CHILE Staff Report for the 2005 Article IV Consultation

The staff report for the 2005 Article IV Consultation for Chile highlights short-term economic outlook and fiscal policy under the structural surplus rule. The government is firmly committed to the structural surplus rule. The core inflation rate has risen, reflecting the gradual closing of the output gap and the second-round effects of higher energy prices. The central bank plans to continue gradually withdrawing monetary stimulus. It has appropriately started to raise interest rates, and further increases will likely be needed, depending on developments in inflation and the closing of the output gap.

Abstract

The staff report for the 2005 Article IV Consultation for Chile highlights short-term economic outlook and fiscal policy under the structural surplus rule. The government is firmly committed to the structural surplus rule. The core inflation rate has risen, reflecting the gradual closing of the output gap and the second-round effects of higher energy prices. The central bank plans to continue gradually withdrawing monetary stimulus. It has appropriately started to raise interest rates, and further increases will likely be needed, depending on developments in inflation and the closing of the output gap.

I. Background

1. Chile’s adherence to a sound and consistent policy framework over the past two decades has helped foster macroeconomic stability and poverty reduction. This policy framework has been based on prudent fiscal policies, a gradual move to inflation targeting, and trade openness. During the 15-year period that ended in 1997, Chile’s rate of economic growth averaged 6½ percent a year, per capita income more than doubled, and poverty rates were cut in half. While economic growth slowed significantly during 1998–2003, to 2¾ percent a year on average, reflecting in part the regional financial crisis, the sharp improvement in the terms of trade that started in mid-2003 contributed to a strong economic rebound in 2004. The economic recovery has continued into 2005.

2. Upon taking office in 2000, the current administration introduced a key fiscal innovation—the structural surplus rule, while the central bank completed the transition to a full-fledged inflation-targeting framework. Under the rule, fiscal policy is, for the first time, anchored to a target—a cyclically-adjusted surplus of 1 percent of GDP in the accounts of the central government. The rule has worked well, in very different macroeconomic environments, providing effective countercyclical stimulus to the economy over the cycle. The inflation targeting framework has been successful at keeping inflation low—2¾ percent a year on average during 2000-04, while allowing the peso to float freely.

3. Progress has been made in several areas since the last Article IV consultation, in line with the views of Executive Directors. The fiscal stance has remained prudent; higher revenue from the increase in copper prices has been sterilized; and the overall surplus of the government used to selectively prepay debt. Also, the proposal to introduce a royalty in the mining sector was modified and care was taken to ensure that the recently-introduced mining fee does not negatively impact foreign investment. In the financial sector area, steps have been taken to further improve risk management in the banking system and reduce risks in the insurance industry, but the recapitalization of the central bank still has not taken place. Prompt passage of the Capital Market II draft law by Congress would help ensure progress in the reforms aimed at strengthening regulation and supervision of the securities industry.

4. Congressional and presidential elections are scheduled for December 2005, with a new administration taking office in March 2006. Political consensus in Chile on the macroeconomic framework remains very strong. All the main candidates have reaffirmed their commitment to fiscal prudence, inflation targeting, and trade openness. Policies to maintain strong economic growth and further reduce income inequality are expected to dominate the political debate, with emphasis on the issues of health, education, and support to small and medium-sized enterprises.

II. Recent developments

5. A strong external environment has helped spur Chile’s economic growth in 2004 and early 2005 (Box 1). Robust growth in the global economy, including Asia—which absorbs one third of Chile’s total exports, has helped boost mineral export prices, particularly copper, Chile’s main export commodity.1 During 2004 and in early 2005, Chile’s year-on-year rate of economic growth has been around 6 percent, with a strong recovery in private investment, particularly in mining, telecommunication, transportation, and construction. In recent months, the recovery has also been supported by an increase in consumption, driven by improved labor market prospects and continued strength in consumer borrowing. The rebound in the terms of trade, a mining export boom (16 percent in volume terms), and a strong performance of nontraditional exports have resulted in a current account surplus of 1½ percent of GDP in 2004—an improvement of 3 percentage points from 2003.2

