Chile: 2006 Article IV Consultation—Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Chile

Structural reforms and prudent economic policies have helped Chile’s successful economic performance. Executive Directors commended the sound macroeconomic policies, the structural fiscal surplus rule, and the robust financial system. They appreciated Chile's monetary policy stance and its leadership role in opening markets through comprehensive and sustained trade and financial market liberalization. They welcomed the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CLT) legislation that helps in obtaining information and combating money laundering, and also emphasized the need for a policy agenda for sustained growth.

Abstract

Structural reforms and prudent economic policies have helped Chile’s successful economic performance. Executive Directors commended the sound macroeconomic policies, the structural fiscal surplus rule, and the robust financial system. They appreciated Chile's monetary policy stance and its leadership role in opening markets through comprehensive and sustained trade and financial market liberalization. They welcomed the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CLT) legislation that helps in obtaining information and combating money laundering, and also emphasized the need for a policy agenda for sustained growth.

I. Background

1. Structural reforms and prudent economic policies have helped anchor Chile’s successful economic performance over the past fifteen years. Fiscal restraint, independent monetary policy, a sound and deep financial system, and an outward-looking trade policy have provided Chile with enviably high rates of economic growth and low inflation. During the 15–year period through 2005, its rate of economic growth averaged 5½ percent a year, per capita income tripled in U. S. dollar terms, and the poverty rate was cut in half, to about 18 percent.1 Income inequality, however, remains high.

2. Following a sharp slowdown during 1998–2003, Chile has returned to a path of strong economic growth. In 1998, a sharp drop in the terms of trade, combined with the impact of global financial turmoil, initiated a prolonged period of slow growth and led to a jump in the unemployment rate. This was compounded by a sharp increase in domestic interest rates, which contributed to a contraction in consumer spending. With the improvement in the global economy and the rise in copper prices since late 2003, economic growth has rebounded in recent years, from 2½ percent a year on average during 1999–2003 to 6¼ percent during 2004–05. This recovery also testifies to the credibility of Chile’s consistent policy framework and to the strength of its institutions.

3. Since 2003, the price of copper, Chile’s main export commodity, has surged to record-high levels. Chile is the world’s largest copper producer, with one third of global supply (the copper sector accounts for 15 percent of Chile’s GDP and over 40 percent of its total exports). Copper prices rose from US$0.8 a pound on average in 2003 to US$3.7 in May 2006, but have eased somewhat, to US$3.5 in mid-July 2006. The strength in prices has been driven in part by an increase in world demand (particularly from China), capacity constraints, low inventories, and a worldwide shift in financial investments toward commodities.

4. President Bachelet’s administration, which assumed office in early March, has reaffirmed its support for the current macroeconomic framework. Upon taking office, the new administration confirmed that it would abide by the structural surplus rule of 1 percent of GDP, but also announced its intention to strengthen social services and to undertake a comprehensive reform of the private pension system.

5. Against this backdrop, the 2006 consultation discussions centered on three key issues: (a) the appropriate policy mix, given the current stage of the economic cycle and the social spending plans of the government; (b) how to manage best the copper boom; and (c) how to help ensure long-term sustained growth.

II. Recent Developments

6. Since mid-2005, Chile’s rate of economic growth has moderated, reflecting a slowdown in investment. Annualized quarterly GDP growth has slowed to about 4 percent since mid–2005 (Figure 1). Domestic demand remains the main driver of economic growth but, after a surge in 2004–05, the rate of investment growth has sharply decelerated while consumption continues to be strong. Year-on-year real GDP growth was 5.1 percent in the first quarter of 2006.

Figure 1.
Figure 1.

GDP and Determinants of Growth

Contribution to GDP growth (ctg) from investment, total consumption and net exports vs. copper prices

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

7. The unemployment rate has dropped to its lowest level since 1999, but it remains above the level of the last economic expansion (Figure 2). Employment has increased sharply since end–2003, registering a cumulative increase of 8½ percent through end-May 2006. Nevertheless, the unemployment rate has continued to hover around 8 percent in seasonally-adjusted terms (near the top of the central bank’s estimate of the NAIRU), with still high unemployment among the young (close to 20 percent). Since mid-2005, the 12–month rate of wage increase has been close to 5¾ percent in nominal terms (Figure 3).

Figure 2.
Figure 2.

Real GDP and Labor Market developments

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Figure 3.
Figure 3.

Trends in CPI Inflation and Wages

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

8. Headline inflation has moved to the upper limit of the target range, primarily reflecting higher energy prices. Since the beginning of 2003, the Chilean peso has appreciated by 25 percent in nominal terms against the U.S. dollar and by 22 percent in real effective terms (Figure 4). Despite this appreciation, 12–month headline CPI inflation rose steadily during 2005, moving at the top of the central bank’s 2–4 percent target range in the first quarter of 2006. Part of this increase was driven by petroleum and nontradable goods prices. Headline inflation was 3.9 percent in June 2006, with narrowly-defined 12-month core inflation (excluding perishables, energy, and regulated prices) at 2.7 percent (up from 1.7 percent a year earlier).

