Aspects and Origins of Chile’s Constitution

Chile’s current constitution is still often referred to as the “1980 constitution,” and indeed the military government that took power in 1973 had a key role in its development. Yet the current constitution can also be seen as a modified version of the 1925 constitution.

Some of the most significant aspects of the constitution, relating to the budget process, were introduced in 1970, before the period of military rule, and subsequently retained in the 1980 constitution. While the 1925 constitution had given the executive ample powers in many areas, governments had difficulty negotiating and obtaining approval of budgets in a timely and effective way; the reforms introduced in 1970 have “greatly limited the scope for vested interests to lobby on fiscal affairs” (Foxley, 2003; and Foxley and Sapelli, 1999). As explained in the section “Fiscal Discipline: The Role of Institutions,” power in the process of determining the budget was tilted strongly toward the executive.

Although the 1980 constitution took a step toward insulating monetary policy from political pressures, the charter of an independent central bank was established constitutionally only in 1989. The 1980 constitution prohibited the central bank from purchasing government securities, but left the bank still vulnerable to government pressure and to private sector demands for direct credit. Independence came with the 1989 Basic Constitutional Act of the Central Bank (discussed in the section “Financial Stability: The Chilean Approach to Banking Supervision, Regulation, and Safety Net”). This special law has a constitutional character, and any amendments to it would require a three-fifths majority in congress.

The Electoral System

The electoral system established by the constitution has a number of aspects likely to influence economic policy outcomes, including the following:

• “Presidentialist,” in that the country’s president is elected in a direct vote, at fixed intervals of six years, and does not require congressional support to remain in office;

• Majoritarian, rather than proportional, determination of congressional representation; and

• Electoral rules for congressional seats, which create strong incentives for individual political parties to join coalitions.³ Most likely reflecting such incentives, the result since the return to democracy has been two large voting blocs, which so far have proven stable. Though at least six political parties of significant size continue to exist, in many ways Chilean politics now approximates a two-party system.

A cross-country empirical literature has found such features to be associated with greater fiscal policy discipline.⁴ As emphasized by Foxley and Sapelli (1999), the incentives in Chile to form coalitions give reasons for individual political parties to moderate their particular demands in favor of the common interest. By avoiding political polarization and governmental instability, incentives for policymakers to behave myopically have been reduced. While the country’s president is limited to serving one term, incentives to pursue only short-term gains are put in check by the term’s being relatively long, as well as by rules on contracting debt with maturity extending beyond the president’s term.

In the area of establishing the annual budget law, the Chilean system assures a prompt resolution, achieving this by giving a critical advantage to the executive over the legislature. In contrast, in other economic policy areas requiring passage of a law, the system is not designed for speed, but rather building consensus. In that sense, the system tends to favor policy stability, something that may give confidence to private agents to make long-term investments.

Inherent Challenges to Fiscal Discipline

In the fiscal area, we focus on institutions relevant to countering the following potential problems and threats to fiscal discipline:

• The common pool problem. Subnational governments with inadequate budget constraints are a prominent example;⁶ more generally, any situation in which a lack of centralized budget decision making allows particular groups to lobby for public sector actions to their own benefit, without internalizing the associated costs.

• Various intertemporal problems. These include time inconsistency issues and the resulting “deficit bias.” Another concern is the so-called myopia of policymakers without adequate incentives to be concerned with the future implications of their decisions (often attributed to situations of very frequent political turnover, or to the fact that future generations lack political representation).

Left unchecked, these problems are likely to result in a weak public sector balance sheet: a high level of public debt (up to the limits of market tolerance), but also a risky structure of liabilities, emphasizing forms of debt that are seemingly cheap from a short-term perspective, but carry high rollover, interest rate, and exchange rate risk.