6. Monetary policy has remained supportive, with low pressure on inflation during most of 2004. The Chilean peso has continued to float freely and, reflecting the improvement in Chile’s terms of trade, it has appreciated sharply against the U.S. dollar since mid-2003. This has contributed to low inflation, with the 12-month rate of increase in the CPI remaining below the 2–4 percent inflation target band of the central bank during most of 2004. In the context of a still weak economic recovery, the monetary authorities eased their policy stance in late 2003 and early 2004. Later in the year, with the economic recovery well under way and with inflation forecasts moving above the center of the target band, the central bank initiated a tightening cycle. Since September 2004, it has raised its policy rate on seven occasions, by a total of 175 basis points, to 3½ percent in mid-July 2005. Nevertheless, monetary conditions still remain supportive, with the policy rate only moderately positive in real terms.

Developments in 2004 and Early 2005

GDP growth. Real GDP grew by 6.1 percent in 2004. After registering a strong rise during the last quarter of 2004 (7¼ percent on a year-on-year basis), the rate of economic growth is estimated to have moderated to just over 6 percent during January–May 2005.

Inflation. The 12-month headline inflation rate was 2.4 percent in December 2004, edging up to 2.7 percent by June (with 12-month core inflation at 2.4 percent). Wage growth moderated in recent years, averaging 3½ percent in 2004, but has recently inched up slightly, to 4½ percent in May.

uA01fig01

Real GDP and Real Investment

(in trillions of 1996 pesos)

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Employment. Employment grew by 3.3 percent during 2004 and by 4.3 percent during the 12-month period ended in May 2005. Although strong economic growth encouraged more workers to return to the labor market, the unemployment rate has declined from 9.2 percent in May 2004 (seasonally adjusted) to 8.1 percent in May 2005.

Current account balance. Boosted by improved terms of trade, the current account registered a surplus of 1½ percent in 2004. Copper prices have hovered at around US$1.50 a pound in the first half of 2005, up from US$1.30 in 2004 and US$0.81 in 2003. Nonmining exports also performed strongly in 2004, rising by 1½ percent in volume terms.

uA01fig02

Copper Prices

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Gross international reserves. At end-June 2005, reserves amounted to US$16¾ billion (16½ percent of GDP and over 120 percent of short-term external debt).

Public sector accounts. The overall balance of the central government registered a surplus of 2½ percent of GDP in 2004. The quasi-fiscal deficit of the central bank narrowed slightly, from 0.8 percent of GDP in 2003 to 0.7 percent in 2004.

uA01fig03

Labor Market Developments

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Exchange rate. During 2004, the Chilean peso appreciated against the U.S. dollar in the first half of the year, but reversed this change in the second half. So far in 2005, it has remained broadly stable.

Sovereign spreads. Chile’s sovereign spreads remain the lowest in the region, at 60 basis points on June 30. In March 2005, Fitch upgraded Chile’s sovereign long-term foreign currency rating to A, following a similar upgrade by S&P in January 2004.

uA01fig04

Country Risk

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

7. Consistent with the structural surplus rule, the position of the central government improved sharply in 2004, and is expected to remain strong in 2005. The overall balance of the central government shifted from a deficit of ½ percent of GDP in 2003 to a surplus of 2¼ percent in 2004. The government used most of the surplus to prepay debt—a total of US$2 billion in 2004 and early 2005, including USS½ billion to multilaterals and US$½ Vi billion on a central bank loan extended at the time of the 1980s banking crisis.

