1. Our authorities would like to thank the staff for a comprehensive and useful Staff Report and Selected Issues papers, which reflect the permanent collaborative dialogue that has characterized the relationship between Chile and the Fund. This year’s report corresponds to a fully-fledged Article IV Consultation, after a streamlined version in 2007. As such, this year’s report was produced taking into account the 2007 Decision, as it explicitly incorporates an assessment of external stability and the real exchange rate and the policy options for achieving and maintaining external and domestic stability in light of the confluence of domestic and external shocks that have recently impacted the Chilean economy. Given these shocks, Chile’s rules-based policy framework has provided enough flexibility in order to respond to them, thereby mitigating their impact in order to ensure domestic and external stability.
Outlook and Risks
2. In 2007, Chile’s output grew 5.1 percent, broadly in line with potential output and above the 4.3 percent growth of 2006. This result reflected the still favorable external environment, a more expansionary fiscal policy, and an overall supportive monetary policy. Growth was more dynamic in the communications, construction, and retail sectors, in contrast with the electricity, gas, and water sectors which contracted, given the lesser availability of hydrological resources coupled with ongoing restrictions in the imports of natural gas and higher prices of oil. Such an idiosyncratic shock to the domestic energy generation sector forced a shift towards energy generation using other sources, such as diesel, in a context of unprecedented increases in the price of oil which resulted in energy prices substantially increasing and directly affecting industrial activity. Reflecting this change in the environment, growth weakened significantly during the second half of 2007. Domestic demand grew 7.8 percent, mostly because of the continued consumption dynamism, sustained by still favorable credit conditions and a solid labor market. Investment remained dynamic, relative to previous years, mainly in the mining and energy sectors.
3. The Banco Central de Chile’s (BCC) output growth forecast for 2008 was recently decreased by half a percentage point to a range between 4 to 5 percent, with the balance of risks tilted to the downside. Such a downward review is due to a less favorable external environment stemming from the slowdown in the world economy, the ongoing financial crisis, and the uncertainties associated with it; a slower domestic demand due to a less dynamic consumption in a context of lower real income, less favorable credit conditions, and potentially weaker conditions in labor markets. The main downside risks are related to how the credit crisis in financial markets would impact emerging economies, which include the possibility of a protracted slowdown in the U.S., the persistence of uncertainties in commodity prices, particularly in terms of oil, the possibility of a large correction in the price of copper, and less favorable global financial conditions overall.
4. During the second half of 2007, inflation exhibited a significant acceleration, as CPI inflation reached 7.8 percent year-on-year in December 2007, well above the upper limit of the 3 ± 1 percent target. During the first six months of 2008, annual CPI inflation continued to rise, reaching 9.5 percent in June 2008. Such an increase in inflation resulted from exogenous supply shocks, including a jump in global food prices along with a drought affecting the prices of domestic food items, both of which have proved to be deeper and more persistent than initially anticipated, as well as increases in energy costs and disruptions in energy supply. In line with these developments, core inflation measures and other inflation trend indicators have also remained above the 3 percent target level. The nominal wages growth rate has been in line with traditional indexation clauses while real wage growth has decelerated, showing that second-round effects have been for now relatively contained and in line with historical patterns. From January to mid-April 2008, the Chilean Peso (CLP) appreciated significantly, in part reflecting the weakness of the U.S. dollar, as well as the improved price of copper and the increased interest rate differential with the U.S., due to the aggressive interest rate cuts that the Federal Reserve has conducted in 2008. However, since mid-April, the peso depreciated to a level similar to that of December 2007, a process that can only be partially associated with the intervention policy of the BCC.
5. CPI inflation is expected to remain above the upper limit of the target range during 2008, due to high oil prices and further increases in domestic food prices. Fiscal measures to reduce the impact of high oil prices on the domestic gasoline prices have helped to somewhat mitigate the risk of an excessive additional propagation of supply shocks to underlying price pressures. CPI inflation is expected to gradually move down toward the target range in the first half of 2009, converging to 3 percent by 2010. In line with these developments and in order to ensure inflation convergence to 3 percent in the policy horizon, the Central Bank has already raised the monetary policy interest rate by 175 basis points since mid-2007, bringing it to 6.75 percent in June 2008. The Central Bank’s Board stands ready to act in order to fulfill its commitment to price stability by further reducing the monetary impulse in order to avoid an undesired postponement of convergence of inflation to the target, given current inflation risks.