Chilean Approaches to Maintaining Fiscal Discipline: Budget Constraints

The problem of indiscipline by subnational governments has been kept to a minimum in Chile by the simple but tough approach of prohibiting subnational governments from borrowing. More precisely, subnational governments are prohibited from issuing or contracting financial debt unless a specific authorizing law is passed, which so far has never happened.⁷ Potential budget constraint problems, then, are limited to arrears that may be run with suppliers (in turn, kept in check by the threat of legal action and suppliers’ ability to suspend deliveries). In recent years, the central government has sought to tie its own hands, to credibly commit not to favor arrears with transfers to local governments, using annual budget laws.

Credibility of the budget constraint on subnational governments is supported by the relatively small size of any one such government. In Chile, “subnational governments” refer to “municipalities,” rather than to a small number of relatively large provinces or regions.⁸ Municipalities therefore tend not to be “too big to fail.”

For the central government, arrangements that harden its budget constraint include:

• Government borrowing is subject to congressional approval;

• Public sector borrowing from the central bank is prohibited, while independence of the central bank insulates it from potential government pressure to finance quasi-fiscal expenditure;

• The current government’s innovative target for its structural balance—discussed below—also focuses attention on the government’s intertemporal budget constraint.

Budget Process

The budget process in Chile contains several features likely to help counter the common pool problem, and that have been found in cross-country empirical studies to be associated with greater fiscal discipline. The budget process is dominated by the executive branch rather than the legislature, and by the finance ministry rather than spending ministries. Budget reforms introduced in 1970 and retained in the 1980 constitution greatly limit the scope for particular interests to lobby on fiscal affairs. Thus only the executive can initiate fiscal measures, and there is a 60-day limit on congress’ budget approval process. If after 60 days congress has not been able to agree among itself, and with the government, on a modification of the government’s proposed budget law, then the government’s initial budget proposal automatically becomes law.

Responding Appropriately to Shocks

Chile is a significant exporter of copper, and since the government is owner of a large copper producer, government receipts are sensitive to variations in world prices. While governments of some countries have stumbled over managing such volatility in their own export earnings—often related to oil exports—Chile has a number of strategies that seem to have helped. First, the government has not insisted on owning all production of the commodity in question, and so has reduced the income volatility it faces. A second strategy involves the Copper Stabilization Fund (CSF), a mechanism established in law. This requires that the government make deposits corresponding to the “excess” income received during periods of higher copper prices and make withdrawals from the CSF during times of lower prices. A third strategy is the recent introduction of a target for the government’s structural balance, which makes an adjustment for copper price variations.

Some authors consider that the CSF has been a useful device, in particular by helping the government increase its saving during the copper boom years around the mid-1990s. Empirically, Davis and others (2001) found that government expenditure has been less tightly correlated with commodity revenue in Chile than elsewhere. However, the mechanism for this apparent success is not clear, since the design of the CSF does not strictly constrain government spending: in principle, the government could simply borrow to replace the funds deposited into the CSF. Possibly, the CSF was instead useful through its special accounting rules, which allowed the government to avoid showing a surplus and therefore reduced political pressure for additional spending.

The Structural Balance Target: An Institution in Development?

The government that took office in early 2000 committed itself to an ongoing target for its structural balance, a significant innovation with the potential to counter some of the most difficult problems in maintaining fiscal discipline. Under this informal rule, the government prepares each year’s budget to be consistent with holding steady the level of its structural balance (see Section III). This new practice:

• Allows tight accountability, yet without need to suppress automatic stabilizers.

• Makes very transparent the government’s budget constraint: any proposal for new expenditure or tax cuts requires an immediate offsetting policy action.

• Provides a longer-term goal for fiscal policy, breaking away from year-at-a-time fiscal decision making. This ties the government’s hands against problems such as election cycle spending.

• Provides a systematic approach to fiscal policy’s response to shocks, eliminating room for slippery decisions of whether to adjust policy now or “later.”

• Ensures attention to the government’s intertemporal budget constraint (all but ruling out problems of debt dynamics and sustainability; see Section VII).