III. Report on the discussions

8. Chile’s return to a strong macroeconomic performance testifies to the importance of consistent policy frameworks and solid institutions. There was full agreement between the staff and the authorities that the overall policy framework had contributed to the return of sustained economic growth. Macroeconomic policy implementation has centered on well-established rules and institutions, reinforced in recent years by strict adherence to the structural surplus rule, the sound implementation of the inflation targeting framework, and a floating exchange rate regime. These policies, in the context of increasing trade integration and a robust financial system, have helped provide counter-cyclical stimulus to the economy while ensuring effective resilience to external shocks. There was agreement also that one of the main tasks ahead would be to continue to improve the efficiency of the economy in order to sustain high rates of economic growth and reduce poverty further.

A. Short-Term Economic Outlook

9. The authorities and staff concurred that the short-term outlook remained very positive. Sentiment in the business community was generally bullish, with many participants considering that the long-anticipated economic recovery was well-entrenched. The authorities estimated that, in the context of a favorable global environment, real GDP growth would be in the range of 5¼–6¼ percent in 2005 and 5½ percent in 2006—broadly in line with the staff forecast and that, on that basis, the output gap would close in 2007. They considered that the pick-up in domestic demand, particularly investment, would help support economic activity in 2005, while the impact of net foreign demand would tail off. Domestic investment was projected to rise by ½ percentage point of GDP, to 22¼ percent of GDP, while consumption would also pick up, boosted by higher incomes, an increase in employment, and strong consumer lending. A possible source of weakness was a build-up in inventories observed over the preceding three quarters, which could signal a somewhat weaker-than-anticipated growth in domestic demand in the second half of this year.

Selected Economic Indicators, 2003–2005

(in percent; unless otherwise indicated)

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

10. There was agreement also that, although some external risks could weigh negatively on growth, these were limited in 2005. There was the risk that high oil prices could lead to a slowdown in global demand and in Chilean exports. Existing global imbalances could also lead to disorderly adjustments that would affect negatively the world economy. However, in the short run, strong copper demand from Asia was likely to keep prices at a high level, or perhaps even higher than projected at the time of the mission.3 The authorities thought that the risks from regional political or economic instability would pose few difficulties, as past experience had shown that Chile was able to attract foreign investment even when unfavorable sentiment prevailed in some countries of the region.

11. A source of concern was the supply of regional gas, including from Argentina. During the first five months of 2005, actual exports of gas from Argentina to Chile fell to about 75 percent of contractual levels, with significant and unpredictable daily variations. However, the authorities noted that about three fourths of Chilean firms that use gas in the production process had already converted their plants to use alternative sources of energy when needed. In addition, new hydroelectric plants have come into production or are under construction. Therefore, the direct impact of gas cuts on domestic output was expected to be small—amounting at most to ¼ percent of GDP in 2005. However, there were also indirect effects on production costs in the economy, associated with the shift from gas to more costly alternatives.

12. Chile has built important safeguards against potential vulnerabilities. Total public debt (including central bank debt) has declined from 41½ percent of GDP in 2001 to 35 percent in 2004, and public external debt has dropped to about 10 percent. Private external debt has also fallen significantly as a share of GDP in recent years, from about 48 percent in 2001-02 to 36 percent at end-2004.4 Although external debt is mostly denominated in foreign currencies, net exposures to exchange rate fluctuations remain limited, with about 40 percent of private external debt originating in the tradable good sectors. Moreover, in the nontradable good sectors, financial hedging against currency risks has increased in recent years and is available at relatively moderate costs. The central bank has built important buffers against external risks, with gross official reserves amounting to US$16 billion at end-2004, equivalent to 17 percent of GDP and covering more than 110 percent of debt maturing during the year.

B. Fiscal Policy under the Structural Surplus Rule

13. The authorities and staff agreed that the structural rule, in place since 2000, has served Chile well. The rule aims at maintaining a cyclically-adjusted surplus of 1 percent of GDP in the accounts of the central government. Under the rule, the government saves all copper revenues from the state copper company CODELCO above a long-term reference price for copper. Other central government revenue is smoothed over the business cycle, using an estimate of potential output. With the help of two independent panels of experts, the government estimates structural revenue adjusted for the long-term price of copper and potential GDP (Box 2). Central government expenditures are set in the budget law, so that the difference between structural revenue and actual expenditure is equal to 1 percent of GDP.