Figure 4.
Figure 4.

St. Lucia: External Competitiveness, 1990–2004

Components of inflation vs. the exchange rate

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

9. In 2005, the external current account surplus narrowed from 1½ percent of GDP in 2004 to ½ percent of GDP. Driven by the rise in copper prices, Chile’s terms of trade improved by 12½ percent, on top of a 21 percent increase in 2004. Despite the appreciation of the peso, non-mining exports have continued to grow strongly, albeit at a slower pace than in the previous year (volume rose by 10 percent in 2005). These factors were more than offset by a drop in mining export volume (by 3 percent from 2004, a year during which exports had been boosted by inventory sales) and a sharp rise in imports (21 percent in volume terms).

10. Chile has continued to adhere strictly to a sound macroeconomic framework. Consistent with the structural surplus rule and copper price levels, the central government registered an overall surplus of 4¾ percent of GDP in 2005, up from 2¼ percent in 2004. The surplus was used by the government in broadly equal amounts to prepay debt and increase its liquid asset holdings. The central bank continued to manage monetary policy prudently, in the context of the inflation targeting framework. Since September 2004, it has raised its policy rate by a total of 325 basis points, to 5 percent, in response to the economic recovery and a gradual closing of the output gap (Figure 5). Since April 2006, it has kept the policy rate unchanged, citing the deceleration in growth, moderation in trend inflation, and well-contained inflation expectations. The authorities view present monetary conditions as still somewhat expansionary, with the policy rate at about 1 percent in real terms.

Figure 5.
Figure 5.

Monetary Policy and Inflation Expectations

Policy rate vs. expected inflation measures: market-based (BCP-5yr - BCU 5yr) and survey of forecasters

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

11. Vulnerability indicators have continued to improve, reflecting strong economic growth and the strengthening of the fiscal position. The ratio of net public sector debt (including central bank debt) to GDP fell from about 13 percent in 2003 to 7½ percent in 2005; over the same period, gross public sector debt declined from 44½ percent of GDP to 31½ percent. Private sector indebtedness abroad fell sharply (by 15 percentage points), to close to 31 percent of GDP at end–2005. Gross official international reserves, at US$17 billion (15 percent of 2005 GDP), are equivalent to close to 110 percent of Chile’s short-term external debt, covering close to five months of imports of good and services.

12. The recent correction in emerging market assets had a limited impact in Chile, confirming the resilience of the economy. In June, the Chilean peso depreciated by almost 3 percent against the U.S. dollar and the stock market fell by about 1½ percent, both from elevated levels. Chile’s sovereign spreads, however, tightened slightly, to around 80 basis points, in contrast to the widening in Latin America EMBI spreads.

III. Outlook

13. The outlook for Chile is positive, reflecting strong prospects for copper and robust domestic demand. Global demand and the improvement in the terms of trade are expected to support investor and consumer confidence, underpinning strong domestic demand. Real GDP is projected to grow by 5-6 percent in 2006–07, as the economic cycle matures, and inflation is projected to gradually return to the middle of the inflation target range. Reflecting the impact of higher copper prices, the central government is expected to register a surplus of close to 6 percent of GDP in 2006, while the external current account surplus would widen to about 2 percent of GDP.

14. The risks to the outlook appear broadly balanced. Global imbalances remain at elevated levels, carrying the risk of a disorderly adjustment and a sudden reversal in investor sentiment. Disruptions in the supply of natural gas from Argentina and further increases in oil prices could also negatively impact growth in Chile. On the upside, the continued strength of global growth could push economic growth in 2006–07 beyond current projections.

  • Global and regional risks. A disorderly adjustment in global imbalances and increased uncertainty about interest rates in the U.S. could weigh more heavily on emerging market assets than the recent sell-off, lead to a pronounced drop in commodity prices and available financing, and negatively impact growth. Regional political developments could also reduce investors’ appetite for Latin American risks and affect capital flows. Chile enjoys an investment grade rating and should, in principle, be sheltered from such developments, but its asset prices have in the past shown a close correlation with regional movements, especially in Brazil.2

  • Energy. Disruptions in the supply of gas from Argentina and further oil price increases could put pressure on production costs and weigh down economic growth. Since 2004, Argentina has reduced its gas exports to Chile. Gas cuts in the second quarter of 2006 were close to 40 percent on average, up from 30 percent during the same period last year. Although these cuts have not thus far had a major impact on economic growth, there is a risk that deeper cuts could materialize. These risks are somewhat mitigated by the fact that three-fourths of Chilean firms that use gas in their production process have already converted their plants to alternative sources of energy. Staff estimates that the effect of further increases in oil prices would be moderate (e.g., a 10 percent increase above the baseline scenario could reduce GDP growth by a ¼ of a percentage point).

