This section considers the role played by institutional factors in Chile’s economic policies and performance. Chile’s successful economic performance is well documented, and its economic policy reforms are generally accepted as key to that performance. Less attention has been given, however, to the role played by institutions in this success, either in terms of their direct effects on economic performance or in the establishment of good economic policies.

This section considers the role played by institutional factors in Chile’s economic policies and performance. Chile’s successful economic performance is well documented, and its economic policy reforms are generally accepted as key to that performance. Less attention has been given, however, to the role played by institutions in this success, either in terms of their direct effects on economic performance or in the establishment of good economic policies.

This section seeks to gain a deeper view of the Chilean experience by considering the role institutional factors have played in sustaining good policies over time. A key motivating idea is that sustaining policy reforms often requires countering negative incentives that had been responsible for previous unsound policies.

The approach taken here differs from most recent applied studies on institutions.1 Much of this literature looks at the association of institutions with out-comes for income and growth, not necessarily considering the role of policies (see Box 2.1). In contrast, the focus of this paper is policy based, taking into account the public sector decision process and the political economy underlying policy actions. Also, while much of the recent empirical literature statistically analyzes differences across countries in perceptions and assessments of institutional quality, it does not usually analyze differences over time. The “narrative approach” used here does not permit statistical analysis, but it does give a closer view of one country, and some historical perspective on how its institutions emerged and how they helped change—or maintain—policies over time.

The Chilean case is particularly instructive partly because the country has not always been so successful.2 Its strong economic performance is still relatively recent—starting in the mid-1980s—and has been tested by episodes of financial crisis that hit the East Asian tigers and other emerging market economies in 1997–98, as well as some of Chile’s neighbors in 2001–02.

This review of Chile’s institutions is selective, looking at those that have been significant in four policy areas in which Chile is widely agreed to be particularly strong:

  • Fiscal policy discipline;

  • Policies to maintain price stability;

  • Banking policies to promote financial stability; and

  • An open trade policy regime.

Of course, not every aspect of Chile’s economic policy record can be traced clearly to some institutional arrangement. Other factors—such as consensus on economic issues, the technical expertise or benevolence of policymakers, or cultural factors more generally—may also play a role, but these are beyond the scope of this section.

This section first looks at the political rules of the game: aspects of Chile’s constitution and political framework relevant for economic policy outcomes. Chile’s system has a number of characteristics that cross-country studies have found to be associated with sound policies.

Next, the role of institutions in each of the four broad areas highlighted above is examined, namely, fiscal discipline, price stability, banking stability, and trade policy. For each area, note is first made of the problems any country may face in choosing, implementing, and sustaining good policies, and then the question of how these problems have been addressed (or not) by institutional arrangements in Chile is examined. Some pending issues and possible areas for future institutional development are also discussed.

Some Other Research Referring to Chilean Institutions

Recent empirical research on the influence of institutions focuses on relating proxies for institutions to countries’ level of income or growth rate. Proxies for public institutions can for example refer to the quality of governance, the extent of legal protection of private property, and limits placed on political leaders (see IMF, 2003a, for a fuller discussion). The focus of this literature is on cross-country differences, since institutional indicators for a given country may not change much, even over long periods.


Selected Countries: Income Per Capita and Institutional Indicators

(Log of GDP per capita on y-axis)

Source: IMF, World Economic Outlook, April 2003.

The hope is to gain insight into the potential rewards to improvements in institutional quality. For example, in studying a sample of Latin American countries, Calderón and Schmidt-Hebbel (2003) find that a one-standard-deviation increase in their index of governance is on average associated with a 0.75 percent increase in the growth rate. IMF (2003a) finds that an increase of one standard deviation in an aggregate measure of governance seems to reduce output volatility by over one-fourth on average. That study also finds that the countries with the weakest institutions would benefit the most from an improvement of their public institutions.

The accompanying figure gives a sense of how Chile fits into such analyses. It uses data from IMF (2003a) for Chile, a group of Latin American and East Asian economies, New Zealand, and the United States, plotting per capita income against each of six indicators of institutions. Chile’s indicators compare favorably to those of the other emerging market economies, but are not as strong as those of New Zealand or the United States. Interestingly, the Chilean data point tends to lie below the fitted lines also shown in the figure, signifying that Chilean institutions are somewhat better than would be expected given the country’s income level, but also that income is less than would be expected given the quality of the country’s institutions.

The final subsection offers some closing observations. These include identifying some additional areas in which institutional arrangements may have played a significant role in Chile in the past, and some which may be particularly important looking forward.

Political Rules of the Game: The Constitution and Political Framework

This section presents selected aspects of the political framework, especially Chile’s constitution, that have significance for economic policies and institutions. This is essential background, for in a basic sense the political framework has to underlie all Chilean institutions: either the political framework gave rise to these or at the minimum allowed their development.

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.

Fiscal Discipline: The Role of Institutions

We first note the problems in sustaining fiscal discipline in any country and then look at how these have been addressed by institutional arrangements in Chile. The focus is on the “big picture” institutions and those factors of direct relevance to maintaining fiscal discipline over time (essentially, safeguarding the balance sheet of the public sector).5 We close by surveying some pending fiscal policy issues in Chile.