The practice of targeting a steady structural balance—if maintained—should thus go a long way in avoiding time inconsistency problems and deficit bias of fiscal policy.

Pending Issues in Fiscal Policy Institutions

We have seen that the institutional framework in Chile has important features that tend to promote fiscal discipline, and certainly the record of sustained discipline in Chile is impressive. Still, it is possible to identify some pending institutional issues:

• Institutionalizing fiscal transparency. Chile able to sustain fiscal discipline over the years without a particularly high level of fiscal transparency; indeed, many of Chile’s current strength in terms of transparency are steps taken just in the last few years.⁹ Nevertheless, transparency may help sustain fiscal discipline in the future, and it could be useful to formally institutionalize many of the recent improvements (many being steps first taken on an ad hoc basis). This process seems to be under way.

• Institutionalization of the structural balance target? Although this new framework represents a significant advance, it has no legal or permanent status, and some of its potential advantages may not be realized if there is doubt that the policy will be sustained. While the commitment of the current government may well be credible, it cannot extend beyond the government’s term. It may be worth considering more formally institutionalizing at least some aspects of the structural balance target.

• Too much reliance on a benevolent executive? Following the literature, we have emphasized the advantages of the dominance of the executive in Chile’s budget process. In principle, this reliance could someday backfire, but the remedy is unclear. Assurances seem to come not from institutional arrangements but rather from the roles of political consensus and political accountability, joined in recent years by the increased transparency of fiscal policy.

The Independence and Mandate of the Central Bank

A Chilean institution that enjoys wide credit for contributing to price stability is the independence of the central bank, with its clear mandate to promote price stability.

The case for central bank independence is well developed in the literature. Arguments such as those summarized in Box 2.2 have led a number of countries to institutionalize the independence of the central bank and charge it with price stability.

Several researchers, including Cukierman (1992) and Alesina and Summers (1993), have constructed indexes to measure central bank independence. In general, they have found a relationship between measures of independence and lower inflation, in samples consisting mostly of developed economies.

Until recently, empirical work had found little evidence of a relationship between independence of the central bank and good inflation performance for Latin America. Recently, Gutiérrez (2003) suggests this is due to a disconnect between what is stated in central bank charters and their actual degree of independence. Gutiérrez constructs an index for Latin American countries that only considers what the constitution states about the central bank and ignores the central bank charter. The way the autonomy of the Central Bank of Chile is embedded in the constitution leads Gutiérrez to rank Chile as third (in a sample of 25 countries) in this refined index of central bank independence. She also finds a relationship in her sample between her measure of central bank independence and low inflation.

Indeed, Chile’s 1980 constitution (Article 97, Chapter XII) granted constitutional status to the existence of an autonomous central bank, defining the bank as a technical entity with its own equity capital. Article 98 states that the central bank may only carry out operations with financial institutions in the public or private sector. The constitution specifically prohibited the central bank from granting guarantees or acquiring documents issued by the state, its agencies or companies.

Only in 1989, however, did the central bank achieve full independence. Only then were the bank’s specific mandate, organization, powers, responsibilities, accountability, and relationships with the finance ministry instituted. The organization and functions of the bank were specified in the 1989 Basic Constitutional Act of the Central Bank of Chile.¹⁰

The 1989 Basic Act charged the central bank with price stability and the normal functioning of the payments system. To achieve this, the bank was granted broad regulatory powers over monetary, credit, financial, and foreign exchange activity.

• To solidify the independence of the central bank, the Basic Act established the selection criteria and composition of its board. The board consists of five members, nominated by the president and ratified by the senate. Terms are 10 years, with one member’s term ending every 2 years. The president names one of the board members as president of the central bank, for a 5-year term.

• The Basic Act establishes clear accountability criteria. The central bank is required to inform the senate and the president of the norms it dictates. The central bank is also obligated to testify before congress twice a year.