  • Copper prices. Low stocks and little recent capacity expansion have combined with rising demand, especially from China, to raise copper prices to record levels. Speculative capital has flowed into copper as well, increasing volatility and the risk of a sudden price correction. However, analysts expect market conditions to continue supporting high prices, at least in the near-to-medium term.

IV. Report on the discussions

15. Discussions took place against the backdrop of the surge in world copper prices. With the economy close to full potential, discussions focused on how best to manage this stage of the cycle, at a time when the tightening of monetary policy was being gradually felt through the economy. The authorities considered that one of the main challenges for economic policy was how to deal with the copper boom, which they considered temporary. They noted that the attendant increase in government revenue would boost spending pressures at a time when the output gap was closing. However, they were committed to avoid placing excessive pressure on resources and, to that effect, to limit aggregate demand growth. To further help alleviate upward pressure on the currency and avoid Dutch disease effects, the authorities announced their intention to lodge abroad part of the financial assets accumulated by the government.3

16. A key question for Chile is how to help ensure long-term sustained economic growth. The potential rate of growth is estimated at around 5 percent a year, with trend productivity growth estimated at ½–1 percent, significantly slower than its 2 percent annual growth observed during the 1990s. Increasing long-term productivity growth will require the adoption of structural reforms to improve competitiveness, skills, and economic efficiency at the microeconomic level. Economic growth would also benefit from labor market reform to combat still-high unemployment rates, particularly among the young, and improve labor force participation by women, which remains low by international standards.

Macroeconomic policy mix

17. The gradual tightening in monetary policy has helped moderate pressures on resources. Most analysts were of the opinion that the output gap was gradually closing, but there were differences of views on its timing. Central bank staff considered that the gap would close by early 2007, while some private analysts thought that the large investments undertaken in 2004–05, together with the significant increase in labor force participation, would push the closing of the gap into the future. Given the paucity of data on labor costs and on resource pressures more generally, it was difficult to assess with precision the extent to which the recent increase in various measures of inflation reflected capacity constraints.4 The staff considered that the increase in headline inflation mostly reflected the pass-through from oil price increases, and that the upward trend in core inflation signaled a mean-reversion to its well-anchored level of 3 percent, after a drop in 2004 caused by a sharp appreciation of the peso.

18. Fiscal policy remains guided by sound principles (Figure 6).5 Beginning with the 2006 budget, the structural surplus rule has been amended to smooth out the impact of higher copper prices on revenue collections accruing not only from the state copper company CODELCO but also from private mining companies.6 Molybdenum receipts from CODELCO are also now included in the computation of structural revenue, based on the average price observed in previous years. These changes have helped reduce the cyclicality of fiscal spending. In the year to April, spending by the central government rose by 5.5 percent in real terms over the same period in 2005, below the budgeted increase of 6.3 percent, while higher copper revenues boosted the surplus to 3.8 percent of annual GDP.

Figure 6.
Figure 6.

Central Government Expenditure

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

19. In the period ahead, the authorities are committed to keeping the rate of growth of fiscal spending at moderate levels. The authorities noted that social spending, particularly in health and education, would rise in 2007 and in subsequent years, consistent with the program of the new administration. However, they also reaffirmed their commitment to the fiscal surplus rule of 1 percent of GDP and emphasized the importance of moderation in expenditure growth, to avoid aggregate demand pressures at a time when the output gap was closing. They recognized that the long-term copper reference price, to be announced by the Copper Committee in July, would be critical to the 2007 fiscal stance, and expressed their confidence that the Committee would be conservative in its assessment.7 The authorities also noted that the envisaged medium-term increases in social expenditure, planned before the recent upswing in copper prices, were consistent with such a conservative assessment. They also shared staff’s view that care should be taken to avoid too sharp an increase in recurrent spending, to avoid creating fiscal rigidities in subsequent years. To that effect, they intended to give priority in the 2007 budget to non–recurrent outlays and the purchase of tradable goods.

20. Buoyant fiscal revenues offer an opportunity to reduce distortionary taxes. Staff noted that the stamp tax, which is paid every time a debt security is issued or a bank credit is extended, constitutes an impediment to efficiency in the financial system. It recommended equating the incidence of the tax across maturities and eliminating it for some operations, including on-lent bank borrowing from abroad. The authorities acknowledged the possible efficiency gains from a modification, including through higher competition in the banking sector, but noted that revenue collections from the tax were significant (0.6 percent of GDP in 2005). As a first step, they planned to eliminate the tax for the refinancing of loans (a measure already in place for mortgage loans since 2003) and indicated that they might consider other changes at a later stage. They also planned to send a bill to congress to simplify the tax regime for small and medium enterprises. The mission also suggested eliminating the small tax on electronic transactions and checks, to help widen access to banking services.

