Chile: Staff Report for the 2001 Article IV Consultation

Chile's economic performance was very strong during most of the 1990s, but the country suffered a recession in 1998–99. In early 1998, Chile faced a widening external current account deficit—resulting from surging domestic demand and a large drop in copper export prices—which together with turbulence in world financial markets weakened investor confidence and put downward pressure on the currency. Chile has maintained a very open trade regime and has continued with the unilateral phased reduction of its uniform external tariff rate.


Chile's economic performance was very strong during most of the 1990s, but the country suffered a recession in 1998–99. In early 1998, Chile faced a widening external current account deficit—resulting from surging domestic demand and a large drop in copper export prices—which together with turbulence in world financial markets weakened investor confidence and put downward pressure on the currency. Chile has maintained a very open trade regime and has continued with the unilateral phased reduction of its uniform external tariff rate.

I. Introduction

1. The 2001 Article IV consultation discussions with Chile were held in Santiago during April 26-May 10.1 The staff team met with the ministers of finance, and economy, mining and energy, the president of the central bank, senior officials in the government and the central bank, private sector representatives, and academics.

2. At the conclusion of the last consultation on July 7, 2000 (EBM/00/68), Directors praised Chilex’;s long record of sound economic policies, which in the 1990s had resulted in high economic growth and declining inflation. They considered that the downturn in economic activity in 1999 had been reversed with the aid of more accommodating macroeconomic policies, and viewed the move to a more neutral policy stance in early 2000 as appropriate. Directors welcomed the authorities’ decision to enhance their inflation-targeting framework by shifting the focus from a specific year-end inflation level to a continuous inflation band starting in 2001, and by increasing transparency in the formulation and implementation of monetary policy. Directors supported the authoritiesx’; intention to strengthen the fiscal position beyond 2000, and the idea of formulating fiscal policy on the basis of a measure of the structural fiscal balance that would exclude the effects of transitory fluctuations in output and copper prices. They also supported the decision to float the peso, measures to liberalize capital flows, and the continued unilateral reduction of Chilex’;s uniform external tariff. Directors noted Chilex’;s strict bank supervision practices, and encouraged the authorities to advance in the introduction of supervision of consolidated balance sheets of financial holdings. They welcomed the authoritiesx’; intention to improve the system of unemployment protection, but recommended that the planned package of other labor reforms be crafted in a way that preserves flexible labor markets.

II. Background and Recent Developments

3. Chile’;s economic performance was very strong during most of the 1990s, but the economy suffered a recession in 1998-99 (Table 1 and Figure 1). In early 1998 the authorities were facing a widening external current account deficit (resulting from surging domestic demand and a large drop in copper prices), which together with turbulence in world financial markets weakened investor confidence and put downward pressure on the currency.2 In response, the authorities raised the “policy” real interest rate markedly, which led to higher lending rates and a slowdown in bank credit to the private sector (Table 2).3 The combination of an adverse terms of trade shock, diminished supply of external finance, and contractionary monetary policy caused a sharp fall in domestic demand and a decline in economic activity. Monetary and fiscal policies were eased starting in late 1998, which together with an increase in copper prices helped reverse the recessionary trend. All in all, the economy registered negative growth (year-on-year) for eleven months starting in October 1998, but was growing at a healthy pace again by late 1999. However, unemployment at end-1999 was considerably higher than before the recession (Figure 2).

Table 1.

Chile: Selected Economic Indicators

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Sources: Central Bank of Chile; and Fund staff estimates.

Excluding fuel and volatile food items, end-of-period.

End of period. A decline indicates a depreciation of the peso.

Yield on 90-day indexed central bank paper (PRBC-90), in percent per annum (period average).

Net of estimated losses of the central bank.

Includes errors and omissions.

Figure 1.
Figure 1.

Chile: Selected Economic Indicators, 1996 - 2001

Citation: IMF Staff Country Reports 2001, 116; 10.5089/9781451807493.002.A001

Source: Central Bank of Chile; and London Metal Exchange.1/ Excluding fuels and perishable agricultural products.
Table 2.

Chile: Selected Indicators of the Financial System 1/

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Sources: Central Bank of Chile; and Fund staff estimates.

Flows measured at constant exchange rates (at the level of the end of the year under consideration). The financial system comprises the central bank, commercial banks, nonbank financial institutions, and private pension funds.

Defined as currency plus sight deposits.

Includes time and savings deposits, deposits in U.S. dollars, and pension fundsx’; liabilities.

Annual average yield on 90-365 days indexed operations.

Figure 2.
Figure 2.

Chile: Labor Market Developments, 1996 - 2001

Citation: IMF Staff Country Reports 2001, 116; 10.5089/9781451807493.002.A001

Source: Central Bank of Chile.

4. Real GDP grew by 5.4 percent for 2000 as a whole, despite a slowdown that began in the second half of the year, and continued into 2001. Output recovered strongly in the first part of 2000, as a result of rapid export growth and, to a lesser extent, expanding domestic demand. Subsequently, however, consumption decelerated markedly, presumably as the persistence of high unemployment became clear to consumers, inducing them to revise their expected income and thus their spending plans. In the end, real GDP growth fell gradually from 6 percent (year-on-year) in the second quarter of 2000 to 3.3 percent in the first quarter of 2001.

5. Despite the growth in economic activity in 2000 and early 2001, unemployment remained high. As of March 2001, the seasonally-adjusted unemployment rate stood at 9.6 percent, compared with 5.7 percent in mid-1998.4 The persistence of high unemployment may reflect a number of cyclical, structural, and institutional factors (Box 1).

Unemployment Persistence in Chile1

A number of factors may have contributed to the persistence of unemployment in Chile following the 1998-99 economic downturn, including: (i) temporary shocks to the economy as a whole, possibly not evenly distributed across sectors; (ii) structural shocks of a more microeconomic, presumably permanent, nature; and (iii) certain rigidities in the labor market.

Evidence from other countries shows that aggregate cyclical shocks can lead to temporary but long-lived labor market fluctuations. A typical pattern is that recovery of employment not only lags that of output, as-average hours worked first increase with output recovery before firms increase their hiring, but also proceeds at a slower pace. Models that include frictions in labor markets, such as job search costs, provide a rationale for the slow adjustment of employment to temporary shocks. In particular, these models suggest that shocks that are concentrated on labor-intensive sectors add significantly not only to the rise in unemployment but also to its persistence.