• The Basic Act also institutes the relationship between the central bank and the finance ministry. In particular, the law states that the finance minister can attend and speak at board meetings, but cannot vote. (If the board does not vote unanimously on an issue, the minister of finance can suspend the application of the board’s decisions, though only for a maximum of 15 days.)

Did an Independent Central Bank Force Fiscal Discipline?

An important fact to highlight along Chile’s disinflationary journey was a switch in the role of the central bank. During some periods prior to 1989, the central bank functioned as a virtual agency of the treasury. Morandé (2001, p. 1), for example, states: “As in many other countries, fiscal policy became extremely expansive and eventually irresponsible… Monetary policy was almost always an expression of fiscal needs; high and volatile inflation was an unsurprising outcome.”

In 1989, the full-fledged autonomy of the central bank came into existence coinciding with two significant developments in Chile. After 1989 the government showed remarkable fiscal discipline in the sense of a dramatic strengthening of its balance sheet. Coupled with strong rates of output growth, fiscal discipline resulted in a smooth decline of the consolidated debt to GDP ratio. At the same time, the country also initiated its convergence to price stability (Figure 2.1). Possibly, the full-fledged independence of the central bank helped prompt fiscal discipline and in that way the attainment of price stability, as suggested by the theories described in Box 2.2. Of course, this association is only suggestive, and it is quite possible that the fiscal authority was convinced on its own of the need for fiscal discipline, and not only as a means to price stability.¹¹

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Inflation and Consolidated Government Debt

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Central Bank Independence: Helpful but Not Enough for Price Stability?

Recently, a number of authors (Sims (2003), Cochrane (2001), and Woodford (2001)) have revisited the idea that the institution of an independent central bank is enough to guarantee price stability. They show that the central bank could be independent, indeed never monetizing government debt, yet bursts of inflation could still occur in response to sharp accumulation of government debt. This theory would suggest that although helpful, central bank independence may not be enough to assure price stability; it may be a good idea to also institute limits to the debt issuance on the part of the fiscal authority or a rule limiting the budget deficit.

Catao and Terrones (2003) carry out an empirical assessment of theories suggesting the importance of fiscal factors in the determination of a country’s inflation rate. They show that the size of fiscal deficits does matter, even for countries with moderate inflation. Although their analysis does not discriminate between the theories in Box 2.2 or the most recent developments of the fiscal theory of the price level, their finding reinforces the view that fiscal factors matter for price stability.

Inflation Targeting: An Emerging Informal Institution

Credit for Chile’s price stability is also due to the practice of inflation targeting, which itself recently has taken on institutional qualities.

Some form of inflation targeting has been a hall-mark of monetary policymaking in Chile since 1990, but in the last several years it has taken a more advanced form, known as an “inflation-targeting framework” (see Section lit). The question is whether inflation targeting has played a substantive role in achieving and maintaining price stability or whether it has been mainly an operational change.¹²

From 1990 to 1999, inflation targeting was not full-fledged.¹³ The target sometimes consisted of announcing an upper bound for next year’s inflation and sometimes of announcing a band. Each year’s announced target was lower than the previous one, but the level of the target was announced only one year at a time. The target was not continuous but rather referred to end-year outcomes, there was no clear policy horizon, and the inflation objective rested uneasily with the exchange rate target band in place at the same time. That said, this period did see an important, if gradual, decline in Chile’s rate of inflation.

Following 1999, by which time the central bank had achieved its desired steady-state inflation rate and dropped the exchange rate target band, inflation targeting in Chile was developed into a full-fledged framework, consisting of a preannounced band, a well-understood measure of inflation, and an announced policy horizon.¹⁴

The move to full-fledged inflation targeting seems more than a change in operational style. Corbo and Schmidt-Hebbel (2001) and Schmidt-Hebbel and Tapia (2002) argue that inflation targeting also has played a substantive role by anchoring expectations and strengthening the credibility of monetary policy and official inflation forecasts. Moreover, the central bank’s announcement of an explicit inflation target is potentially a strong commitment and verification device. Consistent with that interpretation of the Chilean experience, Orphanides and Williams (2002) present a theoretical analysis in which a policy of emphasizing price stability as an operational policy objective, and the periodic communication of a central bank’s inflation objectives, works to anchor inflation expectations, in turn facilitating price stability. In the Chilean case, by choosing a well-known price index and a policy horizon that allows for standard lag effects,¹⁵ inflation targeting may generate greater public understanding of the central bank’s objectives, hence increasing the credibility of the framework.