21. The central bank plans to continue gradually removing monetary stimulus. The authorities and staff concurred that the recent slowdown in economic activity reflected a weakness in supply, driven by specific factors which included the adverse effect of poor weather conditions on agriculture, and that macroeconomic policies could do little to offset this. The central bank considered that the policy rate, set at 5 percent since April 2006, remained below the neutral rate. The authorities and staff agreed that such further moves would be largely data-dependent, particularly with respect to new data on core inflation, nonmining output growth, industrial production, and capital good imports. The monetary stance would also need to take into account, if needed, the possibility of additional fiscal stimulus in 2007.

22. Chile’s economic data are generally of good quality, but there is room for improvement, particularly with respect to the CPI and labor cost components.8 The authorities indicated that steps were underway to expand the CPI survey sample outside Santiago, and saw merit in staff’s suggestion to undertake a new household expenditure survey and use hedonic price analysis to take into account changes in the quality of goods and services. In the area of labor cost statistics, the mission suggested that the recently overhauled establishment survey may need to be reviewed to ensure data quality with respect to compensation and hours worked. The mission also noted that, while aggregate expenditure data collected by the Central Bank were timely and comprehensive, data on inventories could be improved to help distinguish better between persistent consumption shifts and transitory stockpiling increases. The authorities and staff agreed that such changes, which would require significant investments in time and labor, would bring considerable dividends.

Managing the copper boom

23. The Chilean macroeconomic framework is sound and has grown increasingly effective at managing external shocks. Since the late 1990s, the introduction of the fiscal rule, inflation targeting in the context of a floating exchange rate, and trade openness have significantly enhanced the resilience of the economy. In addition, the financial system is solid and has deepened further in recent years, particularly with the development of the bond and derivatives markets, improving the capacity of the economy to absorb shocks. Well-designed social policies have also helped ensure policy sustainability in the face of continued high income inequality. There is room to strengthen some areas of policy, however, and this has been highlighted by the unprecedented size of the current copper boom.

24. The mission welcomed the authorities’ commitment to continue letting the peso float freely, despite renewed pressures to intervene in the foreign exchange market. Since 2003, the peso has appreciated by 22 percent in real effective terms, and some sectors of the economy have called for the central bank to intervene in the foreign exchange market. The central bank has reaffirmed its position that it would only intervene if the following three conditions were met: (i) there is evidence of a misalignment of the currency; (ii) such a misalignment impacts negatively on economic activity; and (iii) intervention has a good chance of success at correcting the misalignment. The authorities did not think that any of these conditions were met, and reaffirmed their plans to let the peso float freely. Staff shared the central bank’s view, noting that this policy has enhanced the development of a deep and efficient market for hedging foreign exchange rate risks. In addition, the peso does not seem out of line with long-term trends (Figure 7) and the growth of nonmining exports has remained strong, an indication that the level of the currency is not hurting competitiveness.

Figure 7.
Figure 7.

International Competitiveness

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

25. The authorities’ decision to define a policy for investing the fiscal surpluses is sound. The government has recently sent a bill to congress to establish rules for investing and managing the fiscal surpluses:

  • Pension fund. Each year, at least 0.2 percent (and, should the cash surplus allow, up to 0.5 percent) of previous–year’s GDP would be invested in a pension fund aimed at covering future pension liabilities of the government (Figure 8). The amounts in the fund would remain locked for a 10–year period; its investment policies would be guided by the same regulations that apply to private pension funds, which are currently allowed to invest up to 30 percent of their assets abroad.

  • Central bank recapitalization. Additionally, up to 0.5 percent of GDP would be assigned to the gradual recapitalization of the central bank for each of the next five years, covering about half of its total recapitalization need. Although staff pressed for an upfront recapitalization of the central bank, the government explained its choice of a gradual approach by the need to take political constraints into account. The central bank plans to use the funds to build up its foreign reserves.

  • Fund for Economic and Social Stabilization (FESS). Finally, all remaining surpluses would be lodged in a newly–created fund, the FESS. This fund would operate in a transparent manner and, to that effect, the government plans to inform the public on the composition of its assets on a quarterly basis. It will be allowed to invest its assets abroad, with a view to helping alleviate upward pressure on the currency. The guidelines would initially allow foreign investment only in government and high–grade corporate bonds. The authorities and staff agreed that investments could become more diversified in the future, including with investment in equities.

Figure 8.
Figure 8.