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 Quest for Price Stability: The Role of Institutional Arrangements

Chile has achieved price stability: low and stable inflation. Here we consider the role institutional arrangements related to monetary policy—for example, central bank independence—have played in this success. However, a recurring theme is that fiscal discipline played a key role in achieving price stability.

Monetary policy frameworks or rules, or exchange rate regimes, in some cases can be seen not only as policies but also as institutional arrangements that may—or may not—promote price stability. We conclude that Chile’s inflation-targeting framework is contributing substantively to price stability, and moreover that this framework is developing a sort of informal institutional status. On the other hand, we argue that the various exchange rate regime choices of Chile’s past worked, in several instances, as a distraction from the price stability goal.

In any country, a number of potential obstacles and incentive problems need to be countered in order to achieve price stability. These include, in various combinations: lack of independence of the central bank, so-called fiscal dominance, unclear mandates, inconsistent policy objectives, or, more generally, time inconsitency problems. As have other countries, Chile struggled with most of these classic problems at one time or other. In this section, we note some of these past difficulties as well as more recent successes.

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.

Central Bank Independence

To achieve price stability, many governments have turned their attention to the design of institutions such as an independent central bank charged with price stability. Inflation targeting has been a hallmark 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.

In their classic work, “Some Unpleasant Monetarist Arithmetic,” Sargent and Wallace (1985) showed how monetary policy and fiscal policy interact so that the effects of changes in monetary policy may depend on the response of fiscal policy. In their analysis, the inflationary implications of a change in monetary policy depend critically on how the government manages its debt. For example, a dominant and undisciplined fiscal policy could result in either an explosive government debt path or, if the monetary authority “blinked,” in high monetization of the ever-growing government debt and consequently high inflation down the road—and possibly in the short run.

A corollary to the Sargent and Wallace argument is that under some conditions, monetary policy could impose discipline on fiscal policy. If there were no question about the monetary policy commitment to low and stable inflation—if the monetary authority “moved first,” and did not or, better yet, could not “blink”—such a commitment could impose discipline on fiscal policy. Knowing that its debt would never be monetized, the fiscal authority would face two choices: continue along an explosive debt path or submit to discipline. The second choice would be more likely because there is a limit to how much government debt can be absorbed by the market.

Another important reason for the establishment of an independent central bank is trying to address a monetary authority’s time inconsistency problem. Barro and Gordon (1983) present an extension of Kydland and Prescott’s (1977) seminal work on a typical government’s time inconsistency problem. Barro and Gordon showed that even a well-intentioned central bank may be tempted to deviate from the long-term optimum, with significant adverse inflationary consequences. An independent central bank may be able to focus on a longer time horizon and thus resist temporary pressures to give in to monetization.

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

Figure 2.1.
Figure 2.1.

Inflation and Consolidated Government Debt

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.

Financial Stability: The Chilean Approach to Banking Supervision, Regulation, and Safety Net

This subsection considers whether Chile’s banking regulatory and safety net institutions have been established to maintain stability. To a large degree this comes down to countering the problem of moral hazard in banking, by providing appropriate incentives to banking system participants, both banks and depositors. Research has shown (e.g., Barth and others (2002) and Boyd and Rolnick (1988)) that a key condition for bank stability is for depositors and banks to be motivated to act as if a government bailout would be an event both very rare and extremely costly for them.

To understand the origin of Chile’s current banking supervision, regulation, and safety net institutions, mostly based in the banking law of 1986, it is useful to start with an overview of the banking crisis of 1982–84. We then review the characteristics of sound banking policy institutions, and document the considerable extent to which the Chilean approach is consistent with these.

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.

Maintaining an Open Trade Policy Regime: The Role of Institutions

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.

Closing Observations

For nearly a generation, the story of Chile’s economic development has been mainly a positive one. This section has highlighted some ways in which institutional arrangements have contributed to this success, in particular by fostering the adoption and maintenance of sound policies, in several key areas. While these institutions did not alone determine Chile’s course, they are likely to have played an important role.

A further analysis of the Chilean economic experience could look also at how other factors, including other kinds of institutional arrangements, promoted favorable decision making by the public and private sectors, and how certain policies may have been self-reinforcing or helped to build institutions. For example, points along the following lines may have been relevant in the Chilean case:

  • Protections on private property, including on foreign investment;

  • Openness to foreign capital, in turn generating incentives to move toward international best practices, and to avoid policy errors or unpredictability that might induce capital flight. Similarly, the importance of trade openness may also go beyond the usual gains from trade, serving as an “anchor” for institutional reform; and

  • International agreements that may be serving as commitment devices.

Commentators on Chile often emphasize the importance of consensus building in the country’s ability to move ahead. While part of the ability to achieve consensus may be due to the political rules discussed earlier, there may be more to the story.

