Outlook and Risks

2. After growing 4 percent in 2006, due to one-off adverse events in natural resource sectors, higher energy prices and restrictions on the supply of natural gas from Argentina, some switching effects from domestic to external production in specific sectors, and a marked cycle in fixed capital investment, output growth has resumed during the first half of 2007 at a faster pace than previously envisaged. A favorable external environment, recovery in investment, firm expansion in private consumption supported by favorable financial conditions as well as positive labor market conditions and supportive macroeconomic policies have facilitated stronger growth. In addition, during 2007 the operation of new plants in the natural resources sector (pulp and mining) will further expand Chile’s productive capacity. The Central Bank of Chile’s (CBCh) central scenario projects GDP growth for 2007 between 5 and 6 percent, with a balance of risks with an upward bias, figures that are above the trend growth of the economy.

3. Given the positive outlook for growth in 2007, the output gap is expected to close gradually over the year, based on expansion in domestic demand and exports. Private consumption has remained a key driver of domestic demand in the current cycle. This strong consumption is expected to continue going forward, in line with increasing household income and credit expansion. Investment has exhibited a rebound from the low levels of the second half of 2006, as evidenced by an acceleration of imported capital goods, an increasing public investment, upward revisions of private investment intentions for 2008 and 2009, and also an improvement in business confidence indicators, strong firm cash flows and favorable financial conditions. In terms of external demand, the favorable outlook for the global economy should be the key driver of a broad based increase in exports, particularly from the non-copper sector which has expanded its export volume above 10 percent during the first semester of this year. It is noteworthy that, despite strong positive terms of trade shock extending over the last few years, the real effective exchange rate has remained approximately equal to its 15-year average.

4. Considering the CBCh growth scenario, risks are tilted to the upside, meaning that growth in the upper part of the range, and even above 6 percent cannot be ruled out. This is consistent with the broadly balanced-risk scenario described in the staff report, given the central scenario considered therein. As highlighted in the staff report, the downside risks are mainly external, such as an unanticipated change in global liquidity conditions, further increases in the price of oil and other food products, and the further limitations in the provision of natural gas from Argentina as well as other restrictions in the energy sector. The upside risks include an expansion of consumption above the dynamic pace already shown in recent months due to the more favorable developments in the labor markets, which could also pose an additional risk in terms of tighter excess capacity going forward.

5. Throughout large part of 2006, CPI inflation was on the upper limit of the 3 ± 1 percent target, due mainly to the incidence of higher fuel prices, while core inflation measures and other inflation trend indicators were close to 3 percent. However, during the last quarter of 2006, the pace of price increases moderated substantially, and both CPI and core inflation measures decreased below the 3 percent level. With decelerating inflation, lower inflation expectations, and below trend GDP growth, in order to ensure inflation convergence to 3 percent and after six months of stability in the policy rate, the Central Bank decreased the monetary policy interest rate in January 2007 by 25 basis points to 5 percent.

6. Over the course of the first five months of 2007, there have been both demand and supply shocks changing materially the inflation outlook. On the one hand, the higher growth rate of both domestic demand and GDP, in an overall context of diminished excess capacity could put upward pressure in inflation. On the other hand, strong price shocks in specific food items (grains and milk) and some increases in the price of oil and gasoline (instead of expected strong declines) have increase inflation marginally above the 3 percent target, much sooner than what was expected at the beginning of 2007. Inflation expectations remain well anchored at 3 percent, as evidenced by the survey data presented in the staff report, and the forward inflation compensation derived from indexed bonds. Furthermore, labor costs remain well contained, as indicated by unit labor costs. The upside risks in terms of inflation are a faster than anticipated closure of the output gap, the continuation of the observed supply shocks to food products as well as oil and gasoline, potential second round effects from higher prices of basic goods, and increases in the price of electricity. The downside risks to inflation are an exchange rate appreciation and a faster resolution of the supply shocks seen to date. So far, the authorities’ view is that risks remain balanced, and if the inflation outlook shifts to a scenario in which the inflation forecast exceeds the 3 percent target over a 24 month period, the CBCh stands ready to act in order to fulfill its commitment to price stability by reducing the monetary impulse.

Fiscal Policy

7. In 2006, the central government posted an overall surplus of 7.7 percent of GDP as a result of the continued application of the structural budget surplus rule established in 2001 and high copper prices. The surplus resulted from a 23.1 percent real increase in revenues and a 6.9 percent real increase in public expenditure. A large budget surplus for a third consecutive year has allowed further major improvement in the financial position of the government via debt prepayments, and a significant increase in its assets from the savings of copper windfall revenues. This has resulted in the government becoming a net creditor if recognition bond liabilities (9.5 percent of GDP in December 2006) are excluded. The robust state of public finances guarantees solvency and flexibility in the face of a deterioration in the external environment in the future. In 2007 the central government is expected to reach a surplus of 7.1 percent of GDP. Again in line with the fiscal policy framework, in 2007 public expenditure is expected to increase by 9 percent in real terms, prioritizing social spending in health, education and social housing.