Use of Prospective Fiscal Surpluses

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Boosting Long–Term Growth

26. Boosting long–run total factor productivity growth is a major challenge for Chile. This will require building on the existing strengths of the Chilean economy through greater efficiency in the financial sector, further enhancements in human capital through education and Research and Development (R&D), and reforms to increase labor productivity. A cross–cutting theme is the need to step up competition in the economy. Efficiency improvements in the labor and financial markets will contribute to this goal, but the authorities explained that they were also taking steps to strengthen competition policy, with a view to reducing conflicts of interest in corporate governance, increasing fines for antitrust violations while tying them to damages, and protecting whistleblowers.

Reforming the pension system

27. Improving Chile’s privatized pension system is one of the priorities of the government. Since their creation in 1981, private pension funds have grown to manage around US$68 billion in assets, equivalent to three–fifths of Chile’s GDP. A commission has been appointed by the government to hear from specialists and a wide spectrum of society about their concerns on the pension system, discuss possible areas of reform, and develop specific proposals. The commission will report by early–July to an interministerial committee which will draft reform legislation, expected to be sent to congress by late 2006 (Box 1). The staff recommended making participation in the pension system compulsory for the self–employed and rationalizing investment restrictions on the pension funds, including raising the limit on investments abroad. The authorities saw merit in these recommendations and noted that they awaited the report of the pension committee to formulate specific policies.

Chile: Pension Reform

The commission has been charged with formulating responses to five main issues: low density of contributions; coverage of the social pillar; competition; rules governing the investments of funds; and how to increase the participation of women.

Chile’s pension system suffers from low density and contribution rates, particularly among the young and the self–employed. While the system currently does an exemplary job at providing for the retirement of workers spending their adult lives in formal employment, various studies have shown that retirement income is uncertain for part of Chile’s workforce. Many workers, particularly young and informal–sector workers, do not understand the need to save in a private account, and education in this area has been neglected. Many self–employed workers are in the formal sector, but increasing their participation (currently only 5 percent participate in the pension system) would require addressing differences in taxation and benefits between the self–employed and others.

The current system does not provide a sufficient safety net for the poor elderly. The pension system was designed to provide a minimum benefit to participants after at least 20 years of participation. A welfare pension is available to the very poor, but eligibility is based on broad assistance–program requirements and takes into account other considerations than income; the minimum pension guarantee is tied only to years of contribution, not need. The commission is researching ways to tie old–age security more closely into the pension system, such as by changing the eligibility requirement for a minimum pension from a time basis to a financial threshold, which would benefit the self–employed and temporary workers (their contributions are not frequent enough to achieve the 20–year minimum record). Any increase in government support for this pillar is likely to be costly, and observers expect this to be funded from general revenue, rather than an additional “solidarity contribution–from workers or employers.

The Chilean pension–fund industry has become monopolistic. The need for a sales force, marketing, and sizeable front–and back–office operations has created significant economies of scale. The commission is analyzing proposals that would reduce costs by separating the management of investments from the administration of accounts. However, studies have found that Chilean workers do not respond elastically to private pension fees (estimated at 2.4 percent of wages). Other proposals include effectively auctioning the accounts of groups of workers (sorted possibly by age or occupational category) to pension funds, allocating new workers to the lowest–cost funds, or restricting the ability of workers to move into higher–cost funds.

Rules for investment of pension–fund assets are generally seen as too restrictive. Complex restrictions on portfolio risk, foreign investment, and asset allocation have combined to depress overall returns and reduce the variance among funds’ returns. The commission is looking at streamlining the more than ninety limits and sub–limits that govern investments in order to increase the funds’ ability to respond to market conditions and at codifying the rules as administrative regulations, to improve flexibility.

Women gain much less than men from the pension system, due to a confluence of issues. Lower wages, more informal employment, childbearing responsibilities, earlier retirement ages, and longer life spans combine to reduce the retirement earnings of women under the current system. Proposals to address the gender disparity in pension earnings focus on the need to encourage more years of contribution for women, for example, by delaying the retirement age (currently, about 60 percent of workers retire early; the average retirement age for women is 54 years and 57 for men), making early retirement less attractive, or subsidizing the pension contributions of mothers. President Bachelet has announced other measures to encourage higher female workforce participation, which may help mitigate the problem.

Figure 9.
Figure 9.

Chile: Financial Market Developments

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

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

Improving Competition in the Financial Sector

28. Prudential indicators continue to show that the banking system is sound, with high capital, a low level of impaired assets, and high provisioning. The authorities were closely tracking developments in consumer credit, which had continued to rise rapidly (the 12–month increase in real terms was 22 percent at end–March), but noted that it accounted for only a small portion (15 percent) of total bank credit and, as such, did not represent a systemic risk to the financial sector. Staff emphasized the need to improve consolidated information on credit risks in the financial sector and, to that effect, supported the creation of a central credit database covering not only banks but also cooperatives and department store credit card lending (estimated to account for at least 20 percent of total consumer credit). With respect to small and medium–sized enterprises, the mission advised the authorities to introduce mechanisms aimed at ensuring the collection of data under a simplified version of the FecuPymes reporting system.

