Introduction

1. On behalf of our authorities we thank the staff for their insightful report and set of papers. They reflect well the open and frank discussion held in this Article IV Consultation. They are also the result of the broad scope of the mission’s enquiry, which included meetings with government officials, private sector representatives, think tanks, and the economic teams of the presidential candidates.

2. The gradual development of sound monetary and fiscal policies over the years has resulted in a very robust macroeconomic policy framework since 2000. The fiscal policy framework is based on a solid commitment to a structural fiscal budget surplus of 1 percent of GDP. The monetary and financial policy framework is characterized by inflation targeting, floating exchange rate, open capital account, sound financial regulation and supervision, and the maintenance of prudent levels of international reserves. The adoption of this framework has allowed macroeconomic policy to be more efficient in smoothing the effects of internal and external shocks on output, and in controlling inflation. At the same time, significant progress has been made in microeconomic policy, institution building, and structural reforms.

3. While these developments have contributed to build up significantly the resilience of the economy, a casual or uninformed reading of the Staff Report could suggest that GDP evolution is mainly driven by fluctuations in the price of copper, and the domestic inflation rate by movements in the foreign exchange rate. In sharp contrast with such an interpretation, the fact is that the performance of the Chilean economy since the adoption of its current policy framework in 2000 has been very successful at administrating and smoothing out, in a sustainable way, fluctuations of the global economic conditions, changes in commodity prices, external and internal negative energy shocks, regional economic and financial turbulence, and the political cycle. During this period, the amplitude of the business cycle has been substantially lower than under similar conditions in the past, and annual inflation has been maintained around the target range set by the CBCh between 2 and 4 percent. The CBCh utilizes an inflation targeting framework and in this framework the evolution of the exchange rate is one among many determinants of the inflation dynamics. Furthermore, the pass-through from exchange rate depreciation to CPI inflation has been reduced significantly in recent years.

Developments and Near-term Economic Prospects

4. During the nineties, Chile was one of the fastest-growing economies in the world, to a large extent due to gains in efficiency. In the past 15 years, the per capita income gap in Chile has diminished compared to high-income countries by around 25 percent. High growth and focalization of social expenditure have resulted in major advances in social indicators and poverty alleviation.

5. After the slowdown in 1998-2003, favorable global and domestic economic conditions have contributed to higher economic growth. Fifteen years of continued high expansion averaging around 6½ percent growth per year was slowed down by the onset of the Asian crisis and by global and regional turbulence in 1998-2003. Appropriate and timely monetary and fiscal policies were able to smooth the fluctuations, ending up with an average GDP growth of 2¾ percent a year. Robust world economic growth, high commodity prices, and a stronger expansion of the most important trade partners such as the Asian economies and the U.S., have been at the background of a 6 percent GDP growth during 2004 and 2005. This higher growth rate also has been decisively supported by an expansionary monetary policy.

6. The pick-up in economic activity has gradually become more broad-based across sectors and aggregate demand components. Both tradable and non-tradable sectors have contributed to the over 6 percent GDP growth rate in 2004 and the first five months of 2005. The value added in the energy sector has recovered, thanks to the improvement in hydrological conditions and the reduction in natural gas cuts. Fixed capital formation remains brisk, whereas exports have decelerated somewhat their year-on-year expansion. Consumption has gradually gained strength, while the pace of inventory accumulation has not accelerated further. Even though the main negative risks to the short-term outlook have tended to dissipate, the positive risk linked to a persistently favorable evolution of capital formation has become more apparent.

7. These very favorable growth developments have not yet translated into higher underlying inflationary pressures. Most, if not all news in the short-term inflationary outlook have been linked to the direct effect of higher oil prices and the related incidence in the regulated services tariffs. Although some propagation of these shocks to core inflation is expected in the next quarters, its magnitude remains very uncertain. Meanwhile, unit labor costs do not yet exhibit year-on-year positive increases, in spite of higher nominal wage growth and the reduction in the legal workweek, thanks to the sharp pace of labor productivity growth.

8. Macroeconomic policies have remained supportive of the current cyclical upturn. Monetary policy conditions remain clearly expansionary in spite of the 175 basis point increase, from 1.75 percent to 3.5 percent, in the monetary policy rate since September 2004. Credit and monetary aggregates still show high growth rates, and domestic interest rates remain low, while the real exchange rate has not shown an additional appreciation in the face of improving fundamentals. Fiscal expenditures in 2004 and 2005 have been in line with the structural budget surplus rule, resulting in a large increase in the current surplus thanks to surprisingly high tax receipts and copper returns. Fiscal policy will likely provide a bit more aggregate demand push in 2006 after the upward revision in the assumptions for the long-term price of copper and trend GDP growth.