Important work remains for Chile’s further economic development, and some of this progress may be associated with institutional enhancements. This section has noted issues pending in several policy areas, but other areas of institutional reform may be possible, such as public sector reform. Indeed, an atypical wave of public corruption and fraud charges that began in late 2002 already has led to major reform of the public sector (see IMF, 2003b and 2003c). The prompt response of the Chilean authorities—and of Chilean society—to these unexpected developments has spoken well of the country’s institutions, including policymakers’ ability to recognize issues and build consensus to confront them. As these reforms begin to be implemented, it will become possible to assess whether further efforts are needed. Also looking ahead, for Chile as for other countries, there will be the ongoing challenge of keeping financial supervision and regulation up with constantly evolving financial markets. An important stocktaking in that regard will begin with the authorities’ participation in the IMF’s Financial Sector Assessment Program in late 2003.


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IMF (2003a) offers a recent survey of this burgeoning literature.


Over the period 1940–70, Chile was in many ways typical of much of Latin America, in following an import-substitution strategy, giving a heavy role to the state in the economy more generally, rationing foreign exchange, and experiencing high and unstable inflation. Moreover, after major reforms of this old regime began in the 1970s, Chile exemplified a problem that has been familiar elsewhere, with its severe financial crisis of the early 1980s.


Many systems of voting rules grant an extra degree of representation to an election’s first-place finisher, and this is true in Chile also. What distinguishes the Chilean system is that there is also an extra reward, in terms of representation, to finishing in second place (as opposed to coming in third). This feature of the voting rules gives political parties incentives to form coalitions, and thus to sacrifice some of their special interests in the process.


An empirical literature has found that large government debt and deficits are more common in countries with proportional rather than majoritarian representation, coalition governments and frequent turnover, and lenient rather than strict budget processes. Many such studies have focused on industrial countries (for a review, see Annett, 2002), but Alesina and others (1999) and Stein and others (1999) also found similar results for Latin American countries.


That is, we do not survey fiscal policy issues in Chile, such as questions of the efficiency of public expenditure and taxation. Nor do we cover all the arrangements that may—or may not—contribute to fiscal discipline (e.g., a good tax administration, in the absence of the right budget incentives, might not be associated with fiscal discipline).


Jones, Sanguinetti, and Tommaso (2000) analyze problems of the Argentine case.


Municipalities do not have to run continuously balanced budgets, as they have the ability to accumulate assets and subsequently draw these down as needed. Taken as a group, however, municipal governments’ annual overall balance in practice has stayed very close to balance.


As part of a decentralization effort, regional governments do exist for each of Chile’s 13 regions. However, these are not separate governments in the usual sense: they are not constituted via regional elections, their revenue and financing powers are quite limited, and their expenditures are part of a unified central government budget.


Ley Organica Constitucional del Banco Central de Chile.


In his own account of his experience as Chile’s Minister of Finance in the early 1990s, Foxley (2003) reports that this was the case.


For a comprehensive analysis of the inflation-targeting experience in Chile and elsewhere, see the conference proceedings of the Central Bank of Chile (2000).


As Morandé (2001, p. 5) notes, inflation targeting was adopted in 1990 “in part by accident, in part out of necessity, in part for lack of alternatives, and in part in reflection of a longerrun view of monetary policy. The move was accidental in that the recently inaugurated independent Central Bank was required by its charter to present a report to Congress each September, outlining the prospects for the economy for the following calendar year (in particular with regard to inflation…). A target for inflation fit naturally with the price stabilization goal established in that charter.…The inflation projection was treated as a target.”


The band centered at 3 percent with a lower bound of 2 percent and an upper bound of 4 percent. The targeted measure of inflation has been in percentage changes in the consumer price index. Recognizing that monetary policy affects inflation with a long lag, the central bank’s policy horizon was specified to be from 12 to 24 months. See also Section III.


Schmidt-Hebbel and Tapia (2002) emphasize also that the announced policy horizon allows constrained discretion.


From 1979 to 1982, the country adopted a hard peg meant to play the role of a nominal anchor by linking domestic inflation to the U.S. inflation. The strategy worked—until losses of official reserves prompted devaluation in 1982, associated with a banking crisis, a burst of inflation, and severe recession.


According to Morandé and Tapia (2002, p. 2), throughout some of the managed float years, “the concern was not placed in the exchange rate as the anchor to lower inflation…, but as an instrument to sustain a depreciated real exchange rate that would boost exports.”


Relatedly, measures to limit capital inflows were also applied, but ended in 1998.


For a detailed description of the cost of the bailout, see, for example, Sanhueza (2001).


Chile’s trade regime may have been among the world’s most distorted: tariffs were not only high but also tremendously varied and subject to frequent ad hoc changes.


Prompted by the early 1980s’ debt crisis, this temporary deviation was essentially an emergency balance of payments/fiscal revenue measure.


See Panagariya and Rodrik (1993) for a review of political economy arguments for a common tariff.


Foxley and Sapelli (1999, p. 410) argue that the benefits of Chile’s uniform tariff were “in some ways jeopardized by bilateral agreements that increased effective protection for many sectors and abandoned the worthy goal of giving all sectors the same degree of protection.”

Institutions and Policies Underpinning Stability and Growth
  • View in gallery

    Selected Countries: Income Per Capita and Institutional Indicators

    (Log of GDP per capita on y-axis)

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    Inflation and Consolidated Government Debt