The Role of the Two Independent Panels of Experts

  • Composition. Each year, the Finance Ministry assembles two independent panels of experts. Each panel is composed of 12–14 members who are widely regarded as experts in their fields. The Finance Ministry has been careful to ensure that the panels have a balanced representation, particularly the potential output panel, where there is generally a wide dispersion of views.

  • Consultation. The panels are consulted each year prior to the preparation of the budget. To ensure transparency, the information requested from the panels is specific, and all information is published on the website of the Budget Office immediately after the panels have met.

  • Copper price panel. The Finance Ministry asks this panel to provide a ten-year forecast of copper prices, and the reference price is set as the arithmetic average of the forecasts (excluding two most extreme estimates). For 2005, the long-term reference copper price was set at US$0.93 a pound.

  • Potential output panel. From the panel, the ministry requests growth forecasts of: (i) labor force; (ii) real investment; and (iii) total factor productivity. Officials compute an average of these forecasts (excluding the two most extreme values) and use them to estimate the output gap from a production function. At the suggestion of the expert panel, officials have made successive improvements to the production function estimates.

14. The structural surplus rule constitutes a useful tool for policy making in terms of budget preparation, benchmark for spending and revenue targets, and transparency (Box 3). In recent years, this rule has served as the primary pillar of fiscal policy. The rule allows the government to run deficits when economic growth is below trend—during 2000-03, the deficit averaged ⅔ percent of GDP a year—and to accumulate surpluses when the external environment is favorable and economic growth strong. In 2004, the central government registered an overall surplus of ¼ percent of GDP, and it is projected to register surpluses averaging 1⅔ percent of GDP in 2005-06.

The Fiscal Rule, a Useful Tool for Policies

  • Budget preparation. At the time of the budget preparation, the rule provides useful ex-ante guidance for setting spending plans. Revenue projections are based on the long-run copper price and projected output levels, with reliance on the two panels of experts.

  • Benchmark for spending and revenue targets. During the year, the spending target is actively used to constrain fiscal policy. In January and June, the Budget Office updates revenue and spending forecasts and, if needed, takes steps to raise revenue or cut spending.

  • Spending adjustments. The rule includes few adjustments, which aids in transparency but makes it stricter. For example, there are no adjustments for changes in inflation or exchange rates. However, some flexibility exists to shift the savings under one expenditure line to other lines. The rule also includes a small contingency fund (¼ percent of GDP) to expand emergency employment programs or increase capital expenditure by up to 10 percent over budgetary allocations, while remaining within the 1 percent structural surplus limit.

  • Transparency. The fiscal rule has helped promote fiscal transparency and compliance with international standards. In particular, in recent years the authorities have brought greater transparency and discipline to military spending—including spending previously treated in off-budget accounts. At present, most government operations, including extra-budgetary operations, are treated according to the 2001 Government Financial Statistics Manual.

15. The authorities were planning to introduce a draft law in congress to formalize some aspects of the rule, including with respect to future pension liabilities. The initiative would seek the creation of two funds to be included in the structural surplus rule: (i) one to allow for employment spending during periods of high unemployment; and (ii) another one to build resources for future pension payments. Regarding future pension payments, the authorities agreed with the staff that the coverage of the pension system had fallen short of the original goals of the reform. In particular, many workers are not participating in the pension system long enough to qualify for a minimum pension.5 As a result, they are running the risk that they will reach old age with insufficient savings to fund an adequate pension. The authorities’ objective would thus be to pre-fund a government account that would gradually help mitigate the future costs of old-age programs. Staff encouraged the authorities to design this mechanism in such a way that it does not discourage workers from contributing to their own retirement accounts. The draft law would also aim at strengthening the internal audit of the government and require future governments to publish an annual estimate of the structural budget balance.