9. There are some external and domestic risks to the near-term economic prospects. The main external risk factor appears to be the persistence of high oil prices. Also important are the widening regional imbalances between public and private savings and investment within and between the main economic zones, and the effect that sudden adjustments in interest rate and currencies might have on financial markets uncertainty and global activity. Particularly relevant is the U.S. monetary normalization and its effect on the sovereign spread conditions. On the domestic side, the risks are related to the evolution of private consumption, against the backdrop of a weakening in several negatively contributing factors such as energy shortages related to the supply of gas and hydrological conditions, and the accumulation of inventories. Also, there is still uncertainty on how will the reduction in the legal working-week weigh on the economy.

Key goals of the economic policy framework: macroeconomic and financial stability, efficiency and social equity

10. The effectiveness and credibility of Chile’s economic policy framework rely on three key aspects:

• A strong commitment to macroeconomic and financial stability reflected in well-specified targets for fiscal and monetary policies operating under a floating exchange rate regime, a fully open capital account, and sound financial regulation and supervision.

• A continuous promotion of microeconomic efficiency by fostering competition and setting appropriate incentives, and implementing a market-friendly supervision and regulatory framework.

• A systematic commitment to social equity, embedded in policies targeting poverty reduction and improved opportunities for low-income groups.

11. The first two aspects are essential in achieving sustained long-term growth and strengthening the economy’s resilience to external shocks, while allowing the provision of a stable flow of resources to implement far-reaching social policies. Putting in place this policy framework has required considerable efforts in building and strengthening Chile’s institutions.

Commitment with macroeconomic and financial stability

12. The fiscal rule operation, explicitly based on a target for the central government structural surplus of 1 percent of GDP, has contributed to strengthen Chile’s credibility in the international financial markets, reducing the spread at which residents can borrow abroad, and allowing monetary policy to be more effective as a result of automatic stabilizers along the cycle. The commitment of the authorities to the fiscal discipline is not only demonstrated by their strong adherence to the policy framework, but also by their strengthening of fiscal transparency and accountability. With that purpose, the government has sent to Congress a draft law committing future administrations to provide information on the medium-term projections of public finances, reflecting all macroeconomic and financial implications. Thus the computation of the structural budget would be incorporated in the draft budget presented to Congress each year. Furthermore, our authorities’ attention to the long-term fiscal consolidation is revealed by the proposed creation of a special fund to finance in part future obligations originated from the government’s guarantees to pay minimum and assistance pensions. As clearly shown in the Selected Issues Paper, possible future pension liabilities are limited in scope and are unlikely to give rise to fiscal stress.

13. An independent central bank with an explicit mandate of achieving price stability sets its monetary policy on an inflation target framework. This is a symmetric 2-to-4 percent range centered on 3 percent. The CBCh’s operational aim is to maintain the overnight nominal interest rate on inter-bank loans equal to the monetary policy interest rate (MPR), which is met with open-market operations. In turn, the MPR level is determined in such a way that the 12-24 month inflation forecast is close to 3 percent. Transparency and accountability of the monetary policy have been continuously strengthened by a timely flow of information to market participants. In this direction, and following the models of Australia, Canada, U.K. and Sweden, the CBCh has recently announced that the disclosure schedule of the minutes of Monetary Policy Meeting will be shortened and that they will highlight the opinions and arguments of its Board members. Institutionalization of both monetary and fiscal policy rules has simplified policy coordination between the government and the CBCh, while preserving the bank’s autonomy.

14. The monetary policy setting has been complemented with a floating exchange rate regime to facilitate the adjustment of the real exchange rate in the presence of external shocks. This regime, together with Chile’s improved creditworthiness, has reduced the benefits of holding a high level of international reserves, which is expected to be reduced by redeeming part of the CBCh’s dollar-linked debt with foreign reserves. However, the Central Bank still considers that maintaining a significant amount is justifiable because it serves as a buffer stock against international liquidity shocks, and permits the authorities to credibly intervene in the foreign exchange market under exceptional circumstances.

15. The CBCh and the Ministry of Finance have also been working on ways to strengthen the bank’s balance sheet, which shows a structural return differential between its assets and liabilities. This is mainly the consequence of actions taken by the CBCh during the crisis of 1982 in order to prevent the collapse of the domestic financial sector.

16. The capital account liberalization was completed in 2001 with the abolition of all remaining capital controls and, therefore, nowadays Chile has a fully open capital account.

17. On the issue of financial integration with the rest of the world, our authorities welcome the Selected Issues Paper which analyzes Chilean external debt. The paper makes the important point that, while Chile’s private external debt is relatively high when using as benchmark other countries with similar credit risk ratings, its external debt is in fact consistent with its per capita income, trade openness and size of the economy. The paper also documents in a systematic way several aspects of the Chilean external debt that make it less vulnerable to market fluctuations than a first look might suggest.