During the 1998-99 economic downturn in Chile, sectors such as construction and commerce, together representing 30 percent of nonagricultural employment, suffered the sharpest output contraction. The background paper on unemployment prepared for this consultation suggests that the variance of changes in employment across economic sectors may have been a significant factor explaining the persistence of unemployment in Chile, after controlling for the impact of aggregate shocks. If the shocks responsible for the slowdown in employment were indeed temporary, the protracted unemployment cycle would run its own course as recovering economic activity in labor-intensive sectors would eventually translate into higher job creation.

The arguments based on structural, presumably permanent changes as the reason for high unemployment hysteresis note that sectors such as agriculture, fishing, commerce and industry had been undergoing a significant transformation in Chile, and claim that this could have reduced the economyx’;s employment capacity, at a given real wage structure and output level. The case of small and medium-sized enterprises (many of which have been facing financial difficulties) may be a relevant example, to the extent that it involves displacement of labor-intensive firms by large capital-intensive firms benefiting from increasing-return-to scale technologies. On the other hand, Chile experienced major economic transformations for more than a decade prior to the recent recession, apparently without adverse consequences on employment. In fact, formal tests have found no significant evidence of a structural shift in the aggregate elasticity of labor demand to output during the 1990s.2

The degree of rigidity in labor markets also helps explain high unemployment persistence. Empirical evidence shows that the 25 percent real increase in the minimum wage since 1998 contributed to increase unemployment among young workers. Also, pervasive wage indexation has probably limited downward adjustment of real wages despite a sharp increase in unemployment. Moreover, high severance costs3 reduce the job creation response to output recovery as firms want to be sure that growth is sustained before hiring additional workers. Finally, uncertainties over a long-debated and contentious labor market reform proposal represent yet another factor that may have inhibited job creation.

1 See also the background paper with the same title, Chapter 2 in the Selected Issues Paper for this consultation.2 See Martinez C., G. Moralez and R. Valdés (2000) “Cambios Estructurales en la Demanda por Trabajo en Chile,” Revista de Economía Chilena,(forthcoming), Central Bank of Chile.3 For a comparative analysis, see Heckman, J. and C. Pagés (2000) “The Cost of Job Security Regulation: Evidence from Latin American Labor Markets,” IDB Working Paper 430, August 2000.

6. After a moderate tightening in early 2000, the authorities adopted an expansionary monetary stance starting in August as the slowdown in economic activity reduced the inflation risk (Figure 3). In the first quarter of 2000, and in the context of rapid output growth, the central bank raised the policy real interest rate by 50 basis points (to 5.5 percent) to contain the inflationary pressures arising from higher oil prices. However, in light of evidence that the recovery of output was weakening, the central bank cut the policy rate back to 5 percent in August, and gradually down to 3.5 percent over the first half of 2001. While headline inflation rose during 2000 to reach 4.5 percent by end-year, it subsequently declined to 3.5 percent by March 2001, within the target band of 2-4 percent that became effective in January; underlying inflation (which excludes fuels and certain food items with volatile prices) remained around 3 percent throughout this period.5

Figure 3.
Figure 3.

Chile: Financial Sector Indicators, 1996 - 2001

Citation: IMF Staff Country Reports 2001, 116; 10.5089/9781451807493.002.A001

Source: Central Bank of Chile.1/ Ml plus savings accounts.

7. The public sector accounts strengthened in 2000, reversing the trend of the previous few years (Table 3). The central government position improved significantly, as a result of increased revenue from the recovery of output and of copper prices, as well as moderate growth in expenditure.6 At the same time, the deficit of the state-owned enterprises rose somewhat, partly due to a domestic fuel price subsidy, and the central bank operational deficit declined slightly to 0.9 percent of GDP.7 As a result, the combined public sector deficit fell to 2.6 percent of GDP, from 3.6 percent of GDP in 1999.

Table 3.

Chile: Summary Operations of the Combined Public Sector 1/

(In percent of GDP)

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Sources: Ministry of Finance; CODELCO; Central Bank of Chile; and Fund staff estimates.

Nonfinancial public sector and operational losses of the central bank.

Includes taxes paid and transfers made by the public enterprises.

Includes amounts transferred directly by CODELCO to the military.

Includingnet lending, with the exception of the special program in 2001 in which banks rescheduling their loans to PYMEs will receive government deposits of up to US$300 million (0.4 percent of GDP).

Differs from staffs presentation in treatment of copper stabilization fund and privatization receipts.

Change in the actual balance in excess of the cyclically neutral balance in relation to the preceding year.

Calculations made at a price of copper of 0.90 U.S. dollar per pound.

Central government expenditure less interest payments and transfers plus investment of public enterprises.

Central government expenditure plus investment of public enterprises.

Percentage of total employment.

Credit from the banking system (excluding the central bank). There are no outstanding domestic bonds, and data on suppliersx’; credit are not available.

8. The external current account deficit increased to 1.4 percent of GDP in 2000, from near balance the previous year (Table 4). As a significant part of the expansion in domestic demand fell on imports, the trade surplus declined. In addition, profits on foreign investment in Chilex’;s mining sector increased (mainly due to higher copper prices in average for the year), and net interest payments abroad also grew (reflecting higher medium- and long-term external debt and higher interest rates).

Table 4.

Chile: Balance of Payments

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Sources: Central Bank of Chile; and Fund staff estimates.

Includes short-term flows and Chilean residentsx’; holdings of medium- and long-term assets (other than equity) overseas.

Does not include short-term direct trade credits.

9. As net capital inflows just about covered the external current account deficit, international reserves remained stable in 2000, and indicators of external vulnerability continued at comfortable levels (Table 5).8 Net foreign direct investment turned negative for the first time in several years, with inflows declining below historical levels and outflows continuing strong. In contrast, short-term net capital flows turned positive, this increase mostly consisting of credit lines to finance the acquisition of a large Chilean firm (some of these lines were replaced by a bond issue in early 2001). At end-2000 international reserves amounted to US$14.7 billion (eight months of imports of goods and services, and about twice the level of short-term external debt on a residual maturity basis, excluding direct trade credits). The Chilean peso, which had been floating freely since September 1999, appreciated by 2.4 percent in real effective terms during 2000, but at end-year it was still 12 percent weaker than at its peak in late 1997 (Figure 4). Moodyx’;s and Standard and Poorx’;s have maintained their investment grade ratings for Chilex’;s sovereign long-term debt (Baal and A-, respectively), the highest among Latin American countries.