Exchange Rate Valuation and External Stability
6. In terms of Chile’s exchange rate valuation, the Staff Report indicates that at the time of the assessment the CLP was currently valued at a level in line with fundamentals or slightly overvalued. Our authorities concur with this assessment. After appreciating markedly during the first three and a half months of 2008, the peso has again reached levels similar to the ones observed by the end of last year. The main reasons behind such temporary misalignment were external as well as domestic. Among the external factors, the generalized weakening of the USD, due to global imbalances which coupled with persistent high copper prices and an aggressive loosening of monetary policy in the U.S., coincided with an increase in the monetary policy rate, and the expectation of further monetary tightening by market participants earlier this year. Such developments impacted the CLP directly, so that in the first quarter of 2008, the CLP was one of the fastest appreciating currencies against the USD, accumulating a 12.2 percent nominal appreciation, reaching a high of CLP 429 in mid-March of 2008. At such a level, the CEGR analysis of April 2008 found the peso to be overvalued in real effective terms.
7. On April 10, the BCC announced a reserves purchase program of USD 8 billion from April to December 2008 to increase its foreign exchange liquidity in order to be better equipped to confront a worsening and uncertain international scenario. This measure was consistent with the assessment that the strength of the peso at the time, relative to its long term fundamental value, provided a financially sound opportunity for the intervention. The purchase of reserves constitutes an investment in stability, as it would strengthen the international reserves position of the BCC as the provider of foreign exchange liquidity when needed. As indicated in the Staff Report, the reserves purchase program was implemented transparently under pre-announced daily purchases of USD 50 million through competitive bids with no target level for the exchange rate. As of July 8, 2008 a total of USD 3 billion have been purchased with an average bid to cover ratio of 2.28. Given the pre-announced nature of the reserves purchases, the program does not constrain the implementation of monetary policy and it also avoids discretionary use of exchange rate policy for disinflationary purposes. The Technical Note II of the Selected Issues papers provides evidence that supports the authorities’ decision to increase the level of reserves to around 15 percent of GDP by end 2008.
8. At the same time, the Ministry of Finance has implemented several measures in order to relieve pressure from the CLP. Given the currency mismatch on the government’s balance sheet, which stems from a large surplus position in foreign currency, the government allowed exporters to pay their income taxes directly in USD for the first time in April 2008 and, as of June 2008, they will also be able to pay other taxes in USD, while at the same time allowing companies to have their accounting be done directly in USD. In early May 2008, the Ministry of Finance announced the issuance of an additional USD 800 million in domestic bonds in local currency, which will be used to recapitalize the BCC in USD, so the purchase of the USD equivalent amount would provide additional relief to the pressure on the CLP, which is in line with the reserves purchase program of the BCC described above.
9. In line with the acceleration in inflation since mid-2007 through the direct impact of the food and energy components given the high weight they have in the CPI, as well as due to idiosyncratic supply shocks, as clearly presented in Box 1 of the Staff Report and in the Technical Note I of the Selected Issues Papers, and in order to address the potential impact on inflation expectations and second round effects, the BCC initiated a monetary policy tightening cycle by raising the monetary policy interest rate by 125 basis points between mid-2007 and January 2008, bringing it to 6.25 percent. The BCC paused the interest rates hikes between February and May 2008, thanks to a lack of further inflationary surprises over the first quarter and in order to assess the impact of the interest rate increases of previous months. Consistent with these developments, the inflation outlook contained in the 2008 May Monetary Policy Report was broadly in line with the forecasts of the January Monetary Policy Report. Further monetary policy decisions where in any case made conditional on the impact of incoming data on the inflation outlook over the two-year policy horizon.
10. Given the developments in the price of oil and the fact that inflation of food products proved to be more persistent that initially anticipated, the short-term prospects for inflation deteriorated markedly after May and inflationary expectations shifter higher. In light of the worsening inflation outlook, and in order to ensure inflation convergence to 3 percent in the policy horizon, the BCC raised the monetary policy interest rates by an additional 50 basis points in its Monetary Policy Meeting in June 2008, bringing it to 6.75 percent in order to avoid an undesired postponement of convergence of inflation to the target given current inflationary risks. The Staff Report indicates that further monetary tightening may be needed if further upside risks to inflation were to materialize. The BCC stands ready to act further in order to fulfill its commitment to price stability, as clearly indicated in the statement of the Monetary Policy Meeting in June 2008.
11. The implementation of the structural budget rule and continuing high copper prices determined that in 2007 the Chilean government posted an overall surplus of 8.8 percent of GDP. In the same period, revenues increased 12.1 percent in real terms, while public expenditure grew 8.3 percent. For 2008, the fiscal surplus is expected to reach 4.8 percent of GDP and, as of the first quarter of 2008, the government has already achieved a surplus of 3 percent of GDP. In order to prudently manage windfall revenues and in consistence with the Fiscal Responsibility Law, the Chilean government has continued saving the surpluses into the Economic and Social Stabilization Fund and into the Pension Reserve Fund. At the same time, the Fiscal Responsibility Law allows the government to use its surplus to recapitalize the Central Bank and a payment of USD 900 million is expected to be made during 2008, of which USD 800 million will be financed by the issuance of domestic bonds, as mentioned above. The 2008 Budget constitutes the first budget constructed under the new structural surplus target of ½ percent of GDP and it prioritizes social spending in health, education, innovation, and social housing. At the same time, it focuses on the execution and quality of public expenditure, as noted in the Staff Report.