18. On the financial sector front, Chile’s sound and resilient financial system, along with its effective regulation and supervision, is the result of a continuous process of reforms and updating, both essential to reduce the impact of external shocks in Chile’s increasingly integrated economy. Currently, Chile’s financial sector is characterized by a sound and profitable banking industry, an active corporate and CBCh bond market, a significant availability of security-related instruments—mortgage-backed securities, mortgage bonds, short-term commercial papers and structured products—, and a growing foreign exchange derivatives market. The CBCh has recently taken new actions, which include the modernization of the payment and settlement systems; the issuance of the Financial Stability Report, intended to monitor the strengths and vulnerabilities of the internal and external payments systems; and the review of liquidity and market risk regulation, in coordination with the Superintendency of Banks.

19. Despite these developments, Chile’s financial system still faces important challenges, which the second reform to the Capital Markets Law should address. As the staff rightly points out, passing this law has been difficult since it includes second-generation financial reforms, such as funding risky projects through tax exemptions and collateralizations, which are not easily approved in a pre-electoral environment. Regarding the Selected Issues Paper on banking competition, despite the staff’s comprehensive and deep analysis, the fundamental question of whether the authorities should be concerned by a banking industry operating in a monopolistically competitive environment remain unanswered. A related issue is which are the regulatory policy implications of this finding.

Supervision and Regulation oriented at Microeconomic efficiency

20. In regards to labor market issues, one of the main concerns of Chile’s administration has been the slow reduction in unemployment rate, which always lags behind the recovery of the activity. The slow decline of the unemployment rate is within the range of experience in previous economic recoveries and is explained by the increase in the labor force as the result of improved expectations on finding a job. Moreover, the increase in the labor force has resulted from the increased participation of women, which in Chile have a relatively low participation rate. On a more structural ground, there has been progress in ensuring worker’s protection by further consolidation of the unemployment insurance scheme, and the expected approval by Congress of oral labor trials with more expeditious procedures is a step forward in that direction.

21. One of the trademarks of the current administration has been the importance given to the development of public infrastructure. Our authorities agree that there are more areas that could be strengthened while going forward, and actions are being taken in this direction. On conflict resolution procedures, the Ministry of Public Works recently established a board of independent professionals to act as arbitration panels. On the issue of project evaluation, public sector benchmarks are being developed for some public projects (e.g. prisons, judiciary buildings in Santiago, and a potential hospital concession). Regarding design and engineering specifications, changes proposed by contractors are being increasingly accepted, like the completed Costanera Norte, an urban highway redesigned by a contractor.

22. In terms of the regulatory framework for utility services, it is worth mentioning the electricity law recently approved by Congress, which will eliminate long-term price uncertainty and promote investment in the sector, thus allowing the diversification of energy sources. Investment in the energy sector is expected to exceed US$ 2 billion in the next decade.

Social Equity

23. Chile has registered significant distributive and poverty changes in the last fifteen years. Thanks to a slight improvement during the first half of the nineties, income distribution is better than in the eighties, but notably more regressive than during the sixties. Historical, social, cultural, territorial, racial and gender factors explain the relative rigidity of income distribution. However, the main achievement in the last 15 years has been the reduction of poverty in Chile. In fact, poverty incidence has decreased substantially from 45 percent in 1987 to 19 percent in 2003.

24. The impact of Chile’s well-focalized social policies is evidenced by the fact that, after considering government transfers, income inequality between the richest and the poorest quintiles of the population is halved. This sizable impact could be enhanced in the future thanks to the government’s initiatives in health care, education, and housing. The government is implementing a health care reform, which reinforces primary health and prevention, reorganizes the medical public sector, and improves public hospital management. The government has also launched the AUGE plan, which aims to improve coverage for critical and expensive illnesses. In education, Congress recently approved the access to publicly-guaranteed credits to students enrolled in private universities. In housing policy, the government is carrying out the renegotiation and forgiveness of mortgage debt for the lowest income groups on publicly-funded dwellings, favoring more than 260 thousand families.

Long-term Challenges

25. Despite Chile’s progress, our authorities are aware that efforts must be redoubled to face the remaining challenges, and thereby further narrow the still large income gap with developed countries. However, in the pursuit of these objectives, special care must be given to policies and institutions that support growth and macroeconomic stability.

26. First, it is necessary to take a new leap in productivity that will support a steady increase in the economy’s growth rate. On technological innovation, policies and institutions must be modernized in order to (i) improve technological education and increase the degree of technological adoption and innovation in the overall economy; (ii) expand the access to new technologies by micro, small and medium-size enterprises; and (iii) to promote greater interaction between universities, technological centers and enterprises. The recently approved mining royalty law will generate revenues from the extraction of non-renewable mineral resources to be used for financing technological innovations, which is a crucial ingredient to sustaining the country’s growth rate over the medium- and long-term.

27. Second, to improve income distribution, efforts should be focused on (i) improving pre-school and high school coverage; (ii) enhancing quality of education at every level, with emphasis on preschool, elementary, and high school for the two lower-income quintiles; and (iii) enhancing coverage and delivery mostly by improving management and efficiency in both the public and private health care sectors.