Table 5.

Chile: Indicators of External Vulnerability (In percent; unless otherwise indicated)

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Sources: Central Bank of Chile; and Fund staff estimates.

The series starts in July 1997.

This indicator is not available before 1998.

Includes errors and omissions.

Gold valued at end-period market prices.

Total short-term external debt is measured as the official figure on short-term debt (which includes amortization of medium- an debt falling due during the following year). Total short-term external debt does not include direct trade credits.

Refers to the commercial banking sector including the Banco del Estado de Chile.

Includes private debt with public guarantee.

Ratings are only shown for the dates on which they were revised by the rating agencies.

Figure 4.
Figure 4.

Chile: Exchange Rate Developments, 1996 - 2001

Citation: IMF Staff Country Reports 2001, 116; 10.5089/9781451807493.002.A001

Source: El Mercurio; Central Bank of Chile; IMFx’;s Information Notice System; International Financial Statistics; Fund staff estimates.

10. Chile has experienced little contagion from the difficulties in some emerging markets during early 2001. While the Latin American Composite bond spread index increased by more than 200 basis points from its low level in early February to its peak in late April, the spread on Chilean sovereign debt declined slightly, and remained much lower than that for other Latin American sovereign debt (Figure 5). The spread on large Chilean corporate borrowers, however, increased slightly, and the peso depreciated by 6 percent with respect to the U.S. dollar during this period.

Figure 5.
Figure 5.

Chile: External Sector Indicators, 1996 - 2001

Citation: IMF Staff Country Reports 2001, 116; 10.5089/9781451807493.002.A001

Source: Central Bank of Chile; Bloomberg; and J.P. Morgan.1/ Average spread on five corporate bonds (data not available before 1997)2/ Chilean sovereign bond issued April 1999, matures 2009.

11. In 2000, the authorities took measures to liberalize capital flows and further develop domestic financial markets. The central bank eliminated an important rule that prevented certain capital inflows from being repatriated before one year, and reduced the minimum risk classification required on banks to issue ADRs and bonds abroad. It also widened the type of operations that banks may undertake to hedge against exchange and credit risk, and eased restrictions on banksx’; investment and credit operations abroad.

12. Congress approved in late 2000 legislation to enhance corporate governance, which is expected to increase the attractiveness of investing in Chilean stocks. The law seeks to protect minority shareholders by setting clear rules for tender offers, increasing their role in the auditing of the company and in the approval of transactions with related parties, and more generally enhancing their access to information on the companyx’;s operations.

13. Chile has a very open trade regime, rated 1 on the 1-10 scale of the Fundx’;s trade restrictiveness index. The country has continued to reduce unilaterally its uniform external tariff by 1 percentage point a year since 1999; the uniform tariff is now 8 percent and will continue to be lowered to 6 percent by January 1, 2003. For a long time Chile has maintained the price of certain agricultural products (wheat, wheat flour, sugar, and edible oils) within bands related to past international prices. In late 1999 Chile introduced safeguards on the importation of those goods, as the tariffs implied by the price-bands exceeded Chilex’;s WTO limit for these goods of 31.5 percent (the safeguards allow temporary exceptions to this limit). Subsequently, import safeguards were also introduced on milk, a good not subject to the price bands. The government has started negotiations to increase its WTO-agreed tariff limit on sugar, to avoid any future conflict with the price-band scheme. Trading partners have turned to the WTO to persuade Chile to abandon the safeguards and the price-band scheme. In 2000, Chile continued trade negotiations with the European Free Trade Association and Korea, and started negotiating a free trade agreement with the United States, and a political and economic cooperation agreement with the European Union.

14. During 2000 the authorities privatized three water and sewage companies, for receipts equivalent to 1.3 percent of GDP. They also granted two private concessions involving roads, for 0.8 percent of GDP.

III. Policy Discussions

A. Macroeconomic Policies

15. The authorities explained their basic economic strategy, which includes monetary policy focused on keeping inflation within a band of 2-4 percent, under a freely floating exchange rate, and fiscal policy geared to maintaining a central government “structural” surplus of 1 percent of GDP, starting this year (see Box 2). Unemployment concerns are being addressed mainly by reallocating government expenditure towards labor-intensive projects, and through a program to facilitate the rescheduling of certain debts of small- and medium-sized enterprises (SMEs), which are an important source of employment in Chile. The authorities expected the current slowdown in output growth to be reversed later in the year, aided by the more accommodating monetary policy of the last several months and an envisaged gradual improvement in world economic activity and copper prices. The staff was broadly in agreement with the authorities regarding their overall policy approach and the outlook for the economy. Staff projected for 2001 real GDP growth of 4 percent, end-period inflation of 3.2 percent, and an external current account deficit of 2.2 percent of GDP.9 These projections are similar to those in surveys of private forecasts.

Chilex’;s New Structural Balance Target1

Soon after taking office in March 2000, Chilex’;s new government committed itself to tightening the central government accounts, defining its objective in terms of a new structural balance measure. The announced objective was a surplus of 1 percent of GDP, to be first achieved in 2001 and then maintained in each subsequent year.

Potential benefits of the new fiscal framework. By removing apparent short-term “noise” from the fiscal balance, the new measure helps focus policy discussions on medium-term considerations. Since the target refers to a more controllable concept, it permits a tighter standard of accountability, and the commitment to a precise target does not imply suppressing automatic stabilizers. Consistent application of the new framework would rule out a trend deterioration of the central government balance, potentially bringing benefits from enhanced credibility. Chile already enjoys a low ratio of total public sector debt to output; whether this would decline further would depend on, inter alia, how policy responds to copper export price shifts, the performance of accounts not covered by the new target (see below), and the pace of economic growth.

Derivation of the structural balance begins with a set of accounting adjustments, deriving from the traditional central government balance the new “adjusted balance,” which better captures changes in net worth (e.g., all flows related to privatization and government lending are put below the line). Adjustments are then made for the estimated effects on revenue of the output gap and deviations of copper export prices from a notional “reference price.”