8. In order to manage copper windfall revenues prudently, in 2006 the Government passed the Fiscal Responsibility Law (FRL), which created two funds for the management of the government surpluses. The CBCh is currently responsible for the management of these funds as a Fiscal Agent. The first of these funds - the Economic and Social Stabilization Fund (ESSF) - was constituted with an initial deposit of USD 6 billion, and the second fund - the Pension Reserve Fund (PRF) - was established with a USD 600 million initial deposit. At the end of April 2007, the ESSF had a total of USD 7.2 billion in assets under management, while the PRF had a total of USD 617 million. In the setup of the two funds, the authorities have sought to establish institutions to manage the windfall gains from the high copper prices of recent years. As part of the governance structure associated with the setup of the ESSF and the PRF, an advisory body called the Financial Advisory Council constituted by a six-member panel of independent economists was established in order to provide advice to the Minister of Finance on the establishment of investment guidelines and other matters related to the funds. The FRL also allowed the government to make use of its surplus to recapitalize the CBCh by up to 0.5 percent of GDP for 5 years. The first payment of USD 600 million was made in 2006, and a second payment of USD 735 million was made recently.

9. On May 21, during her annual address to Congress, President Bachelet announced a reduction in the fiscal rule from a 1 percent to a 0.5 percent of GDP structural surplus target. Such a change in the surplus target of the rule was the result of thorough review of the conditions underlying the establishment of the 1 percent structural surplus target, namely the structural deficit of the CBCh, the existence of future contingent liabilities of the government arising from the state guarantee of minimum and basic pensions, and the vulnerabilities associated with the currency mismatches of the government’s assets and liabilities.

10. During the last 6 years, the 1 percent surplus target has provided a clear anchor to fiscal policy and has allowed a significant reduction in the cost of accessing the international capital markets as well as a secular fall in long-term interest rates. At the same time, the fall in public debt and increased asset accumulation has resulted in a reduction in external vulnerability, while the CBCh has also reduced its structural deficit. As a result, it was deemed necessary to reduce the structural surplus target to 0.5 percent from 2008 onwards. This adjustment flows from improvements in the conditions that led to the rule’s establishment, and maintains the current rules-based framework for the conduct of fiscal policy.

Monetary and Exchange Rate Policy

11. Last January, the CBCh announced a refinement to its inflation targeting framework, including the inflation target itself as well as the horizon in which monetary policy aims to achieve the target. The previous framework was based on an inflation target in a range between 2 and 4 percent. Under the new framework, price stability will be understood as achieving most of the time a year-on-year CPI inflation rate of 3 percent, with a tolerance range of ± 1 percent. This change in the definition of the inflation target provides a clear signal that reassures the Central Bank’s commitment to price stability and also strengthens the midpoint of the previous range as the economy’s relevant nominal anchor. Regarding the policy horizon, the “12 to 24 months horizon” was replaced by a policy horizon “around two-years time”. This change reflects that, on the one hand, the CBCh has been giving the practice of monetary policy a higher weight to the two-year horizon, and on the other hand, it takes into account the trend of other central banks in the definition of the policy horizon.

12. In line with the developments of the inflation outlook, monetary policy has shifted from an easing bias at the beginning of this year, which included a 25 bp. cut in January, to a restrictive bias. As correctly assessed in the staff report, the remaining monetary stimulus will probably be withdrawn in the near future, although as usual, monetary policy decisions will continue to be contingent on incoming data, particularly on its impact on the inflation outlook in a two-year horizon.

13. The floating exchange rate regime creates greater scope for monetary policy, and hence provides a buffer against external shocks. We concur with the staff’s assessment that the exchange rate is broadly in line with fundamentals, and there is no evidence of misalignment of the Chilean peso (CLP). In terms of the real exchange rate, fiscal policy has played a key role due to the policy framework established to save abroad the windfall revenues of the government from the copper price boom as it has helped significantly in avoiding the loss of competitiveness that would have prevailed otherwise. These developments have been instrumental in preventing the possibility of Dutch disease in light of the large positive terms of trade shock from commodities prices.

Human capital

14. The change in the fiscal rule’s target surplus from 1 percent to 0.5 percent of GDP increases available government resources by approximately USD 740 million on a permanent basis. Given the government’s emphasis on social spending USD 650 million will be spent on education: the education voucher for children at mainly state-funded schools will rise by 15 percent, coupled with an increase in schools’ accountability with regard to the use of these resources; the preferential education subsidy which targets the most vulnerable children in the school system will increase; a family library program for four hundred thousand low-income families will be established; existing scholarship programs for students of technical careers will be expanded; and funds to improve the educational and financial capabilities of municipal schools will be allocated.

