This Selected Issues paper examines the acceleration of inflation over the past year in Chile, identifying domestic shocks to food and energy prices as main drivers. The paper uses the Jeanne-Rancière model to calculate Chile’s optimal ratio of international reserves to GDP. It analyzes the stabilization properties of Chile’s macroeconomic framework and compares it with alternative policy rules. The paper concludes that Chile’s framework based on an explicit inflation target, a floating exchange rate, and a structural fiscal surplus rule is superior to other arrangements.

Abstract

This Selected Issues paper examines the acceleration of inflation over the past year in Chile, identifying domestic shocks to food and energy prices as main drivers. The paper uses the Jeanne-Rancière model to calculate Chile’s optimal ratio of international reserves to GDP. It analyzes the stabilization properties of Chile’s macroeconomic framework and compares it with alternative policy rules. The paper concludes that Chile’s framework based on an explicit inflation target, a floating exchange rate, and a structural fiscal surplus rule is superior to other arrangements.

VI. Deepening Chile’s Capital Markets Through GLOBAL Integration1

In many respects, Chilean financial markets are among the most developed in Latin America. However, key challenges remain, notably deepening the secondary market and increasing the global integration of Chilean capital markets. Removing obstacles for foreign investors and strengthening the financial sector infrastructure, as well as improving the framework for public debt management, would go a long way achieving these objectives.

1. Chile’s financial markets are generally well-developed, and the corporate bond market is large by emerging market standards. However, some characteristics of the fixed income market suggest that liquidity is not very high:

  • The outstanding stock of domestic public debt securities is low in global comparison both in relative and absolute terms (Figure 1 and 2).

  • Turnover in the secondary public debt market is comparable to that of emerging countries with moderately liquid bond markets, but liquidity is scarce in the corporate bond market (Figure 3).

  • Foreign investor participation is minimal compared to local bond markets in other emerging markets.

Fig. 1:
Fig. 1:

Size of Domestic Bond Markets 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Outstanding stock in Sep 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Fig. 2:
Fig. 2:

Absolute Size of Domestic Bond Markets 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Outstanding stock in Sep 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Fig. 3:
Fig. 3:

Annual Trading of Locally Issued Bonds 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ As share of outstanding local bonds in Sep 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007

2. As fiscal surpluses in recent years have reduced gross public debt, deepening the domestic secondary market for public debt is becoming a challenge. The large share of buy and-hold investors contributes to the problem of low liquidity, with pension funds assets at six times of government bonds and two times of total domestic bonds (Figure 4). However, pension funds’ high demand for domestic bonds may abate somewhat in the future with the ongoing liberalization of foreign investment limits.

Fig. 4:
Fig. 4:

Pension Fund Assets 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ As ratio to government bonds;2/ Figure for 2005Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007

3. Likewise, Chile’s derivatives markets show strength in some areas, but need to be developed further in others. Total over-the-counter foreign exchange (FX) market turnover is in line with the country’s income level, but this masks significant differences across market segments.2 While Chile’s FX forward turnover is high relative to both GDP and GDP per capita, the country ranks very low in terms of FX swap turnover, and very little FX options are traded (Figures 5 and 6). Turnover in cross-currency swaps and interest rate derivatives is also low (Figures 7 and 8). Moreover, trading with foreign counterparties has not reached the relatively high levels shown in many other emerging market countries (Table 1).

Fig. 5:
Fig. 5:

OTC FX forwards 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Annualized turnover, 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Fig. 6:
Fig. 6:

OTC FX swaps 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Annualized turnover, 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Fig. 7:
Fig. 7:

OTC Cross Currency swaps 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Annualized turnover, 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Fig. 8:
Fig. 8:

Total IR derivatives 1/

Citation: IMF Staff Country Reports 2008, 239; 10.5089/9781451807677.002.A006

1/ Annualized turnover, 2007Source: EMTA, OECD, BIS and BIS Triennial Central Bank Survey 2007
Table 1.

Chile: OTC FX Trading Activity with Foreign Dealers

(In percent of trading activity)

article image
Source: IMF staff estimates based on BIS (2007).

4. Larger participation by foreign investors could bring important benefits to Chile. Foreign participants could help diversify an investor base dominated by large domestic institutional investors that often have very similar portfolio allocation strategies, increasing market heterogeneity and reducing the potential for one–sided bets. They would potentially add demand for Chilean assets as pension funds can increasingly invest abroad, and would likely contribute to the development of the nominal bond market (domestic investors have a preference for inflation-protected securities). Ongoing improvements in the regulatory and supervisory framework (including the shift to Basel II capital standards) will help manage the risks associated with a larger presence of foreign investors.

5. Attracting foreign investors on a larger scale would seem to require action on a number of fronts. In addition to impediments for onshore derivative trading, low public debt, and remaining shortcomings in market infrastructure, the development of Chile’s fixed income and derivatives markets would require addressing the following key issues:

  • Chile levies a 35 percent capital gains tax on debt instruments for most foreign investors. There is a cumbersome administrative process to exempt foreign institutional investors.

  • The central bank law restricts the use of the local currency in settling most capital account transactions with non-residents, segmenting the offshore and onshore derivative markets.

  • There is a lack of regulation for the netting of transactions in the derivatives market.

  • Pension funds and insurance companies face strict restrictions on the use of derivatives.

  • Public debt issuance is relatively fragmented between the central bank and the government, between inflation-indexed and nominal bonds, and across maturities.

  • Sovereign benchmark issues have grown in size, but typically remain at US$400-500 million, a fraction of benchmarks in mature and liquid emerging bond markets.

6. Reforms are also needed to facilitate local currency issues by foreigners, one of the authorities’ reform objectives. Attracting foreigners to issue local currency-denominated bonds in Chile could help expand the supply of investment assets and increase portfolio diversification for domestic investors. Chile could benefit by following the example of countries like Canada and Australia that have successfully developed local-currency denominated markets for non-residents. However, the success of these countries depended on important preconditions, not all of which are currently present in Chile. Key impediments to local currency issues by foreigners include:

  • Only investors of a limited group of countries are permitted to issue debt in Chile.

  • The securities issuance process is relatively slow, especially for first-time issuers.

  • The stamp tax raises the cost of local bond issuance.

  • The cross currency swap market is relatively small, limiting the extent to which foreign issuers can manage their exchange rate exposures.

  • Credit risk management capacities by some institutional investors may need to be upgraded to manage exposures to non-sovereign foreign entities.

1

This chapter is a summary of a technical paper prepared by Zsófia Árvai (MCM).

2

The peer group chosen for this analysis is investment-grade emerging market countries and Australia, Canada and New Zealand. The analysis is based on data from the 2007 BIS Triennial Central Bank Survey.

Chile: Selected Issues Paper
Author: International Monetary Fund