International comparison. Chilex’;s fiscal balance target is notable for applying in every year, and for making an allowance for changes in export (copper) prices but no allowance for cyclical expenditure fluctuations. The framework is without escape clauses or other formal room for maneuver; but neither is it legally binding, being a self-imposed commitment of the current government.

Interpretation. The adjustments noted above yield a much smoother, more controllable fiscal balance measure, but two main issues arise if it is interpreted as an indicator of the underlying position of the public sector. One is that the measure does not capture the public enterprises, off-budget military expenditure, or the central bank losses. A second issue concerns the determination of the reference copper price, around which “cyclical” movements are defined. Here arises a fundamental problem that complicates fiscal policymaking in Chile more generally: it is very difficult to predict copper prices in the future, thus it is unclear how to set the reference price. 2 Using a fixed reference price would imply no policy adjustment at all to copper price shocks. On the other extreme, using the spot price as a reference would imply full and immediate policy adjustment to price shocks. So far, the reference price used in Chile has been quite smooth in relation to actual prices.

Evolution of the new framework. Looking ahead, as experience with the new framework grows, a number of questions will be relevant. Will the framework be made legally binding and otherwise become formalized? Will it address, ex ante, possible deviations from the point-target level, and specify consequences and responses in those situations? Will the framework continue to require little policy adjustment to copper price movements? Would the level of the ongoing target ever be revised? What procedures will be developed to determine the output gap and copper price adjustments both accurately and transparently?

1 See also the background paper, “Chilex’;s Structural Balance Target: Aspects of Design and Implementation,” Chapter 1 in the Selected Issues Paper for this consultation.2 See ”Prediciendo El Precio Del Cobre: ?Más Allá del Camino Aleatorio?” E. Engel and R. Valdes (2001).

16. There was broad agreement with the authorities on the stance of monetary policy. The level of the policy real interest rate, at an historical low, seems consistent with maintaining inflation within the 2-4 percent target band. Output is expected to be below its potential level during most of the relevant policy horizon, and the risks around the central bankx’;s baseline inflation projection appear to be well balanced. The authorities said that they were satisfied with the working of their inflation targeting framework under the freely floating exchange rate, and indicated that they might reduce the publication lag of minutes of monetary policy meetings from the current three months.10

17. On fiscal policy, the staff agreed with the authoritiesx’; projection of a central government structural surplus of 0.9 percent of GDP in 2001, following a surplus of 0.2 percent of GDP in 2000. (The authorities consider this projection to be sufficiently close to their target, and thus do not plan an adjustment in policies). At the same time, the staff projects a central government actual deficit of 0.9 percent of GDP, broadly unchanged from last year, as both revenue and expenditure are envisaged to grow in line with GDP.11 The modest overall deficit of the state-owned enterprises would shrink by about ½ percentage point of GDP this year, as the cost of last yearx’;s oil price subsidy would not be repeated owing to a change in the rules for setting the subsidy.12 Central bank losses would be unchanged at 0.9 percent of GDP. Overall, the deficit of the combined public sector would decline from 2.6 percent of GDP last year to 2.1 percent of GDP in 2001. Staff considers this stance broadly appropriate in the current economic environment and in consonance with the easing of monetary policy.

18. The mission discussed the official methodology for calculating the structural fiscal balance, and the use of a fixed-point target to be achieved every year. The staff favored using a comprehensive measure of the structural balance, including (in addition to the central government balance) the central bank losses, and preferably also the overall balance of the state-owned enterprises. The government has influence on the operations of these enterprises (for instance, by approving their budgets), and some of these firms have performed quasi-fiscal activities. Also, as the government is presumably the ultimate guarantor of their liabilities, the performance of these firms is relevant for the net worth of the government. The authorities, however, considered that the current measure of the structural balance provides the proper yardstick for the stance of fiscal policy in the case of Chile. They said that state-owned enterprises operate with a market orientation and not as a fiscal policy instrument, and noted that central bank losses were taken into account in setting the level of the target for the structural balance.

19. The staff also recommended using a copper reference price that reflects expected prices over the next few years, rather than a notional “long-run” price. The long-run value of copper prices is highly uncertain, so temporary shocks are difficult to identify. Also, these shocks seem to disappear quite slowly. Thus, using a reference price that is very different from the current price runs the risk that the actual price would remain substantially different from the reference price for a very long and uncertain period; in that case, the measured structural balance might not accurately capture the underlying fiscal situation. On this basis, it would be preferable to use as a reference price the best available projection of average prices over the next few years, rather than a value less directly related to the current price. The staff also suggested introducing some flexibility in the fiscal target (a band around the point-target, or explicit escape clauses that would justify departures from the target) to respond to major events.13 The authorities said that they were considering the possibility of using a medium-term (rather than long-term) horizon for the copper reference price, and were contemplating establishing a commission that periodically would revise that price.

20. The authorities expressed interest in having the fiscal transparency ROSC module prepared for Chile for the next consultation. They also explained that the government had made commitments to congress that will enhance the transparency of fiscal policy, including the preparation of studies on important aspects of the public sector operations (for instance, on contingent fiscal liabilities). The mission welcomed these plans, and noted the importance of making these studies available to the public. Regarding transparency in the pursuit of the structural balance target, the mission recommended formalizing and making transparent the setting of the copper reference price, publishing the method used to estimate the output gap, and regularly publishing in detail the various accounting and cyclical adjustments used to derive the structural balance measure.

21. The authorities estimated that the recently approved law on tax evasion and tax avoidance would increase government revenue by about 1 percent of GDP over the medium term (the projected effect for this year is very small). The law seeks to reduce tax evasion by strengthening the administrative power of the tax and customs authorities, raising fines and defining new tax crimes, and to reduce tax avoidance by closing certain tax loopholes.

22. The authoritiesx’; strategy to address high unemployment includes the reallocation of government expenditure towards labor-intensive projects and some new employment programs (involving resources for about 0.7 percent of GDP). This effort will be concentrated in the months with high seasonal unemployment, and will give priority to regions with high unemployment rates and to heads of households that became unemployed. Some of the programs aim at helping generate jobs in the private sector by contracting projects with the private sector or by subsidizing private employment. For instance, a new wage subsidy program provides payments for the equivalent of 40 percent of the monthly minimum wage for a period of four months, plus an initial payment of about 50 percent of the monthly minimum wage (to finance training), for the hiring of a new worker.