29. The authorities intend to continue pressing forward with the draft Capital Market Law II, which has not made headway in congress in recent months, partly due to its broad coverage and technical complexity. They were considering various alternatives to move ahead with the reform, including giving consideration to narrowing its scope in order to ensure early passage by congress. The draft law would bring wide–ranging improvements to several existing laws and introduce incentives for risk capital and entrepreneurship, a new national registry for pledges aimed at improving SMEs’ access to financing, strengthen corporate governance legislation to bring it to OECD standards, and increase powers for the superintendents to share information. A separate draft law, aiming at restoring some of the powers of the Financial Intelligence Unit, is expected to be approved by congress in the near future; passage of this law is critical to ensure that the FIU is capable of effectively combating money laundering.

30. In recent years, the domestic bond market has grown steadily, but it remains characterized by a relatively low level of activity. Staff recommended that liquidity be improved by relaxing some of the investment restrictions on the private pension funds and reviewing the procedures surrounding the taxation of foreign investors.9 Staff also suggested removing the distortions caused by the stamp tax and considering introducing a system of specialists in public debt with obligations tailored to the needs of the market. As the Central Bank has successfully set out an explicit objective for its debt management and effectively communicated it to the market, the government should do so as well. Sporadic bond issuance by the Finance Ministry has created uncertainty in the market, highlighting the need for a coordinated medium–term debt management strategy with the Central Bank. An asset–liability management approach would suggest that the Finance Ministry should concentrate on the long end of the curve, including through inflation–indexed issues, providing benchmarks at the longer tenors and complementing the Central Bank’s issuance at the medium–and shorter–tenors. The authorities considered that they needed more time to specify their policy in this area. The Central Bank authorities also noted that, since the last Article IV consultation, they had made public key aspects of their reserve management policy, including with respect to currency composition.

Making the economy more flexible

31. Improving the quality of human capital and boosting innovation will be key to Chile’s long–term development. Taking into account Chile’s low attainment and performance in education by international standards, the new government has placed education at the top of its priorities (Figure 10 and 11). Over its four–year term, it plans to make pre–school care coverage universal; broaden the system of preferential subsidy vouchers; increase the number of scholarships and government loan guarantees to improve access to tertiary education for the poor; and provide grants for Chileans to study abroad. In the R&D area, a law establishing a Fund for Innovation financed with the proceeds of the special tax on mining is awaiting approval by congress.10 A transitional commission is preparing guidelines for projects and financing, based on successful experiences in foreign countries. To enhance technological innovation and productivity growth, this fund will provide resources for seed and venture capital, partly through the National Development Corporation (CORFO) and the National Commission for Scientific and Technological Research (CONICYT). Performance will be closely monitored to ensure results.

Figure 10.
Figure 10.

Student Performance: Chile and Selected Countries

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Source: OECD (2003), Literacy Skills for the World of Tomorrow-Further Results for PISA 2000, Paris.
Figure 11.
Figure 11.

Tertiary Education Attainment: Chile and Selected Countries

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Source: OECD (2005) Education at a Glance, OECD Indicators.

32. The authorities intend to build a social consensus for labor market reforms. Staff supported this approach, while noting the pressing need for action in this area, as unemployment is still high and the labor market plagued with rigidities (Figure 12). Chile’s labor force participation rates are low by international standards, particularly for the young and for women, severance payments are high, and about one fourth of Chile’s workforce is under temporary work arrangements:

  • Increasing employment for the young and women is a priority of the government. To help enhance job creation for the young, the authorities agreed that there was some room to make more intensive use of short–term and part–time contracts for them. The government plans to subsidize 50 percent of the minimum wage for some 1,500 first–time young workers and extend this benefit to workers up to 25 years old (from 21years old at present). Bonuses will also be offered to firms that employ youths at social risk. With respect to women, the authorities considered that the broadening of childcare coverage would help improve their participation in the labor force.

  • Severance payments are high by international standards. Severance payments in Chile, equivalent to one month’s wages for each year of service (up to a maximum of 11 months’ wages), are considered to hinder job creation. Workers’ dismissal rules are generally flexible, but the rules governing permissible dismissals remain narrowly defined, hampering the matching of jobs with employees’ skills, and penalties for unjustified dismissal are usually prohibitively high.