16. Based on their experience with the fiscal rule, the authorities thought that some adjustments could be made in the future to strengthen counter-cyclical policies. They noted that it was conceivable that the 1 percent of GDP level of the structural surplus could be changed at some point in the future, particularly if the definition of the fiscal accounts were to be broadened to include the quasi-fiscal deficit of the central bank. The authorities also noted that there was still a pro-cyclical bias in revenue and spending because the estimates of structural revenue used to establish the expenditure level did not seem to fully smooth out the swings in income tax and VAT collections over the business cycle. They noted that, by capturing the cyclicality of revenue better, they would be able to follow the practice in several OECD countries, under which expenditure is allowed to rise during economic downturns, in part to make room for unemployment benefit payments. Such a change would help provide an additional component to existing counter-cyclical policies. Staff also suggested that the definition of copper-related operations in the copper price adjustor could be broadened to include, inter alia, corporate tax payments by private mining companies and the proceeds from the recently-introduced fee on mining activity.6

17. Fiscal projections point to a central government surplus equivalent to 2¼ percent of GDP in 2005.7 Revenue projections take into account the steady increase in tax collections registered in recent months, particularly income taxes and VAT receipts, reflecting higher corporate profits, a sharp increase in domestic demand, and improvements in tax administration. As a percent of GDP, expenditure has been declining in recent years, from 22¼ percent in 1999–2000 to 20¼ percent in 2004, despite increases in social spending averaging 4 percent a year in real terms (Figure 4). The mission took the view that, in 2005, it would be important to avoid permanent increases in spending and to keep the rate of expenditure growth to a moderate level (the budget already assumes a 5½ percent increase in expenditure in real terms). It thus strongly encouraged the authorities to save any excess tax revenue. The authorities expected the preparation of the budget for 2006 to be finalized by September, and indicated that it would be consistent with the fiscal rule, even though it would be implemented by the next administration. On the basis of projected WEO copper prices, the balance of the central government would show a surplus of around 1½ percent of GDP in 2006.

Figure 1.
Figure 1.

GDP and Determinants of Growth

Contributions to Real GDP growth, by selected components

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Figure 2.
Figure 2.

Unemployment Rate

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Figure 3.
Figure 3.

Exchange Rate and Inflation

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

Figure 4.
Figure 4.

Central Government Expenditure

Citation: IMF Staff Country Reports 2005, 315; 10.5089/9781451951592.002.A001

18. The authorities intend to use the strength of the fiscal position to consolidate their debt management strategy. They plan to continue using the forthcoming surpluses to retire debt and replenish the Copper Stabilization Fund (the Debt Sustainability Analysis is presented in Appendix IV). The Finance Ministry has been coordinating the issuance of new public debt with the central bank, with a view to establishing government benchmarks in the long-term segment of the market while the central bank focuses on short- and medium-term issues. During the remainder of 2005, the government does not plan to issue new bonds in the international markets, but it is considering placing a ten-year peso-denominated issue locally. It also plans to participate in the Euroclear trading system, with a view to facilitating the access of international investors to the domestic market.

C. A Sound and Credible Monetary Policy Framework

19. Implementation of the inflation targeting framework has been successful in reducing inflation and anchoring expectations. Under this framework, the central bank aims at keeping expected CPI inflation within the 2–4 percent target range over a 12–24 month horizon. Although the 12-month rate of headline inflation trailed below the lower end of the central bank’s target range during most of 2004, it has returned well within the target range since end-2004. In recent months, core inflation has also returned within the target band and inflation expectations have been close to the mid-range of the target band.