Labor markets

15. One of the key reforms that President Bachelet’s government is committed to is a major reform of the pension system. Last year, a high-level technical commission headed by the former Budget Secretary was setup with the purpose of gathering a wide range of reform proposals from different relevant agents. Based on the proposals contained in the report, in December of 2006 the government submitted to Congress the bill with the Reform to the Pension System. The main elements of the reform is the establishment of a basic solidarity pillar which includes the basic solidarity pension (BSP) and the solidarity pension contribution (SPC) as explained in Box 1 of the report, the resolution of gender inequalities of the system, incentives to incorporate independent workers to the pension system, and increase competition by allowing new players to enter the system. The government’s goal is to start paying the basic solidarity pensions by mid 2008. In order to achieve this goal, the government reached an agreement with the parties of the government coalition to accelerate the discussion in Congress, which implies that as early as August of this year the pension reform bill would be discussed in the Senate after being discussed in the Lower House, to become law by early 2008.

16. In terms of labor markets, one of the latest developments which was not covered in the report was the increase in the minimum wage of 6.7 percent, introducing a forward looking clause so that if actual growth (in the period from the 4^th quarter of 2006 to the 3^rd quarter of 2007) exceeds 5.8 percent in real terms, the minimum wage increases by an additional 0.7 percent. The introduction of this forward-looking clause based on GDP growth is seen by the government as a major step towards linking wage increases to economic performance.

Financial Sector

17. In June 2007 the Capital Markets II reform bill became law, introducing key improvements to domestic capital markets in three broad areas: promoting access to venture capital and funding for SMEs, strengthening financial market security, and promoting the development and deepening of financial markets. In the first area, the law establishes tax exemptions on capital gains from venture capital investments; promotes the participation of the public sector and bank subsidiaries in venture capital funds; simplifies the legal framework for the setup of both venture capital funds and companies; redesigns the current system for the establishment of collateral; and extends for a further eight years the existing tax benefit on trading of newly listed stocks.

18. The second area of the project improves market security by simplifying the review process for banks, insurance companies and AFPs license applications, centralizing it in the corresponding Superintendency; improves the legal protection of financial supervisors; sets higher custody requirements on securities so as to enhance the security of transactions between market participants; establishes professional requirements for traders at stockbrokers; and provides for the dematerialized issuance of securities.

19. The third area of the project promotes the development of capital markets. Among these measures are changes in the definition of sight and time deposits and reserve requirements (that will now be based on effective net worth, rather than basic capital in line with Basel II guidelines), allowing for further development of the money market; the authorization of derivatives netting in case of bankruptcy; increases in investment limits for insurance companies; modernization of the off-shore stock market; collective action clauses for bond issuance; and a new tax benefit for mutual fund investors to promote saving, competition and portfolio reallocation in the market segment.

Other Issues

20. In March 2007, the government announced the Chile Invests Plan, a package of measures aimed to boost investment, facilitate entrepreneurship, globalize the domestic financial markets, further enhance trade integration, improve government effectiveness, foster innovation and human capital, and address the country’s expanding energy needs. The plan included a new accelerated depreciation tax benefit (still under review by the legislature), the identification and elimination of bottlenecks in the investment process; and an increased focus on the execution and quality of public investment. To facilitate entrepreneurship, the government will indirectly provide long-term financing products for small and medium-sized enterprises (SMEs) via the banking system, create a fund to guarantee the investments of small and medium-sized enterprises, and will create a standardized balance sheet reporting system for this sector that will be automatically prepared for SMEs using tax information. To further the integration of domestic financial markets, a derivatives law setting out a comprehensive tax framework will be submitted to Congress; to move toward the use of the Chilean peso as an international currency the government will facilitate connections to global settlement and custody systems, and will reduce the administrative burdens on foreign investors in domestic markets.

Conclusion

21. Chile’s rules-based policy framework for monetary and fiscal policy has proven to be instrumental in the country’s efforts towards sustaining growth so as to improve the living standards of the population, particularly those of low and middle-income Chileans, as evidenced by the latest figures on poverty reduction and income distribution. According to recently released figures, in the last 3 years the population in poverty fell by 5 percentage points, from 18.7 to 13.7 percent, and in terms of income distribution the figures show the largest improvement since 1990, as evidenced in by a fall in the Gini coefficient. These improvements and the rules-based policy framework have been recognized recently by the invitation extended to Chile in May to open discussions for membership of the OECD.