23. The authorities also explained the recent measures to help SMEs, intended to support employment in this labor-intensive sector. These measures include the rescheduling of arrears on taxes and pension contributions (for up to 1.3 percent of GDP), and incentives for the rescheduling of commercial bank loans to these firms. The government will provide a partial guarantee (for up to 0.6 percent of GDP) on rescheduled loans, and will place long-term deposits (for up to 0.4 percent of GDP) in those banks that reschedule loans, in order to facilitate maturity-matching between assets and liabilities. The authorities considered that the risk of moral hazard from these measures was small: (i) the program for bank loans could be used to reschedule performing as well as nonperforming loans (so it would not provide incentives to delay payments); (ii) the previous rescheduling of pension contributions was done 16 years earlier (so firms would not expect it to be repeated in the foreseeable future); and (iii) the rescheduling of tax arrears was undertaken together with renewed government emphasis on tax collections (including through their legislative initiative on tax evasion and tax avoidance).

24. The staff sees the authoritiesx’; decision to reallocate government spending towards labor-intensive projects as a reasonable response to a problem for which no immediate and complete solution is available. This effort is in part aimed at generating private-sector jobs and improving the skills of unemployed workers, and will be covered by resources already budgeted. The measures to help SMEs, on the other hand, are less well-targeted to reduce unemployment, create a contingent fiscal liability, and could weaken firmsx’; discipline in the timely payment of their obligations; however, to the extent that these measures are not expanded in coverage, and are not repeated in the future, these drawbacks seem to be limited. In any case, the staff sees the role of these initiatives as providing temporary relief to unemployment problems until a strong and sustained pickup in economic activity starts to generate employment again. However, for unemployment to decline on a sustained basis it will be crucial to maintain labor market flexibility. In this regard, the staff considers that the increase in the minimum wage of 5.5 percent granted on May 2001 is likely to add pressure on unemployment, particularly among young workers, for whom the unemployment rate is above 20 percent. The authorities were of the opinion that the impact of the recent minimum wage adjustment would be limited as it was small in real terms. However, as a significant share of workers is believed to receive wages close to the minimum wage, even a modest increase could represent a constraint to hiring decisions.

25. The external current account deficit is projected to increase moderately in 2001, reflecting mainly a deterioration in the terms of trade of about 2 percent, as growth of both export and import volumes is envisaged to slow. Exports would be affected by the decline in foreign demand and only a modest increase in copper production, while imports would be limited by lower output growth and the recent real depreciation of the currency. The current account deficit is expected to be financed mainly by bank loans and bond issuance. Net foreign direct investment inflows are envisaged to be positive, although small, following large gross inflows in the first quarter of the year.

B. Financial Sector and Structural Issues

26. Indicators of banks soundness remain favorable. The share of nonperforming loans in total bank loans was 1.8 percent in March 2001, unchanged from a year earlier;14 as of February 2001, loan provisions amounted to 140 percent of nonperforming loans and the risk-weighted capital-assets ratio was 14.8 percent for the banking system (and above 10.5 percent for every bank). The staff noted Chilex’;s strict bank supervision practices, but observed the absence of a legal framework for the supervision of financial conglomerates on a consolidated basis. The authorities said that a committee of the various agencies supervising the financial system had initiated a coordinated monitoring of the largest financial conglomerates in Chile, with the final objective of eventually supervising these groups on a consolidated basis. Also, to enhance its ability to combat money laundering, the government submitted to congress a proposal that would create a financial intelligence unit to analyze suspicious transactions and report the cases that merit investigation to the judicial authorities.

27. The staff was provided with an assessment of Chilex’;s compliance with the Basel Core Principles of banking supervision, prepared by external consultants hired by the bank supervisory agency (SBIF). The assessment is generally positive, and most of the issues that were identified as needing improvement were being addressed at the time the report was completed (February 2000). The staff considered that it was also important for Chile to make progress on two issues not yet addressed, enhancing the operational independence of the SBIF and providing officials of the SBIF with proper legal protection in the discharge of their responsibilities. The authorities saw those matters as relevant to further strengthen the institutional capacity of the SBIF, but did not include them in their work program because they felt that addressing them was not urgent and the legislative agenda for this year was already very heavy.

28. The authorities indicated that they were discussing ideas for the capitalization of the central bank, but were not sure when a specific plan would be finalized and implemented.15 They explained that the current situation does not hamper the central bankx’;s ability to pursue its objectives. The mission agreed with this point, but considered it important to solve this problem promptly, in order to enhance fiscal transparency and consolidate public confidence in the central bankx’;s independence.

29. The mission shared the authoritiesx’; view that the elimination of remaining restrictions to capital flows and the plan for a capital market reform, both announced in April, would be important to increase the efficiency and liquidity of Chilean financial markets. These initiatives constitute the last step in a slow and careful relaxation of restrictions imposed both on the domestic financial markets and the capital account in the aftermath of the banking crisis in the early 1980s (see Box 3).

Liberalization of the Capital Account

In April 2001, Chile completed a long and careful process of capital account liberalization, and the country is now essentially free of capital account controls.

Compared to most other emerging market economies, Chilex’;s approach to capital account liberalization has been particularly cautious, reflecting the lessons the authorities drew from the - currency and banking crisis of the early 1980s. The rapid capital account liberalization in preceding years was considered to have contributed to the overvaluation of the peso and the large foreign borrowing which—together with weak banking regulation and supervision—were identified to be the main causes of the crisis. In order to help prevent a similar episode, the Chilean authorities decided to impose strict prudential regulations on financial institutions and restrictions on external capital flows.

The new central bank charter of 1990 gave the central bank authority to impose or remove a number of restrictions on foreign exchange operations. The central bank used these powers over the following years in a process that led to a comprehensive liberalization of the capital account. The process was asymmetric, as restrictions on outflows were relatively rapidly removed but restrictions on inflows were maintained during most of the 1990s. Some controls on capital inflows were judged useful as the central bank sought to maintain some monetary policy independence, to limit the real appreciation of the currency, and to prevent a heavy reliance on short-term borrowing, which was suspected to be destabilizing. In part reflecting these additional objectives, the process of liberalization was not always smooth, and in some instances was reversed. For instance, the unremunerated reserve requirement on capital inflows was used actively throughout the period, being tightened at times of substantial inflows (e.g., 1992, 1995, 1996).