20. The staff enquired whether the below-target inflation outturn in 2004 reflected an undershooting bias in policy decisions. The authorities stressed their commitment to a symmetric treatment of the lower and upper ends of the target range and observed that, in recent years, the monetary policy response has been broadly appropriate. Specifically, they noted that, in the face of downward pressures on prices in late 2003-early 2004, the central bank had decisively cut its policy rate by a total of 100 basis points. They attributed the sharp drop in headline inflation, below the target band during most of 2004, to the earlier appreciation of the peso, a reduction of margins in the retail sector, and a slower increase in unit labor costs. The determined cut in the policy rate had helped bring inflation within the target range, while providing support to the economy. In September 2004, when it had become clear that the inflation forecast had returned well within the target range over the 12–24 month horizon, the central bank began gradually raising its policy rate. By that time, the pick up in economic activity also justified withdrawing monetary stimulus. These actions have helped keep inflation expectations well anchored near the middle of the 2–4 percent target range.

21. There was agreement that the gradual withdrawal of monetary stimulus should continue. The monetary authorities noted that the policy rate remained below its neutral level and indicated that they planned to continue reducing the stimulus gradually. They recognized that there was some uncertainty about the actual level of the neutral rate, but interpreted the recent increase in underlying inflation as an indication that a neutral policy stance would require further tightening. The staff noted that the still benign price pressures, firmly anchored expectations, and high credibility of the central bank suggested a measured approach to tightening, particularly given the uncertainties about the level of the neutral rate. The authorities generally agreed and stressed that the next moves in interest rates would depend on developments in inflation and the closing of the output gap.

22. Staff shared the central bank’s view that the inflation target band of 2—4 percent remained appropriate. Staff enquired whether the low rates of inflation registered during 2004 warranted consideration of a lower target range. Central bank officials thought that the 2–4 percent target range was appropriate for Chile, for a series of reasons. First, in emerging market countries, there tends to be a relatively high upward measurement bias in price indices because, typically, large relative price changes result in pronounced variations in the composition of the consumption baskets. Second, the target range provides a buffer for adjustments in relative prices, given the downward rigidity in nominal wages associated in part with still-widespread wage indexation. Third, setting the target at too low a level carries risks of entering into deflation. The authorities also noted that changing the target range could undermine the credibility of the central bank and weaken the nominal anchor value of the target. The staff fully agreed with the central bank that the inflation target range should be kept at the 2–4 percent level. Central bank officials are in the process of developing a full-fledged dynamic stochastic general equilibrium (DSGE) model to complement their current set of macro-econometric forecasting models. Staff welcomed the central bank’s efforts toward further enhancing its forecasting framework and, in that context, its plans to deepen its understanding of the transmission mechanism.

23. The central bank is moving ahead with its plan to reduce its yearly deficits. Since November 2003, after a comprehensive evaluation of the benefits and costs of holding international liquidity, it has embarked on a program to gradually redeem its stock of dollar-denominated bonds while simultaneously reducing its stock of gross international reserves.8 The U.S. dollar debt stock has been cut by about US$1 billion, to US$5 billion, and the central bank plans to reduce it further by US$2½ billion during the remainder of 2005. The joint retirement of dollar-linked debt and reduction in foreign reserves is projected to help narrow further the deficit of central bank to about ½ percent of GDP in 2005. The authorities were confident that the associated reduction in gross international reserves was well anticipated by the market and would therefore have no adverse impact on financial stability.

24. The gradual recapitalization of the central bank awaits finalization of an agreement on a new methodology with the government. While previously the authorities had envisaged that the government would recapitalize the central bank upfront, the government now plans to cover the central bank’s yearly deficits. To this end, discussions are ongoing between the central bank and the government on a definition of these deficits and on a mechanism to compensate for them. Staff stressed that an appropriate mechanism should help ensure that the annual payments are transparently registered in the fiscal accounts and do not impair the institutional independence of the central bank while gradually helping rebuild its capital.

