru, Uncertainty at Home, Consistency Abroad,” Geopolitical Futures, June 16, 2021

Perhaps sensing this predicament, the President’s top economic advisor, Pedro Francke, a former economist, has tried to walk back some of Castillo’s most controversial positions. The advisor recently said that Castillo would pay the nation’s debt, respect the central bank’s independence, and not nationalize any parts of the mining sector.6 Some analysts have pointed out that Peru experienced a similar situation in 2011 when was elected president. Although he took positions on the far left of the during the election campaign, he ended up governing much more moderately. Because of all these factors, we feel that resource projects will not be nationalized and the constitution will not be rewritten. The most likely scenario for the mining sector is that more stringent regulations will be passed, and taxes will be raised. It is important to note, however, that having to negotiate with Congress means that the actual increase in taxes will be less than initially proposed. In contrast, mining regulations will likely become significantly more stringent given that the President can implement them without congressional approval. We also predict that the combination of congressional gridlock and broad resistance to Castillo from the political establishment and business elite means the next few years will be marked by political turbulence. The fact that the country is divided between poorer, rural regions that massively voted for Castillo and wealthier, more urban coastal areas that strongly opposed him adds to these tensions.

Chile, long a bastion of stability in region, hit by unrest Even though Chile has been one of Latin America’s fastest-growing economies in recent decades, it has not been able to avoid political unrest. In 2019, Chile was hit by the worst protests in a generation. They were sparked by high-school students in Santiago who were upset about an increase in subway fares but then quickly expanded to include such matters as the high cost of healthcare and education. In an attempt to quell the demonstrations, Chile’s conservative president, Sebastián Piñera, agreed to hold a referendum to replace the constitution drafted in 1980 by the military dictatorship of General Augusto Pinochet.

6 “Peru Picks President and Mexican Voters Give Verdict on AMLO,” Bloomberg, June 6, 2021 3 Geopolitical Briefing Economics and Strategy

Last October, against a backdrop of renewed street protests and a COVID-19-induced economic contraction of 6%,7 79% of those who came out to vote supported drafting a new constitution. Another vote was then organized in mid-May to choose who would sit on the constituent assembly responsible for drafting the new document. To the surprise of many people, about 70% of the assembly’s seats went to left-leaning candidates. President Piñera’s ruling centre-right coalition failed to win the minimum one-third of seats needed to exercise veto power over any proposed changes. Once completed, the new constitution will still need to be approved via a referendum scheduled for sometime in the second half of 2022. The proposed changes will no doubt include a greater social safety net and tighter environment guidelines for the mining sector, particularly regarding water usage. More than 80% of Chile’s copper is produced in water-stressed areas ranked among the driest in the world. In 2020, McKinsey estimated that miners consumed enough water annually to provide for 75% of the needs of Chile’s 19 million citizens. Two solutions are being increasingly adopted to reduce the stress on scarce water reserves: desalination and recycling. It is important to note, however, that these necessary measures will add to costs.8

Source: “Desalination is not the only answer to Chile’s water problems,” McKinsey & Company, September 2020

Proposed tax changes for the mining sector Lawmakers in Chile’s lower house, who had already approved a bill to introduce a flat 3% tax on sales of both copper and lithium, voted to add another tax on copper. Marginal rates would start at 15% for prices between $2.00-$2.50 per pound and peak at 75% for additional income at prices over $4.00 a pound (The price of copper has been trading above this level since last April).9 There is some confusion over whether these proposals would replace the existing system or run alongside current levies. The latter choice obviously represents a much higher tax rate.

7 “The World Bank In Chile,” April 2021 8 “Desalination is not the only answer to Chile’s water problems,” McKinsey & Company, September 2020 9 “Chile copper miners cry foul as royalty bill advances to Senate,” Reuters, May 6, 2021 4 Geopolitical Briefing Economics and Strategy

Source: “Game of Chicken Is Clouding Tax Debate in Top Copper Nation,” Bloomberg, May 24, 2021

The price of copper has risen significantly Weekly averages

4.8 $US per pound 4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 2.2 2.0 1.8 2015 2016 2017 2018 2019 2020 2021 2022 NBF Economics and Strategy (data via Refinitiv)

5 Geopolitical Briefing Economics and Strategy

While most mining companies in Chile have already negotiated tax agreements that will not expire for several years, they will likely face intense pressure to amend these agreements. Something similar happened in 2010 when miners were persuaded to accept a temporary tax hike to finance reconstruction after Chile was devastated by an earthquake and tsunami. These tax proposals will soon be debated in the Senate. We feel that a watered-down version of the original tax proposal will ultimately become law either under this administration or under the next. We also feel that this tax system will not be added to the existing structure and will instead replace it.

