This buff updates information presented in the staff report (SM/02/195). This additional information does not modify the thrust of the staff appraisal. Some of the information has resulted in a moderate downward revision of the staffs projection for output growth.

1. The monthly index of economic activity increased in April-May by 2.4 percent (year-on-year), bringing the rate of growth in the first five months of the year to 1.9 percent (year-on-year). Unemployment data for the period March-May indicate a seasonally adjusted rate of just over 9 percent, essentially about the average level of the last several quarters. In the first six months of the year, exports declined by 5 percent (year-on-year) in U.S. dollar terms, while imports fell by 10 percent (partial information suggests that export volume expanded during this period, while the figure for imports reflects declines in both prices and volume). Inflation recently has been unexpectedly low, as both the headline and underlying price indices declined slightly in June, taking the 12-month rate of inflation down to 2.0 percent and 2.7 percent, respectively. Over the first six months of this year, both price indices grew by only 0.8 percent.

2. In financial market developments, the peso weakened and international bond spreads increased suddenly, though not severely, at mid-June. Over three trading days, June 19-21, the peso lost 4 percent, moving from 672 to almost 700 pesos per U.S. dollar. Subsequently, the exchange rate has tended to remain in the 690-700 pesos per U.S. dollar range. Also at mid-June, the spreads on sovereign bonds and on an index of corporate bonds jumped, both by about 45 basis points (compared with an increase of around 100 basis points in the EMBI+ index of sovereign spreads), reaching about 200 and 300 basis points, respectively. Subsequently, sovereign bond spreads have stayed close to 200 basis points, while the index of corporate spread widened further in the early days of July, to about 330 basis points. The stock market has weakened gradually, declining by more than 10 percent since end-May in domestic currency terms (the main Chilean index has continued to move rather closely with the U.S. Dow Jones index).

3. In terms of policy developments, the central bank lowered its target policy interest rate from 4 percent to 3¼ percent in its July monetary policy meeting. At that time, the policy council noted risks associated with recent declines in the world’s major stock markets, and that the prospects for growth of Chile’s trading partners had been affected by negative developments in several Latin American economies. The central bank also noted signs that output and domestic demand in Chile had expanded less than expected in the second quarter, and indicated that projections for growth over the coming quarters would need to be lowered. Overall, the central bank judged that the recent low level of inflation, the persistence of the output gap, and low rate of exchange rate pass-through would allow for a new monetary policy impulse to be consistent with inflation converging to the middle of the target band over the policy horizon.

4. On the basis of recent indicators, including developments in the external environment, the staff considers that the projection for output growth in the staff report for this year and next, 3 percent and 5½ percent, respectively, are not as likely to materialize as a scenario involving a somewhat slower recovery of domestic demand and output. The revised staff projections are for growth of 2.6 percent for this year and 4.8 percent for 2003. The staff projection for inflation at end-2002 has also been revised downward, from 3.0 percent to 2.5 percent, for both headline and underlying CPI measures. These projections take into account this month’s cut in the policy interest rate, which seems appropriate given the circumstances.

5. Regarding recent financial market developments, the staff considers that the drop in the peso and increase in bond spreads are noteworthy more for their suddenness and association with weaknesses in other emerging markets, than for their size. These movements have been moderate and needed to be viewed in a broader perspective, including Chile’s floating exchange rate regime and absence of exchange market intervention during the period. For some 12 months now, the exchange rate has tended to remain in a range of about 650-700 pesos per U.S. dollar, always fluctuating but showing no strong direction or trend. Recent market exchange rates near 700 pesos per U.S. dollar are neither destabilizing nor likely to generate significant inflation. Regarding the rise in bond spreads over the last month, this followed a decline in spreads earlier this year, and the levels of these spreads remain relatively low by emerging market standards and manageable (including because of the low level of U.S. interest rates).