The track record under inflation targeting has been favorable. Actual inflation has generally remained inside the target band. Indicators of inflation expectations also have been consistent with the inflation target (see Section III).

Exchange Rate Arrangements: Help or Hindrance in the Journey to Price Stability?

Fixed exchange rate schemes are sometimes considered as institutional arrangements to attain price stability. However, no such supporting role is found in Chile’s modern experience. The last attempt to use the exchange rate as a nominal anchor resulted in a temporary decline in inflation before ending in failure in 1982.¹⁶

Subsequently, a kind of hybrid, more ad hoc exchange rate regime, sometimes called a managed float, was pursued from 1985 to 1999, which included an exchange rate band. However, this policy was not used to help the disinflation objective being pursued during the 1990s: rather than an effort to limit depreciation of the peso and thereby establish a nominal anchor, during much of the 1990s it involved an active effort to avoid or slow down peso appreciation.¹⁷ Significant purchases of foreign exchange during this period required a costly sterilization process, aimed to counteract inflationary consequences of pursuing the exchange rate objective.¹⁸

The floating exchange rate regime in place since 1999 is fully compatible with the goal of price stability. The absence of an exchange rate objective allows the central bank more room to pursue its inflation objective, with greater focus.

Pending Issues and Questions

In light of Chile’s success in achieving price stability, there certainly is no presumption that important changes in institutional arrangements are needed. However, a few points could be considered:

• If inflation targeting contributes importantly to price stability, this might suggest formally institutionalizing the practice, as a way to ensure its continuance. Currently, the framework is implemented at the discretion of the central bank’s board. However, in the absence of any clear threat to maintaining the best aspects of inflation targeting, any legal changes might be unnecessary (and not worth the possible risks inherent in opening up the central bank law for political discussion).

• More practically, the inflation-targeting framework could be enhanced by making more explicit the model and assumptions used in the inflation-targeting framework, in particular the methods used to forecast inflation over the horizon used to evaluate the monetary stance. Indeed, the central bank plans to do this soon.

• As noted earlier, Chile’s constitution defines the central bank as an autonomous entity “with its own capital.” However, the central bank’s tendency to run an operational deficit (see Section VII) could—if sustained—undermine the bank’s capital base. A solution to this situation would be for the government to recapitalize the central bank, a move that would also increase transparency of fiscal policy and that would tend to safeguard public confidence in the future independence of the central bank.

The Banking Crisis of 1982–84: Setting the Stage for Reform

The consensus view (e.g., de la Cuadra and Valdes, 1992) of this banking crisis is that external shocks triggered a chain of events that revealed underlying vulnerabilities. These included connected lending, overly generous implicit deposit insurance, lender of last resort operations conducive to excessive risk taking by banks, and a lack of prudential regulation.

By mid-1982, as problems in the banking system became more prominent, the central bank cast a wide safety net. It began by providing a preferential exchange rate for dollar debtors and buying the banks’ bad portfolios at face value. The nonperforming assets of commercial banks were replaced by central bank bonds. The government intervened in the flagship banks of the two largest conglomerates. Furthermore, the government explicitly guaranteed the total outstanding bank debt. In the end, the bailout led to a substantial buildup of central bank debt and quasi-fiscal deficits that continue to be part of today’s landscape.¹⁹

The experience of the 1982–84 banking crisis set the stage for breakthrough reform, in the banking law of 1986. The eventual winners of the new regulation would be the public at large, who had become well aware of the costs of poor regulation. Large conglomerates and owners of commercial banks were poised to lose as the subsidized connected lending would come to an end. In the after-math of the banking crisis, the new law was designed and adopted in a setting basically void of political constraints of special interests normally binding in reform efforts. The large conglomerates, owners of the largest banks, had been hit hard by the 1982–83 crisis, two prominent bankers were in jail, and all the banks had solvency problems. The banking interest group was thus in a weak position to lobby against new regulations.