Toward the end of the 1990s, the process of capital account opening gained renewed impetus, reflecting complementary policy developments and a reduced supply of capital to emerging markets in general, including Chile. The unremunerated reserve requirement on capital inflows was set to zero in September 1998, and the minimum holding period was eliminated in May 2000. In April 2001 the remaining restrictions were removed as the central bank considered that the conditions for completing the liberalization were in place, including: (i) solid macroeconomic fundamentals; (ii) successful adoption of a floating exchange rate and inflation targeting regime; (iii) convergence of the inflation rate to that of industrial countries; (iv) a fiscal policy framework aimed at a small structural surplus; (v) a high standard of solvency of the financial system, including the development of instruments to hedge exchange rate risk and regulations that take into account the exchange-rate risks of bank clients; (vi) increased diversification of foreign trade; and (vii) a high level of international reserves.

Sources: Le Fort G., 1994, “Financial System Macroeconomic Stability: The Chilean Experience,” in “Financial Sector Reforms, Economic Growth and Stability,” ed. Shakil Faruqui in Economic Development Institute of the World Bank Seminar Series; and Nadal-De Simone, F and P. Sorsa, 1999, “A Review of Capital Restrictions in Chile in the 1990s.” IMF Working Paper, WP/99/52.

30. The main restrictions eliminated by the central bank include (i) remaining authorization requirement for some capital transactions (which together with a major simplification of regulatory prerequisites removed administrative burden and uncertainty); (ii) the nonremunerated reserve requirement on capital inflows (which had a zero rate since September 1998); (iii) the minimum rating and maturity requirements for bond issues; and (iv) remaining restrictions on ADR issues. These measures were welcomed by private market participants.

31. Also welcomed was the proposed capital market reform, which among other measures would: (i) eliminate certain capital gains taxes for both foreigners and residents; (ii) reduce taxes that foreigners pay on interest from bonds issued domestically by Chilean residents (to equal the rate on bonds issued abroad); (iii) create a stock exchange for “emerging” companies (those deemed to have high growth potential); (iv) widen the choices for individuals to invest their pension savings; and (v) deregulate the mutual funds and insurance industries. The authorities have already submitted draft legislation for this reform.

32. The authorities noted that the unemployment insurance scheme approved by congress in April 2001 was an important step in enhancing the social safety net. The new scheme is based on a combination of individual accounts financed by employers and employees (these accounts can be accessed in the event of lay-off, voluntary separation, retirement, or work disability) and an insurance fund financed by employers and the government (to ensure a minimal level of protection for workers with low balances in their individual accounts). The pre-existing system of severance payments (one month of salary for every year worked at the firm, up to a maximum of eleven months of salary) is maintained, but some of its adverse effects on labor market flexibility are reduced. Severance payments may discourage employers from laying-off workers, and also discourage workers from voluntarily changing jobs (as they would forego “severance payments rights” they have accumulated in their current job); these effects are particularly important for long-tenure workers. Under the new unemployment insurance scheme, the employer contribution to an individual account would be counted against the required severance payments in the event of lay-off (thus reducing the marginal cost of laying-off workers), and the worker keeps the amounts deposited in his individual account in the event of voluntary separation (thus reducing the disincentives for voluntary changing jobs). The new scheme will be introduced gradually, with individuals starting employment after May 2002 being required to participate, and those already employed by that date being able to do so on a voluntary basis. The new unemployment insurance system will increase indirect labor costs by up to 3 percent of wages. On balance, the staff considers this scheme an advance over the previous situation.

33. The authorities explained that the labor reform proposal currently in congress seeks to strengthen workersx’; rights and introduce additional flexibility in labor contracts.16 The mission - viewed favorably certain aspects of the proposal (such as reducing restrictions on work schedules, and allowing part-time contracts and work at a distance). However, it expressed concern over other elements (such as allowing collective negotiations at the inter-firm level, and increasing the cost of replacing striking workers) which would reduce labor market flexibility, imposing further constraints on employment creation.

34. The mission supported Chilex’;s open trade regime, and the continued unilateral reduction of its uniform external tariff. The mission considered that the price-band scheme on certain agricultural products has resulted in high tariffs that distorted resource allocation and generated a negative response from trading partners, and thus argued for its elimination. The authorities said that the price bands are used in response to distortions in international markets in these products owing to subsidies and protection to industrial countriesx’; producers; subsequent to the mission the bands were renewed through late-2002 and early-2003. The authorities also said that they had no plans to renew the safeguards on products under price bands when these safeguards expire later this year. (Whether the tariffs resulting from the operation of the price bands will conflict with the WTO limit for these goods will depend on the evolution of international prices). The authorities indicated that they were making progress in their trade negotiations. They also restated their interest in becoming a full member of Mercosur, but said that this would be considered only if Chile is not required to adopt Mercosur common external tariff rates, and maintains its independence to negotiate trade agreements until Mercosur external tariff rates converge to that of Chile.

35. The authorities explained that they are not planning further sales of state-owned enterprises, but instead are considering changes to the statutes of those enterprises to improve their efficiency (by giving them incentives to behave as if they were privately owned), and to enhance the transparency of their operations.17 They also explained that operation of all the water utility companies that remain in state hands (which serve about 25 percent of customers) would be transferred to the private sector under concessions for 20-30 years, moving away from the previous approach of selling water companies to the private sector (with the state keeping of the shares). The authorities prefer concessions because this will keep the public sector away from the management of the firms, thus avoiding conflict of interest with its regulatory activities, and water rights as well as the residual value of the companies will remain in state hands, which the authorities consider positive as it widen the choices for future public policies. Other concessions being planned for 2001 include the management of roads, railways, airports, dams, and prisons. The mission considered that the envisaged changes in the statute of state-owned enterprises was likely to represent an improvement over the current situation, but that it would be difficult to replicate completely the set of incentives that private ownership would provide. Thus, it would be advisable to move in the direction of privatizing some of those firms.