  • Chile’s minimum wage is relatively high, hindering formal employment contracts, particularly for the unskilled. In July 2005, the previous government increased the minimum wage by 6¼ percent and announced that it would be raised again by close to 6 percent in July 2006, leaving no flexibility to the new government for this year. The mission advised restraint in the determination of the minimum wage for next year, taking into account that, when compared to the median wage, its level is significantly higher than in emerging and OECD countries (Figure 13).

  • In the formal sector, about one fourth of all workers are under temporary work arrangements. Chile does not allow fixed–term employment contracts with a duration of more than a year. In practice, this is often circumvented by annual contracts which are renewed at the end of each year, the use of subcontractor services, and the hiring of temporary workers. A draft law was recently approved in congress, requiring firms to ascertain that their subcontractors comply with existing labor and social security regulations. The government planned to veto some aspects of the draft law, with a view to ensuring that it does not lead to excessive bureaucratic demands and to the introduction of new rigidities.

Figure 12.
Figure 12.

Chile and Selected Countries: Labor Market Impediments

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Source: OECD, Labor Force Statistics; OECD (2003), Chile Country Survey, Paris; and INE.1/ Indices prepared by OECD. Scores are in the range of 0-6, with lower scores implying less rigidity.
Figure 13.
Figure 13.

Minimum Wages: Chile and Selected Countries

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

Source: OECD, Labor Force Statistics and OECD (2003), Chile Country Survey.Note: Data for OECD counties refer to 2000. Chile’s data are OECD staff estimates for 2002.

33. Access to energy is key for Chile to ensure sustainable long–term growth. In the electricity sector, the approval in 2005 of changes in the regulatory framework has led to a strong increase in investment in electricity generation, including hydroelectric capacity. Faced with the uncertainty associated with the supply from Argentina, Chile has worked to reduce its reliance on natural gas. In the Northern part of the country, many mining companies have been investing in their own sources of energy supply, including coal and diesel plants. Concerns about the reliability of supply to the center of the country have led the government to initiate construction of a liquid natural gas terminal near Santiago.

34. The authorities and staff agreed that trade liberalization has served Chile well. Officials noted that Chile has one the lowest tariff rates in the world and that almost four–fifths of all trade is undertaken under some level of tariff preference (Figure 14). Partly as a result of the implementation of a series of free trade agreements, including with the United States and the European Union, non–mining exports grew at an annual rate of 13 percent during 2001–05. An FTA with China and a trans–Pacific trade pact with Singapore, New Zealand, and Brunei are to become operational by end–2006. A partial trade agreement was signed with India in March, and trade negotiations are under way with Japan. The authorities have also reiterated their strong commitment to multilateral trade liberalization.

Figure 14.
Figure 14.

International Comparison of Average Tariff

Citation: IMF Staff Country Reports 2006, 335; 10.5089/9781451807646.002.A001

1/ Average tariff is the unweighted mean of all tariff lines and includes other duties and charges.

V. Staff Appraisal

35. With a very favorable external environment, prospects for the Chilean economy remain strong, notwithstanding the recent slowdown in activity. Economic growth has slowed since mid–2005, in part because investment has returned to a more sustainable rate of growth after a spurt during the previous two years. Consumer confidence remains high, private consumption is growing at a sustainable rate, and the economy is set to continue expanding at a steady pace in 2006 and 2007.

36. Risks to the outlook are mitigated by the quality of macroeconomic policies. The fiscal surplus rule, inflation targeting in the context of a floating exchange rate, and trade openness have significantly improved the resilience of the Chilean economy. In addition, the financial system is solid and has deepened in recent years with the development of the bond and futures markets, improving the capacity of the economy to absorb shocks. The relatively modest reaction to the recent sell–off in emerging markets confirms Chile’s resilience to market turbulence and the ability of the markets to differentiate Chile from other risks in the region.

37. Macroeconomic policymaking remains first–rate and well coordinated. The authorities are appropriately treating the sharp increase in copper price as temporary. Fiscal policy has continued to be managed prudently, with expenditure growth tied via the structural surplus rule to Chile’s long–term revenue capacity, while the central bank is appropriately gradually removing monetary stimulus. Chile’s external competitiveness does not appear to have suffered from the appreciation of the currency, as nonmineral exports have continued to perform well. Staff supports the authorities’ decision to invest part of the fiscal surpluses abroad while providing more transparency in the information given to the public. A prudent fiscal policy stance, together with investing the fiscal surpluses abroad, should help limit upward pressure on the currency.

38. The uncertainty surrounding measures of the output gap poses a challenge to policymakers. Central bank estimates point to a closing of the gap in early 2007, but some computations show that the gap may still persist next year, reflecting large investments and a sizeable labor force growth in recent years. The recent pickup in inflation in early 2006 seems to largely reflect the effect of higher energy prices; there are also no conclusive data on possible pressures on resources and labor costs.