Characteristics of Stability-Promoting Banking Institutions

A characteristic of sound banking institutions is that they provide the incentives for depositors and banks to act as if a bailout would be a rare and costly event. An increasingly accepted approach in assessing the vulnerability of a banking system has been to look at regulatory and safety net institutions simultaneously (e.g., Demirgüç-Kunt and Kane, 2002; and Boyd and others, 2001). The idea is that bank regulations should be viewed as a complement to market discipline. The degree of market discipline may in turn be affected by the specific type of safety net in place. Depositors’ incentives to monitor banks will depend on whether full deposit insurance is anticipated. Similarly, if closure procedures are not clearly defined and enforced, banks may feel they can safely bet on an indiscriminate extension of a safety net in times of trouble (e.g., a highly discretionary role of lender of last resort (LOLR)).

More concretely, suppose the Chilean government stated that there would be no repeat of the early 1980s bailout. Such a commitment would be most likely to prevail:

• If deposit insurance were not too generous;

• If LOLR facilities were used only to face unanticipated short-term liquidity needs of the system;

• If bank regulation were effective in limiting risk taking; and

• If there were timely and public disclosure of relevant prudential and profit indicators of each bank.

The Banking Landscape After 1986

The Superintendency of Banks and Financial Institutions (SBIF) was created in 1925 and is related to the government through the ministry of finance. Over the years, the SBIF has undergone several changes as part of the country’s modernization efforts. The SBIF authorizes the creation of new banks and has increasingly gained powers to interpret and enforce regulations.

The banking law of 1986, and subsequent amendments in 1989 and 1997, provided the SBIF with essential new tools to limit risk taking by banks: restriction of business with related parties (Article 84, No. 2); rating the quality of banking investments (Articles 116, 119, and 126); and requiring compliance with Basel capital requirements.

The banking law also fulfilled other essential requirements. It allowed the regulatory body to quickly identify compliance failures to prevent equity holders from rolling over loan losses (Article 15). It stated explicitly and clearly procedures to deal with solvency problems and close banks (Articles 130–39). Furthermore, it protected the property rights of bank creditors and debtors by stating the different capitalization and other workout mechanisms (Articles 118, 120–29, and 140).

Information to Facilitate Private Monitoring and Reduce Moral Hazard

To reduce the moral hazard problem, timely and accurate information should allow depositors to discipline banks and consequently can be an important complement to regulation. When information reveals that banks are engaging in riskier practices, depositors can penalize these banks by withdrawing their deposits. The SBIF requires banks to publish three times a year a detailed report on compliance with capital requirements and has considerably reduced the scope of the banking secrecy laws.

The Safety Net: Deposit Insurance

In principle, deposit insurance reduces incentives for depositors to use the information available to monitor banks. There is still some debate about the net benefits of explicit deposit insurance (see, e.g., Demirgüç-Kunt and Kane, 2002) but there seems to be consensus on the need for the following: an emphasis on the private funding of the explicit deposit insurance; private monitoring to complement official supervision; compulsory membership in the deposit insurance system; and avoiding too-generous deposit insurance.

In Chile, the strategy of the current deposit insurance system has been to state up front less generous deposit insurance rules of the game in order to diminish its negative impact. Prior to the financial crisis of the early 1980s, there had been no explicit deposit insurance in Chile. Yet, in the event of that crisis, the government ended up casting a wide safety net, which included 100 percent deposit insurance. Looking forward, such generous deposit insurance could be problematic, inducing moral hazard and undermining the market discipline that would otherwise limit risk taking. On the other hand, going with no explicit deposit insurance might again end up translating into full implicit insurance. Chile instead moved to an explicit but less generous deposit insurance.