C. Medium-Term Outlook

36. The staff prepared a medium-term scenario, presented in Table 6, based on the assumptions of a recovery of copper prices (close to 20 percent in U.S. dollar terms over the next five years), a gradual strengthening of world economic activity, the continuation of sound macroeconomic policies, and continued progress with structural reforms. On that basis, real GDP growth is envisaged to recover over the next few years, and settle at 5½ percent over the medium term. Admittedly, there is considerable uncertainty about the rate of potential growth for the Chilean economy. The difficulty in sustaining a strong recovery from the recent recession has led to a general downward revision of potential growth estimates, from the rates of 7 percent or higher that were usual until recent years.18 However, revisions based on the behavior of output over the last few years, which has an important cyclical component that is difficult to isolate, necessarily carry significant uncertainty. Thus, the staff does not rule out the possibility that important advances in structural areas could result in growth rates somewhat higher than those in Table 6.19

Table 6.

Chile: Balance of Payments—Medium-Term Projections

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Sources: Data provided by the Chilean authorities; and Fund staff estimates.

Includes errors and omissions.

Gold at market valuation. End-year stock of reserves in relation to imports of the following year.

Chilean export price.

37. The medium-term scenario envisages a gradual widening of the external current account deficit to about 3 percent of GDP, a level that would be consistent with declining debt and debt-service ratios (Table 7). Domestic investment would remain broadly unchanged as a ratio to GDP, while national savings would decline modestly. Public sector savings would grow, mainly reflecting an increase in central government revenue resulting from the closing of the output gap and the increase in copper prices. In contrast, private sector savings would decline to levels more similar to those observed during 1990-98.

Table 7.

Chile: External Debt and Debt Service

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Sources: Central Bank of Chile; and Fund staff estimates.

Excludes direct short-term trade credits.

Original maturity basis.

38. Regarding competitiveness, the staff understands that the authorities are inclined to focus directly on the current account rather than on exchange rate-based indicators, and correspondingly on influencing national savings rather than the nominal exchange rate. The staff believes that this focus is appropriate, particularly under the current system of a flexible exchange rate and inflation targeting. In any case, as of end-May 2001 the peso was estimated to be about 14 percent weaker in real effective terms than at its peak in late 1997; such a level should be consistent with continued growth of export volumes.

39. As regards risks in the medium-term scenario, the staff considers that plausible negative shocks would be unlikely to induce an external crisis or disorderly adjustment, but these shocks could imply a period of slower growth.20 Among possible shocks, considerable uncertainty attaches to copper export prices; although the consensus view is that there is more room for these to rise than fall, it is possible that the recovery envisaged in the medium-term scenario would not fully materialize.21 Also, although foreign investors are expected to continue to favorably distinguish Chile among emerging markets, it is possible that developments abroad could reduce gross investment flows into Chile. The authorities indicated that in the event of adverse external shocks they would allow the exchange rate to adjust freely and continue with their approach of moving the policy interest rate only to the extent that it is needed to meet their inflation target, a view that was shared by the mission.

D. Statistical Issues

40. The staff considers that Chilex’;s economic data are broadly adequate for surveillance purposes. The authorities are working to enhance information on the financing items of the fiscal accounts, and to obtain reliable estimates for direct trade credits (which are currently missing from the official statistics on external debt). Progress in these areas, as well as in improving the coverage of military transactions in the fiscal and external data, would enhance the usefulness of the official statistics. The authorities are also revising the national accounts, updating the base-year from 1986 to 1996 to reflect important changes in the structure of the economy and relative prices that occurred in the intervening period. The publication of the revised series, planned for March 2002, will permit a better assessment of economic developments and prospects.

41. The mission that recently prepared the ROSC Data Module for Chile concluded that: (i) Chile is in full observance of the SDDS since March 30, 2000 and meets the specifications for the data dimension for all data categories, using two SDDS flexibility options, and for the dissemination of Advance Release Calendars; (ii) all agencies have a legal and institutional framework that supports statistical quality, demonstrate professionalism, and are transparent in their practices and policies; (iii) statistics generally follow international accepted standards for compilation, with a few exceptions largely due to the transition to the most current methodologies; (iv) accuracy and reliability are high in most data categories, but could be improved in others; and (v) accessibility of data and metadata is high, and assistance to data users is of high quality. These issues are discussed in detail in the ROSC Data Module issued separately as a background paper for this consultation.

IV. Staff Appraisal

42. Chilex’;s long record of very strong economic performance was interrupted by a downturn in economic activity in the late 1990s, from which output started to recover in late 1999. In 2000, the authorities restrained government expenditure to reverse a previous trend for a weakening of the public accounts, and early in the year firmed-up monetary policy to contain inflationary pressures arising in part from rising oil prices. As output growth started to slow in the second half of the year, the outlook was for inflationary pressures to decline, and the authorities started easing monetary policy.

43. The staff believes that the authoritiesx’; macroeconomic policy stance for 2001 is appropriate. Monetary policy, with interest rates at an historical low, seems consistent with maintaining inflation within the target band of 2-4 percent under present circumstances. Fiscal policy is geared toward achieving a central government surplus of 1 percent of GDP on a structural basis, defined to exclude the revenue effects of output gaps and deviations of copper prices from a notional reference level. This objective implies this year a moderate strengthening of the fiscal position at the combined public sector level.

44. Unemployment, which has remained high, is being addressed mainly through reallocating government spending towards labor-intensive projects, and a program to facilitate rescheduling of debt of small and medium-sized enterprises, which are an important source of employment in Chile. The reallocation of spending is a pragmatic and reasonable response to a difficult problem for which no easy solution is available. The rescheduling of debts seems less appropriate, as it creates a contingent fiscal liability and runs the risk of generating moral hazard; thus, it would be advisable not to expand the coverage of these measures. All these initiatives will contribute to alleviate unemployment problems transitorily, and it would be important to accompany them by caution in granting adjustments to the minimum wage and to keep labor markets flexible more generally.

45. Assuming that demand strengthens later in the year on account of the recent easing of monetary policy and a gradual improvement in the external environment, real GDP in 2001 is expected to grow by about 4 percent and inflation to converge close to the center of the band by the end of the year. The external current account deficit and other indicators of external vulnerability would remain at comfortable levels.

