This note discusses Chile's macroeconomic policy framework, the role of institutions in Chile, policies over time, export specialization and economic growth, trade policy strategy and recent agreements, an overview of recent developments in capital markets, and corporate financing in Chile. The role of the public sector in establishing debt benchmarks, an assessment of the country’s external position, distress among Chile's foreign-owned firms, balance sheets of public sector finances, and an update on the Chilean banking system have been noted in this paper.

Abstract

This note discusses Chile's macroeconomic policy framework, the role of institutions in Chile, policies over time, export specialization and economic growth, trade policy strategy and recent agreements, an overview of recent developments in capital markets, and corporate financing in Chile. The role of the public sector in establishing debt benchmarks, an assessment of the country’s external position, distress among Chile's foreign-owned firms, balance sheets of public sector finances, and an update on the Chilean banking system have been noted in this paper.

I. Overview

1. This report presents analyses of select issues on the Chilean economy, its policies and prospects. The contributions are grouped in four thematic areas: the macroeconomic and institutional framework; exports, trade policy, and growth; capital markets; and assessing the strength of the economy’s financial position.

2. Chapters II and III examine Chile’s macroeconomic and institutional framework.

3. Chapter II focuses on current policy, Chile’s macro policy framework—with central bank policies focused on inflation targeting, in the context of a floating exchange rate, and fiscal policy aiming at a structural balance target—is still relatively recent. The inflation targeting framework in Chile currently consists of: (i) a pre-specified continuous inflation target band (ii) a pre-announced “policy horizon;” and (hi) timely communication of the authorities’ inflation forecast, the rationale for their policy decisions, and the reasons for any temporary deviations from the inflation target. An important supplement to this framework is the absence of an exchange rate target. Exchange rate policy calls for zero intervention under normal circumstances, with the possibility of intervention only under exceptional circumstances. When intervention does take place, the authorities announce the event, do not target a specific exchange rate and the amount of the intervention is revealed.

4. Chapter II also explains the mechanics of the fiscal rule. This mechanism has increased transparency and accountability of the Treasury, by defining a specific medium-term fiscal policy path while enabling automatic stabilizers. The rule removes policy discretion and has strict technical requirements. On the latter, the use of expert panels to determine cyclical adjustments to meet the rule has enhanced transparency and credibility.

5. Chapter III takes a longer views of Chile’s reform experience and considers the role played by institutional factors in Chile’s economic performance. A sizable literature has documented Chile’s sound economic policies over the last decade, but less attention has been given to the factors behind the adoption and continuation of such policies. A deeper view of the Chilean experience is sought by considering how institutional arrangements may have helped to identify “sound policies” and allow them to be sustained over time.

6. The review of Chile’s institutions focuses on four policy areas where it is widely acknowledged that Chile is particularly strong (and which are among the core areas of IMF work): sustaining fiscal policy discipline; policies to maintain price stability; policies that promote financial stability; and an open and stable trade policy regime. Among the numerous institutional arrangements discussed, the constitutional features that have promoted fiscal discipline—including budget process rules and the tight constraints on subnational governments—and effective central bank independence have been especially important.

7. Chapters IV and V relate to the role of trade in Chile’s development.

8. Chapter IV considers the role, past and prospective, of exports in growth of the Chilean economy. The focus is on export specialization: in the Chilean case following comparative advantage often has meant exporting goods that are natural resources-based. The chapter offers a critical assessment of the notion that such exports are necessarily stagnant and impact negatively on a country’s rate of growth. The chapter argues that in the case of Chile such exports were associated with positive spillovers leading to the creation of new products. Furthermore, the chapter suggests the need to promote human capital accumulation in order to take advantage of these spillovers, increase productivity, and continue diversifying the Chilean export basket.

9. Chapter V considers Chile’s trade policy. The trade policy regime has been highly liberal for quite some time. The trade policy strategy has included the unilateral reduction of tariffs, as well as a wave of trade agreements. The chapter focuses especially on recent trade agreements with Chile’s two largest trading partners, the European Union and the United States.

10. Chapters VI – VIII relate to financial markets.

11. Chapter VI reviews the development of domestic capital markets and corporate financing in recent years and draws on remaining policy challenges going forward. The analysis underscores the role of macroeconomic policies and structural reforms as the driving factors underpinning the development of local securities markets in the 1990s. The presence of a well-developed and large institutional investor base has also played a fundamental role as stable and growing source of domestic finance. While equity markets saw a rapid expansion in the early 1990s, the domestic corporate bond market experienced a remarkable resurgence since 2000 as large corporate firms, in particular, sought to time the market following the sharp drop in domestic interest rates.