39. Against this background, staff agreed with the authorities that the monetary stance in the period ahead should largely be data driven. Inflation expectations remain well anchored near the mid–point of the inflation target range, and the central bank’s communications strategy with the markets works well. Given that the policy rate remains below the neutral rate, there is still room for the central bank to remove stimulus, particularly if fiscal policy were to become more expansionary in 2007.

40. The 2007 budget should keep the growth in central government expenditure at a moderate level. Under the structural surplus rule, revenue in 2007 could be boosted by an increase in the reference price for copper, leading to undesirable pressures to expand spending. Beyond their commitment to the rule as a disciplining device, the authorities have helpfully reaffirmed their intention to limit expenditure increases in the 2007 budget and to give prominence to nonrecurrent spending.

41. Staff welcomes the government’s intention to gradually recapitalize the central bank. The government’s plans to provide the central bank with about half of its capital need over a five–year period will help strengthen the institutional independence of the bank as well as its foreign reserves position, but it will not allow the central bank to cover all its losses. Although the fiscal surpluses provided an opportunity for an upfront and full recapitalization of the central bank, the government’ decision to opt for gradual recapitalization reflects the need to take political constraints into account.

42. The rapid increase in consumer credit growth requires vigilance and better information sharing between banks and non–bank credit card issuers. To enhance the consolidation of risk information, it would be desirable to create a central database applied not only to banks but also to cooperatives and credit card lending by department stores. Proceeding with a simplified version of the FecuPymes reporting system would help provide better information on credit risks of small and medium–sized enterprises and improve their access to financing.

43. To enhance efficiency and competition in the financial sector, the scope and rate of the stamp tax should be reduced. Beyond the government’s plans to waive the stamp tax in the refinancing of existing loans, a more comprehensive reform of the stamp tax would help reduce the costs of financial intermediation and encourage competition, by giving borrowers more flexibility in securing the best cost of financing possible. Consideration should also be given to eliminating the small tax on electronic transactions and checks.

44. Improving liquidity in the capital market is a priority. The government is encouraged to develop a medium–term public debt strategy, beyond the political cycle, and decide if it will maintain a presence in issuing bonds. Regulations are needed to clarify exemptions from capital gains tax for foreign institutional investors. This may help enhance further the development of the financial sector and contribute to internationalizing the peso.

45. Improving the quality of human capital and boosting innovation is key to Chile’s long–term development. The new administration has placed education at the top of its priorities, with plans to generalize pre–school care, broaden university education for the poor, and provide grants to study abroad. Its plan to support R&D and innovation, based on successful experiences abroad, appears well placed.

46. The labor market remains in need of further reform. The authorities’ approach in this area, aimed at seeking consensus among the main social partners, is well advised. Staff urges the authorities to take bold action in this area, to help address the still high unemployment rate—especially among the young—and improve labor force participation. In particular, reforms should aim at introducing more flexibility in working hours, allowing longer fixed–term contracts, and avoiding too rapid increases in the minimum wages rather than subsidizing them.

47. Further improving data quality and coverage would help improve economic management. Strengthening data quality in the areas of the consumer price index, labor indicators, and inventories would help better assess short–term developments. These improvements would likely require a significant investment in time and labor, but would bring considerable dividends over time.

48. It is recommended that the next consultation occur on the usual 12–month cycle.

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.

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

End of period; INS definition of the real effective exchange rate. A decline indicates a depreciation of the peso; data for 2006 as of April 30, 2006.

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

Gross consolidated debt of the public sector (central bank, non–financial public enterprises, and general government).

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.

Based on the 2006 Budget and updated staff estimates, including copper price assumptions of US$2.56 in 2006 and US$2.15 in 2007.

Figures for 2006 based on the June 2006 budget update.

Table 3.

Central Government Spending, 1997–2005 1/

(by GFSM functional classification, in percent of GDP)

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Source: Ministry of Finance: DIPRES.

Totals may not be identical to those in Table 2 due to of minor accounting and methodological differences.

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.

Includes the effects of valuation changes (inflation) to the stock of UF debt and accrued interest on Treasury debt.

On a cash basis.

Table 5.

Chile: Indicators of External Vulnerability

(In percent; unless otherwise indicated)

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

Includes Central Bank, DMBs and other banking institutions

Official measure of non–performing loans.

Data for 2006 as of April 30, 2006. For risk–based capital ratio, as of March 30, 2006.

Includes errors and omissions.

Gold valued at end–period market prices.

As measured by the central bank; includes amortization of medium/long–term debt due during the following year.

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.

Includes errors and omissions.

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

Net of estimated losses of the central bank.

Updated staff forecasts.

Table 7.

Chile: External Debt and Debt Service Projections

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

Includes bank and nonbank institutions.

Original maturity basis; end of period basis.

At current prices and exchange rates.