In 1986, Chile’s new explicit deposit insurance scheme introduced a distinction between sight and time deposits. Since 1986, there has been an explicit 100 percent coverage to sight deposits but term deposits have a cap (for each depositor) of approximately US$2,800.

How “generous” is Chile’s deposit insurance? Two recent studies shed some light:

• According to Budnevich and Franken (2003), the current deposit insurance scheme could represent up to 0.7 percent of GDP. This coverage could be classified as relatively less generous when contrasted with other countries’ explicit deposit insurance schemes.

• Martinez-Peria and Schmukler (2001) contribute an empirical analysis, using bank-level data for Chile and other countries. They conclude that deposit insurance in Chile is not so generous as to preclude depositors (both small and large) from disciplining banks for risky behavior.

The Safety Net: A Case of Exceptional Liquidity Provision

An unconstrained LOLR role to banks in trouble will exacerbate the central bank-induced moral hazard problem. LOLR facilities should not to used to bail out specific insolvent banks. LOLR should be used to either help solvent institutions with adequate collateral meet liquidity shocks with the provision of liquidity at market interest rates or to help the banking system meet unanticipated short-term liquidity needs. An example of a recent deployment of Chile’s LOLR facilities is the response of the central bank to the “CORFO-Inverlink” affair (see Section V). This refers to a case of fraud of some significance, involving a financial holding company, that emerged in March 2003. Although this case originated outside the banking system, its repercussions soon extended to the banking system, as it induced many financial market players to seek liquidity urgently.

In response to that shock, during March 10–14, 2003, the central bank provided liquidity through its overnight window, and swap operations in U.S. dollars with resale agreements. As described in Section V, the central bank’s liquidity provision did not target a specific bank; instead, it provided liquidity to the system, which subsequently was gradually removed.

Closure Procedures

Are Chilean institutions credible in the sense of providing the right incentives to avoid a repeat of the early 1980s bailout? More specifically, are bank closure procedures clearly defined and credible? Brock (1992) reports two examples illustrating closure procedures at work. In 1988, the Banco del Pacifico was required to increase its loan-loss provisions by 60 percent against bad loans. The funds came from subordinated debt from another bank. In 1989, the SBIF intervened in Banco Nacional after discovering hidden losses. The government did not bail out the banks in either case.

Pending Issues and Questions

We have argued that Chile has achieved a good balance between prudential regulation, market discipline, and not overly generous banking deposit insurance. However, looking forward, it may be worth reflecting on a few questions.

• Do Chile’s banking regulators enjoy adequate legal protection in the exercise of their duties? Legal protection of supervisory staff in the fulfillment of their duties is key to reducing the threat of intimidation. In Chile, the only protection in place is Article 25 of the 1986 banking law but it is specific to the protection of SBIF staff only during a bank intervention.

• Should the structure of the banking system deposit insurance be revised? Consider the following example of how the ever-evolving banking system could affect the central bank’s deposit insurance liability. In June 2002, the central bank authorized banks to issue interest-bearing sight deposit accounts. So far, the move has not induced a large switch from noninterest-bearing to interest-bearing accounts—in part due to the low opportunity cost that the current low interest environment represents. However, the situation is likely to change when the central bank switches to a tighter mode. Significant increases in sight deposit accounts would represent a larger potential deposit insurance liability for the central bank. In light of this possibility it might be a good idea to revisit the question of how generous deposit insurance might be.

• Have steps been taken to allow consolidated supervision of the financial system? In response to the CORFO-Inverlink affair, the authorities appended a number of proposals to the capital market reform package that had been already in preparation. Capital Market Reform II (CMII) is an ambitious set of 60 proposals, recently sent to congress, to either modify old or create new laws. CMII includes a proposal to improve coordination of the financial system supervisory agencies. It does not include the, in principle, more desirable alternative of consolidation of supervision.