12. Despite this remarkable progress, the future development of domestic capital markets faces key challenges related to the low liquidity in equity and corporate bond markets, and the high degree of ownership and investor concentration. Recent changes in financial regulation and legislation have sought to address concerns on the relative depth of capital markets and effectiveness of corporate governance while improving capital markets regulation. Policymakers have thus been actively working to improve financial market infrastructure seeking to establish appropriate incentives to harness market discipline and self regulation. As demonstrated by the recent reforms, the authorities have underscored the role of bridging missing markets, promoting liquidity and transparency, and providing incentives to wider access to investment resources.

13. Chapter VII has a narrower focus, on the public sector’s role in establishing debt benchmarks. In 2002, the authorities began a program of modernizing debt management procedures, aiming to increase the liquidity, and facilitate the internationalization of. The domestic fixed-income securities market. Such internationalization will take time, but careful establishment of benchmarks (as described in Chapter VII) is a step in that direction. The benchmarking initiative builds on earlier actions to reduce the use of inflation-indexed debt and to extend the maturity of public debt. The authorities expect that recent reforms will generate a rising volume of financial intermediation, and allow the market to create new hedging markets for specific risks.

14. Chapter VIII summarizes recent empirical work on an important aspect of the monetary policy transmission in Chile: “pass-through” of moves in the monetary policy interest rate to retail interest rates in the banking system. The focus is on a study conducted by IMF staff members for the Sixth Annual Conference of the Central Bank of Chile. The chapter also highlights findings of another recent study, which uses bank-level data. In contrast to some previous findings that the pass-through in Chile is weak, both studies suggest that while there may be some room for greater speed and completeness of interest rate pass-through, during the period studied pass-through was generally adequate and not atypical.

15. Chapters IX – XII present several perspectives for assessing the financial position of the Chilean economy.

16. Chapter IX provides an assessment of Chile’s external position, integrating information on the country’s international investment position and structure of external debt. The analysis considers the possibility of an external liquidity squeeze on the balance of payments while testing for potential solvency problems. The approach combines the standard IMF debt sustainability analysis framework and alternative tests using newly published data on Chile’s international investment position. The analysis focuses on (i) external debt dynamics, (ii) sensitivity of gross external financing requirements to specific shocks, and (iii) implications of Chile’s international investment position for external vulnerability.

17. The analysis underscores the strength of Chile’s aggregate external position. In a standard debt sustainability framework, various hypothetical shocks considered would lead to substantial, though temporary, increase in the external debt-to-GDP ratio. However, the risks of these standardized shocks seems remote, given the strength of Chile’s current policy framework, as well as the already relatively weak states of such variables as the real exchange rate and copper export prices. Liquidity problems are not expected given the country’s significant liquid foreign assets, held by both the public and private sectors. Chile’s large foreign asset-liability structure is another source of strength. The large foreign direct investment in Chile helps explain that foreign-owned Chilean resident firms held more than half of Chile’s total external debt. Sensitivity analysis using the net international investment position also shows the dampening effects of the large direct investment on the country’s aggregate net liability.

18. Chapter X looks at some recent cases of distress in Chile’s corporate sector, including the first example in years of a sizable Chilean-resident company experiencing distress. These cases involved companies that are mainly foreign-owned (such companies account for more than half of Chile’s external debt), so the behavior of the parent company can be key to the outcome. Importantly, investors’ perceptions of Chile and Chilean companies more generally have not been significantly affected by these companies’ difficulties.

19. Chapter XI examines the public sector financial position. The analysis emphasizes the balance sheet information, and in particular is able to make use of newly-available data on both the debt and financial assets of the Chilean public sector. Much of the analysis is on the finances of the central government, which in Chile has been the key to the evolution of total public debt. Taking into account the government’s structural balance target, it is difficult to see debt sustainability problems emerging, as long as this target (or other restrained fiscal policy) is met. The central bank’s balance sheet is also examined, including its tendency to run a modest operational deficit, but also its considerable strengths in terms of foreign exchange and liquidity positions. Though the bank’s deficit has been fairly stable and has not interfered with its monetary policy objectives, the chapter notes some steps, including a capital injection from the government, that could be taken to improve its financial position. The situation of the public enterprises appears sound, especially in light of their overall profitability and limited debt.

20. Finally, Chapter XII provides an update on the Chilean banking system, indicating that it continues to remain robust, also highlighting some structural features and recent developments. In particular, the chapter documents the recent “Inverlink” case, in which a corrupt private financial company fell, after having sold stolen government securities in the secondary market This case originated outside of, but nevertheless had repercussions for, the banking system. The chapter discusses the responses of the authorities to this episode, both the immediate actions to address liquidity needs, as well as forward-looking measures to improve financial security.