25. The authorities reiterated their commitment to a flexible exchange rate. They noted that, since the Chilean peso has been floating freely, it has displayed more volatility than in the past, reflecting in part developments in the external terms of trade and in the major currencies. However, the economy had adapted well to this new situation and the market for financial hedges had grown rapidly. Furthermore, upward pressures on the peso had moderated in the course of the past year, reflecting in part high public sector saving (effectively sterilizing part of the improvement in the terms of trade), an increase in the foreign assets of pension funds, and financial intermediaries’ investments abroad to take advantage of arbitrage opportunities. In real effective terms, the peso has appreciated by about 10 percent since mid-2003, following a depreciation of close to 29 percent from early 1998 to mid-2003—suggesting that competitiveness remains appropriate. In addition, wage increases in the industrial sector have been moderate in recent years, averaging ¼ percent a year in real terms over the past three years. In the authorities’ view, a stronger increase in nominal wages in recent months and the reduction in official working hours (from 48 hours to 45 hours) that became effective in early 2005 have been accompanied by large productivity gains, leaving unit labor costs broadly unchanged. However, they recognized that the recent pick up in nominal wage increases would need to be kept under close scrutiny, to ensure that it does not lead to pressure on inflation.

D. Financial Sector Issues

26. The Chilean banking sector is robust, with strong profits and a low level of impaired assets. Capital adequacy is 13½ percent and the ratio of nonperforming loans to total loans has remained low, at 1¼ percent in May 2005, with a provisioning rate of over 160 percent. Consumer lending has begun to moderate, with the 12-month rate of growth down from 37 percent in December 2004 to 23 percent in May 2005. Despite this relatively rapid increase in consumer lending, bank supervisors were confident that the risk classification and provisioning procedures remained adequate. They also noted that the increase registered during 2004-05 was taking place after several years of virtually flat consumer lending, and from a low base. The growth of this high-margin market contributed to an increase in banks’ return on equity to 19 percent in the 12-month period ended in April 2005.

27. Although competition in the banking sector has intensified with the entrance of niche players, staff analysis suggests that there is further room for competition in the sector.9 Cross-country comparisons show that the profitability of Chilean banks is above what can be explained by macroeconomic and banking sector characteristics in Chile. Although regulatory barriers to entry are low, competition from other non-bank financial intermediaries still plays a small role and the restrictions on the investments of private pension funds (the largest institutional depositors) remain in place, both of which appear to have contributed to high bank profitability.

28. Progress in the implementation of the 2004 FSAP recommendations awaits the approval of the Capital Market Reform II draft law by Congress. The FS AP stressed the need for greater competition in financial services, modernization of the securities markets infrastructure, and reforms of the segmented financial oversight organization to enhance efficiency and risk management. The recent change in regulations that allow banks and corporates to trade call and put options is a further step toward implementing the FSAP recommendations. Many FSAP recommendations, including netting arrangements for derivatives, and institutionalizing the Committee of Superintendents, are to be addressed in the comprehensive Capital Markets Reform II law (CMII). However, this draft law has so far stalled in Congress, in part because of the difficulty to secure consensus on technically complex financial issues. The mission noted that prompt approval of the draft law was critical to help ensure a well-sequenced implementation of FSAP recommendations. The authorities reiterated their hope that the law could be approved in the coming months.

29. In the pension and insurance sectors, progress on further reforms has been limited. In late 2004, the authorities prepared proposals aimed at introducing more competition among private pension funds and a risk-based approach in the management of their investments. The debate on these issues is still ongoing, and the authorities noted that they needed more time to build consensus. In the insurance sector, the annuities market plays a unique role in Chile as the natural continuation of the pension fund system during retirement. To help minimize the contingent liabilities of the government associated with the guarantees that it provides on the minimum annuity performance, the mission called for vigilant supervision of the insurance market. The officials noted that the update in mortality tables to fully reflect higher life expectancies and the associated increase in provisioning requirements are expected to help reduce default risks, but that improvements to credit risk regulations were still pending.