46. In 2001, the authorities are consolidating a number of important initiatives to enhance macroeconomic management. The target band for inflation became effective this year, and monetary policy continues to be managed transparently with the primary objective of maintaining low and stable inflation. The authorities also started to set their fiscal target on the basis of a measure of structural balance, which helps guide fiscal policy with a medium-term perspective, and enhances credibility in the governmentx’;s commitment to a sound fiscal position. As the official definition of the structural balance includes only the accounts of the central government, it will be important also to monitor the evolution of central bank losses and the operations of state-owned enterprises to have a more comprehensive view of the public accounts. Also, to have a more reliable indicator of the underlying fiscal position, it would be important to use a copper reference price that reflects projected prices over the next few years, rather than a notional long run price, to limit the possibility that actual prices would differ substantially from the reference price for a very long and uncertain period. The authorities also are taking steps to increase fiscal transparency, including participation in the fiscal transparency ROSC module, which is welcome. Early progress in the capitalization of the central bank would also add to transparency, and would help consolidate public confidence in the central bankx’;s independence.

47. The banking system remains sound, and the banking supervisory agency (SBIF) continues to apply strict standards. The SBIF is coordinating the monitoring of financial conglomerates with the other supervisory agencies of the financial system; this important step should be followed by the establishment of a legal framework for the supervision of these conglomerates on a consolidated basis. To strengthen the supervisory framework further, it would be important to increase the operational independence of the SBIF and provide its officials with proper legal protection in the discharge of their responsibilities.

48. The authorities have continued to take steps to further develop domestic financial markets and strengthen Chilex’;s financial integration with the rest of the world. Congress approved legislation to enhance corporate governance; the central bank widened the type of transactions that banks may undertake—including for hedging purposes—and eliminated remaining restriction on capital flows; and the government has submitted to congress a proposal for a capital market reform. All these measures should contribute to deeper and more efficient domestic financial markets, proper incentives for capital flows in the context of a sound banking system, and ultimately a higher potential growth for the economy.

49. The recently-approved unemployment insurance scheme, which will enhance the social safety net and reduce distortions generated by severance payments but increase indirect labor costs, is, on balance, an advance. The government also has submitted to congress a labor reform proposal, which seeks to strengthen workersx’; rights and introduce some flexibility in labor contracts. The authorities should remain watchful, as some elements of this proposal have the potential to introduce rigidities in labor markets, with adverse consequences on the economyx’;s ability to generate employment.

50. Chile has a very open trade regime and has continued to reduce unilaterally its uniform external tariff, which is commendable. It would be desirable that the authorities also reevaluate the long-standing practice of keeping the domestic prices of certain agricultural products within bands, with a view to helping improve resource allocation and solidify Chilex’;s reputation as a country committed to open international trade.

51. Although the pace of the recovery from the 1998-99 recession has not met all expectations, Chilex’;s medium-term outlook remains favorable. Growth will be supported by continued prudent monetary and fiscal policies—to ensure an environment of low and stable inflation—and by recent structural reforms, including capital account liberalization and import tariff reduction. Protecting labor market flexibility will be important, and consideration could be given to new privatizations. As both monetary and fiscal policies have a rules-orientation, risks to the medium-term outlook mainly arise from a less favorable external environment, including lower global growth, weaker copper prices, and reduced capital flows to emerging economies. Such factors could reduce the pace of growth for a few years, but Chilex’;s comfortable level of reserves, strong banking system, credible policy framework, and exchange rate flexibility, should help the country adjust to a changing external environment.

52. The recently-completed ROSC data module provides a positive overall assessment of Chilex’;s data dissemination practices and data quality, and data received by the staff are timely and broadly adequate for surveillance purposes. The authorities should persevere in their efforts to improve the statistical base, and it would be particularly useful to widen the coverage of fiscal and external statistics to fully capture military transactions.

53. It is expected that the next Article IV consultation with Chile will take place on the standard 12-month cycle.

Appendix Chile: Fund Relations

(As of May 31, 2001)

I. Membership Status: Joined 12/31/45; Article VIII. Chilex’;s exchange system is currently free of restrictions on the making of payments and transfers for current international transactions.

II. General Resources Account

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III. SDR Department

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IV. Outstanding Purchases and Loans:

V. Financial Arrangements:

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VI. Projected Obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs): None

VII. Exchange Arrangements: The exchange rate is permitted to float freely. On June 21, 2001 the interbank exchange rate was Ch$622.96 per U.S. dollar.

VIII. Article IV Consultations: The Executive Board concluded the 2000 Article IV consultation on July 7, 2000 (SM/00/116).

IX. Technical Assistance: In May 1997 a mission from the Fiscal Affairs Department (FAD) assisted the authorities in the evaluation of Chilex’;s tax system. In June 1998 an FAD mission advised on the desirability of moving to a system of accrual accounting and budgeting. In June 1999 a mission from FAD and STA advised on public expenditure management, the implementation of accrual based accounting, and government finance statistical systems. In May 2000 a mission from STA advised on money and banking statistics. In March 2001, a mission from STA assessed the quality of national account statistics. In March-April 2001, a mission from STA assessed Chilex’;s data dissemination practices against the IMFx’;s SDDS. In April-May 2001, a mission from FAD advised on VAT administration issues.

Appendix II Chile: Financial Relations with the World Bank

The most recent Country Assistance Strategy (CAS) for Chile was discussed by the Board in April 1995. The emphasis of the Bankx’;s assistance program for Chile was on selectivity and an increased reliance on the government in determining future assistance priorities for both sector work and new lending, through a strategic and productive dialogue with the Bank. It aimed at implementing about one new project each year and at providing guarantees to certain infrastructure projects. The latter was not realized and, after operations for secondary education and rural poverty were approved, Chile was not an active borrower between FY 1996 and FY 1998. However, Chile made use of Bank nonlending services, including the preparation of a poverty assessment, a study on tax reform and a study on catastrophic health insurance. In addition, technical assistance was provided under the reimbursable program in areas such as privatization, regulatory issues, and education. After the hiatus in borrowing from the Bank since FY96, three new operations, totaling US$160 million, were approved in FY99: Higher Education Reform Loan (US$145 million), Second Municipal Development Loan (US$10 million), and Millennium Science Initiative LIL (US$5 million). The undisbursed balance of the Chile portfolio totals US$143.2 million, as of March 31, 2001.

Lending for FY2001-FY03 is now expected to target water resources, public financial management and education. The World Bank will be preparing a new CAS in FY2002.

Chile: Financial Relations with the World Bank

(In millions of U.S. dollars)

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Source: World Bank.

Includes repayment from third parties.

As of May 29, 2001.