The first round of the presidential election will take place November 21, with a possible run-off slated for December. On top of the immensely complicated task of rewriting the country’s constitution, Chile must also contend with the upcoming presidential and legislative elections, which are held on the same day. The two leading candidates are former student leader Gabriel Boric on the left and Sebastian Sichel on the right. Boric got his start in 2011 leading nationwide protests demanding free education. He ran successfully as lower house deputy in 2013. Sichel was a former Cabinet minister and president of Chile's developments agency Corfo. Both, to varying degrees, support the increased funding of public services, such as education and healthcare.

Conclusion The tax and regulatory landscapes of Peru and Chile look set to undergo major changes, especially where mining is concerned. Looming tax hikes and regulatory changes could cause mining companies to delay plans to invest new production. At the very least, many of them will postpone their investment decisions until the details of future tax levels and new regulations are agreed upon. In the case of Chile, this comes at a time when declining ore quality means significant additional investment is required just to prevent copper production from shrinking further. For instance, state-owned Codelco needs to spend $35 billion between now and 2030 to maintain current output levels.10 Over the past 15 years, Chile’s share of global copper production has already dropped from 34%11 to about 25%.12 Meanwhile, global demand for copper as an input for alternative energy is set to surge. Goldman Sachs has estimated that an electric vehicle contains five times as much copper (60–83kg) as does a car with an internal combustion engine, while a 3- megawatt wind turbine includes up to 4.7 tonnes of copper.13 Regardless of the political climate, we project that strong long-term demand trends for copper will eventually lead to opening of new mines in Peru and Chile. What will be different is that the decision process taken by mining companies to approve new production will likely have been slowed down by a year or so more than would have been the case under a different set of political circumstances. This will add to the already very long lead time required to get mining production running. Bloomberg Intelligence calculated it takes on average 14 years to move a copper mining project from the discovery to the production phase.14 The International Energy Agency has estimated that it takes over 16 years. (Refer to following report for more a detailed analysis of lead times: “The monumental challenge of trying to hit climate targets”

10 “Copper boom: how clean energy is driving a commodities supercycle,” , June 7, 2021 11 “BHP says tax rises pose threat to Chile’s mining industry,” Financial Times, May 2, 2021 12 “Turmoil casts doubt on Latin America's mining of energy-transition minerals,” S&P, May 2, 2021 13 “Copper boom: how clean energy is driving a commodities supercycle,” Financial Times, June 7, 2021 14 “The World Will Need 10 Million Tons More Copper to Meet Demand,” Bloomberg, March 19, 2021 6 Geopolitical Briefing Economics and Strategy

Source: “The Role of Critical Minerals in Clean Energy Transitions,” IEA, May 2021 Finally, the following map illustrates the crucial role Latin America’s mining sector will play in the transition to green energy. This will increasingly force the United States to pay more attention to Latin America.

Source: “Turmoil casts doubt on Latin America's mining of energy-transition minerals,” S&P, May 2, 2021

7 Geopolitical Briefing Economics and Strategy

Economics and Strategy

Montreal Office Toronto Office 514-879-2529 416-869-8598 Stéfane Marion Matthieu Arseneau Paul-André Pinsonnault Warren Lovely Chief Economist and Strategist Deputy Chief Economist Senior Economist Chief Rates and Public Sector Strategist [email protected] [email protected] [email protected] [email protected] Kyle Dahms Daren King Jocelyn Paquet Taylor Schleich Economist Economist Economist Rates Strategist [email protected] [email protected] [email protected] [email protected] Angelo Katsoras David Djavidi Alexandra Ducharme Alpa Atha Geopolitical Analyst Intern Economist Intern Economist Fixed Income Economist [email protected] [email protected] [email protected] [email protected]

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Geopolitical Briefing Economics and Strategy

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