The Problems to Be Confronted

Trade policy is a classic arena for lobbying and rent seeking.²⁰ The essential problem is that from the point of view of an individual industry, trade protection can bring enormous benefits and so creates incentives to lobby for special treatment; on the other hand, the costs of each case of special treatment are usually diffuse, not associated with any particular interest group. One might therefore expect a general tendency toward ever higher and more dispersed rates, yielding high effective rates of protection. Moreover, even if the “common interest” can occasionally break through and generate a reform of the tariff structure, such reform may prove difficult to maintain, if all the factors that previously generated distortions remain in place.

Chile’s Trade Policy Experience

In the area of trade policy, Chile has moved from a highly distorted tariff structure to one of the world’s most liberal. In the period after World War II, Chile shared with other Latin American countries a strategy of import substitution. Indeed, by the late 1960s, Chile was considered an extreme case, even for the time, in terms of tariff distortion, complexity, and lack of transparency.²¹ The military government that took over in 1973 soon implemented a major tariff reform, making Chile the first in the region to break from the import substitution strategy. Subsequently, there was only one significant slippage in the tariff reform, and this turned out to be temporary.²²

The return to democracy was followed by further trade liberalization. In fact, there have been two further unilateral tariff reductions. In the early 1990s, the uniform external tariff was cut from 15 percent to 11 percent. Starting in the late 1990s, there was a phased reduction of the uniform tariff, from 11 percent to 6 percent (beginning in 1999 and ending in 2003).

How Has a Liberal Trade Regime Been Sustained?

Political economy considerations suggest that a liberal, nondistortionary tariff structure is an economic policy particularly likely to be subject to attack. Chile’s success in sustaining such a trade policy has been facilitated by several institutional arrangements:

• An outright ban on nontariff barriers, which greatly limits room for industries to lobby for special treatment. This ban has a quasi-constitutional status, being embodied in the Basic Constitutional Act of the Central Bank (amendment of which would require a three-fifths majority of congress).

• A uniform tariff also limits the scope for lobbying for special treatment.²³

• A transparent tariff-setting process. Formerly, tariffs were subject to presidential decrees. Foxley and Sapelli (1999) emphasize that the need to discuss tariff changes in congress brought tariff setting “out of the backrooms of bilateral political deals and into the open arena of competitive politics.”

Of course, the effect of these institutional arrangements may have been complemented by other factors, such as a deeper appreciation in Chile of the flaws of the import substitution strategy. Certainly, as trade liberalization eventually moved resources into the traded goods sector, it created a growing constituency interested in preserving or deepening liberalization.

Pending Issues in Trade Policy

Chile has been extraordinarily successful in creating and sustaining a liberal trade policy regime. Nevertheless, several second-order issues can be mentioned, in that the uniform external tariff policy does not in fact guarantee a single tariff rate will apply to all imports:

• “Price bands” scheme for certain agricultural imports. In place since the 1980s, this system of special, variable import tariffs tends on average to provide some special protection for some agricultural products. However, the list of affected goods is short and has been stable. Moreover, the mechanism for determining these special tariffs is linked to world prices by a nondiscretionary formula, a device that both limits the potential distortion and avoids creating room for lobbying.

• New trade safeguards law. This law, enacted several years ago, is consistent with the requirements of the World Trade Organization, but does open a door for individual industries to lobby for special treatment. However, institutional checks should help insulate the process from political pressures. Most importantly, Chile’s safeguards law provides for only temporary special protection (expiring automatically after a year, with a maximum renewal of one additional year).

• Bilateral trade agreements. During the 1990s, new bilateral trade agreements increased effective protection for many sectors.²⁴ The significance of potentially resulting distortions is limited, however, since the level of the uniform tariff is now down to just 6 percent.