12. In light of the ongoing increases in oil prices in international markets, the government has undertaken several measures to alleviate its impact on inflation and the overall level of economic activity. Thus, in January 2008 the government submitted a bill to Congress destined to provide an additional injection of USD 200 million to the Fuel Prices Stabilization Fund (FPSF). In March 2008, the government sent another bill to Congress to reduce the excise tax on gasoline by 25 percent for the next 2 years, until March 2010. Congress approved both measures and gasoline and consumer prices reduced significantly in relation to observed prices at the end of 2007. In June 2008, the government sent a bill to Congress to inject an additional USD 1 billion to the FPSF, as well as USD 250 million in new capital to ENAP, the public refining company. The purpose of these new resources is to provide an ample basis for the stabilization of domestic prices of not only gasoline, but also other fuels, such as those that have a high impact on the population, i.e., heating oil and liquefied gas, in a context of additional increases in the price of oil. These measures should reduce the inflationary impact of potential further increases in the price of oil and other fuels in the short run.
Sovereign Wealth Funds and Macroeconomic Policy
13. Our authorities would like to thank the staff for very useful discussions regarding Chile’s Sovereign Wealth Funds (SWFs). The Fund is currently providing technical assistance to Chile to assess the macrofinancial linkages of the management of Chile’s SWFs. In addition, a good review of the institutional background is provided in the Selected Issues Paper, the international best practices, and how Chile compares to them, and some preliminary suggestions going forward for the Pension Reserve Fund (PRF) and the Fund for Economic and Social Stabilization (FESS). Even though Chile’s SWFs are relatively new compared to other SWFs, our authorities have a firm commitment to manage the resources accumulated in these Funds according to the international best-practice, and in that spirit, in response to an offer by the Minister of Finance, the meeting of the International Working Group of Sovereign Wealth Funds will be held in Santiago in September 2008. In terms of management of the Funds, the Financial Advisory Committee recommended a new Strategic Asset Allocation (SAA) which expands the current SAA comprised of sovereign and agencies bonds (66 percent), money market securities and deposits (30 percent) and indexed bonds (4 percent) to a more broad based portfolio in terms of asset classes, by incorporating corporate bonds (20 percent) and stocks (15 percent), and currencies. The management of this new asset classes will be outsourced to external managers by the end of 2008.
14. Given the size of the resources accumulated in these Funds, returns stemming from the investment of the Funds constitute an important new source of fiscal structural income that is a new feature in terms of fiscal policy. During 2007, the returns from the FESS amounted to USD 933 million (0.6 percent of GDP and 2.1 percent of total revenues) which correspond to structural income. In terms of the real exchange rate, the establishment of the SWFs to save abroad the windfall revenues of the government from the copper price boom has also helped significantly in avoiding the loss of competitiveness that would have otherwise prevailed. As such, Chile’s SWFs remain instrumental in preventing the possibility of Dutch disease in light of the large positive terms of trade shock from commodities prices.
15. During the annual address to Congress in May 2008, President Bachelet announced the establishment of a USD 6 billion Fund named the Bicentennial Fund after Chile’s forthcoming bicentennial in 2010, which will be setup to secure a permanent income flow from the investment returns in order to fund the provision of scholarships to study abroad for a total of 30,000 students of professional and technical careers over a 10-year period. This initiative constitutes a major investment in the improvement in human capital of the Chilean labor force with the purpose of significantly improving its productivity over the medium term.
Capital Market Development
16. As indicated in the Staff Report, our authorities have concentrated their efforts in increasing the promotion of foreign investor participation in domestic markets and a new bill (Capital Markets III - MKIII), which aims to foster the use of the CLP as a fully internationally traded currency, increases the depth and liquidity of domestic financial markets, and promotes market access for Small and Medium Enterprises, will be sent to Congress before the end of the year. In 2008, the government will issue bonds in the domestic markets up to USD 2 billion. The purpose of this debt issuance is to provide additional liquidity to the local fixed income markets, as well as to establish benchmark securities to foster the development of the domestic financial market. It is also the first time that a 30-year bond is issued by the Chilean Treasury. In reference to the staff’s recommendation of an FSAP Update in 2009, our authorities are currently in the process of analyzing such a possibility, as it would provide a useful means to check progress on the recommendations of the previous FSAP of 2004, as well as a chance to address new issues.
17. In light of the recent confluence of domestic and external shocks in terms of higher energy and food prices, as well as the financial turmoil and its impact on world activity, Chile’s rules-based policy framework has provided enough flexibility in terms of monetary and fiscal policy in order to respond to these shocks, thereby mitigating their impact so as to ensure domestic and external stability, even under the possibility of a worsening scenario.