30. Domestic capital market activity is buoyant, with new bond issues of US$2–3 billion a year. Chilean long-term interest rates are broadly in line with long-term rates in mature markets, at around 2½ percent for 10-year inflation-adjusted bonds. The market for financial hedges has grown rapidly in recent years, enhanced by an increase in the supply of foreign exchange rate hedges by pension funds.10 To further enhance the development of the financial market, the staff suggested to gradually phase out the stamp tax and the retention tax on lending by non-residents. The authorities agreed that these taxes introduced distortions, but did not see room to reduce them in the near future because of the large associated tax collections.

31. In the area of AML/CFT, the Financial Intelligence Unit (FIU) became fully operational in May 2005. In November 2004, it was accepted as an Egmont member and, in April 2005, MFD provided training to its staff. New legislation, enhancing the ability of the FIU to obtain information, is expected to be approved by Congress during 2005. GAFISUD is in the process of assessing the regulatory oversight of its members for cash remittances, and the mission encouraged the authorities to participate in this project.

E. Laying the Ground for Strong and Equitable Medium–Term Growth

32. The authorities and staff agreed that structural policies should focus on a comprehensive approach to medium-term growth. The mission noted that implementation of the government’s Pro-Growth Agenda had helped deepen the reform efforts and promote total factor productivity growth. The authorities, as well as most players in the political spectrum, recognized that it would only be possible to sustain strong long-term growth by further increasing human capital, while simultaneously continuing to improve income distribution. Significant progress has been made toward achieving Chile’s Millennium Development Goals (Table 9).

Table 1.

Chile: Selected Economic Indicators

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Sources: Central Bank of Chile, Ministry of Finance, Haver Analytics, and Fund staff estimates.

Contribution to growth.

Excluding time deposits of private pension funds.

Nominal rates, in percent per annum, period average, on 90-day central bank promissory notes.

Gross saving of the general government sector, including the deficit of the central bank.

Table 2.

Chile: Summary Operations of the Central Government

(in percent of GDP)

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Sources: Ministry of Finance (DIPRES) and staff estimates.

The staff projections reflect the economic assumptions for the WEO forecast.

The 2005 figures are based on the June update to the budget, and the 2006 figures are from the December 2005 budget forecast.

Table 3.

Central Government Spending, 1996–2004

(by GFSM functional classification, in percent of GDP)

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Source: Ministry of Finance: DIPRES.
Table 4.

Chile: Summary Operations of the Public Sector

(in percent of GDP)

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Sources: Ministry of Finance (DIPRES), Central Bank of Chile, and staff estimates.

Intergovernment transfters between central and local governmental units

On a cash basis.

Table 5.

Chile: Indicators of Financial and External Vulnerability

(in percent; unless otherwise indicated)

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Sources: Central Bank of Chile, Haver Analytics, WEO, and Fund staff estimates.

Official measure of non-performing loans.

Data as of April 2005.

Gold valued at end-period market prices.

As measured by the central bank; includes amortization of medium and long-term debt falling due during the following year.

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

Morgan-Stanley Capital International index (Dec/1987=100).

Table 6.

Chile: Balance of Payments—Medium-Term Projections

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Sources: Central Bank of Chile, Haver Analytics, and Fund staff estimates.

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

Chilean export price index up to 2004; projections for 2005 onwards derived from WEO assumptions.

Net of estimated losses of the central bank.

WEO assumptions.

Table 7.

Chile: External Debt and Debt Service Projections

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Sources: Central Bank of Chile, Haver Analytics, and Fund staff estimates.

Original maturity basis; end of period basis.

At current prices and exchange rates.

Table 8.

Social and Demographic Indicators

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Sources: Haver Analytics, INE, World Bank, Encuesta CASEN, and staff estimates.
Table 9.

Millennium Development Goals

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Sources: World Bank Development Indicators database, April 2004; authorities’ estimates for 2003.