Chile
2008 Article IV Consultation-Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Chile
Author: International Monetary Fund
Publication Date:
23 Jul 2008
eISBN:
9781451807684
Language:
English
Keywords:
ISCR; CR; inflation expectation; staff forecast; monetary policy; staff appraisal; structural surplus; current account; headline inflation; fiscal policy; foreign currency; Inflation; Exports; Metal prices; Global
Download PDF (1.6 MB)

This 2008 Article IV Consultation highlights that the Chilean economy has proved resilient in the face of strong economic and financial headwinds during the past year. Rising world prices for energy and food have been exacerbated by drought and a tight domestic energy situation. The government continues to move forward with a bold structural agenda. In the financial sector, the authorities plan to introduce initiatives aimed at enhancing market access for small and medium-sized enterprises, increase market depth, and boost the internationalization of the peso.

Abstract

This 2008 Article IV Consultation highlights that the Chilean economy has proved resilient in the face of strong economic and financial headwinds during the past year. Rising world prices for energy and food have been exacerbated by drought and a tight domestic energy situation. The government continues to move forward with a bold structural agenda. In the financial sector, the authorities plan to introduce initiatives aimed at enhancing market access for small and medium-sized enterprises, increase market depth, and boost the internationalization of the peso.

Figure 1.
Figure 1.

Economic Developments from a Regional Perspective

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Haver, IFS, Bloomberg.

I. Recent Global Shocks, Outlook, And Risks

1. Chile’s adherence to a prudent, rules-based macroeconomic policy framework has delivered important economic and social rewards.1 Responsible economic policies, trade openness, and institutional reforms have helped foster growth and price stability. Real per capita incomes have increased by 3 percent on average over the past 12 years, the poverty rate has been more than halved over the same period, the public sector has become a net creditor, and Chile has begun membership discussions with the OECD.

2. This policy framework has helped Chile preserve economic stability through the ongoing copper boom. Steady fiscal policy, following the structural surplus rule, has largely de-linked the economy from rising copper prices as most domestic mining revenues are accumulated abroad. This has prevented overheating, mitigated upward pressure on the currency, and led to the accumulation of a combined 15 percent of GDP worth of foreign assets in two sovereign wealth funds (SWFs).

3. More recently, the economy has been hit by a confluence of large domestic and external shocks that has proved more difficult to absorb (Box 1). Chile provides no general subsidies on food and energy, whose domestic prices have increased sharply with global price spikes. At the same time, a severe drought raised prices for local food produce and affected the production of hydroelectricity. With natural gas imports from Argentina diminishing, electricity producers have shifted to diesel fuel at a high marginal cost. As these are also being passed on, inflation has increased to close to 9 percent in May, well beyond the central bank’s 3-percent target.2

4. The impact of these shocks has affected growth, and a global scenario of lower growth and higher energy prices poses further risks to the outlook.3 Much of the slowdown since mid-2007 is due to a drop in value-added in the electricity sector, but demand growth is also expected to slow, given past interest rate increases, tighter credit conditions, and a drop in consumer confidence despite higher fiscal transfers. However, investment has benefited from lower prices for imported capital goods and a recent rise in FDI, helping growth to stay above 4 percent in 2008. Given Chile’s diversified geographical trade structure, the impact of a U.S. recession would likely be moderate, but the risk of a broader global slowdown (Box 2) and the difficult energy situation continue to weigh on the outlook.

5. Emergency steps have succeeded in avoiding electricity rationing, but limited energy supply will remain a challenge through 2009. The government extended daylight saving time and reduced network voltage by 10 percent, which—together with recent rainfall—has secured electricity supply. However, the cost of electricity generation remains at a record high, and relief is only expected from new power generation plants and an LNG import terminal becoming operational in late 2009.

Economic Outlook

(In annualized percent change from previous period; unless otherwise indicated)

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6. Long-term inflation expectations remain anchored by the monetary framework, with inflation projected to return to target toward the end of the 24-month horizon. Staff and authorities expect inflation to fall in the second half of 2008, helped by past monetary tightening, recent rainfall, and base effects, and then to decline gradually toward the 3-percent target by mid-2010. Despite a 50 basis point interest rate increase in June, risks remain on the upside, given the upward momentum in oil prices, a weaker peso, rising short-term inflation expectations, and still high core inflation. Nominal wages have kept pace with inflation, partly due to indexation, but unit labor cost increases have remained moderate—consistent with staff estimates that output remains currently below potential.4

7. Throughout the global financial turmoil, domestic financial markets have continued to function normally. Given Chilean banks’ low exposure to subprime mortgages, overnight spreads have risen only modestly since last fall. A recent survey confirms that most banks have tightened lending standards, although bank balance sheets remain strong amid ample funding sources. Should credit conditions in developed markets deteriorate further, however, the strong presence of foreign bank subsidiaries could pose a spillover risk (Box 3).

General Government Budget: Staff Projections

(In percent of GDP)

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8. Chile’s fiscal position remains exceptionally strong. The government registered a record surplus of 8¾ percent of GDP in 2007, owing to both record-high copper prices and domestic tax revenue growth. With the reduction of the 2008 structural surplus target to ½ percent of GDP, real expenditure has been budgeted to grow by 9 percent. The 2008 fiscal surplus is likely to again reach close to 8 percent of GDP.

9. After a major pension reform passed Congress in January 2008, political support for new reform projects may be more difficult to obtain. The government lost its majority in both houses of Congress, although its poll standings have improved in recent months. A report by a Presidential commission on labor and social equity provides a roadmap for further discussions; key reforms will have to find a broad national consensus in order to be implemented. Municipal elections are scheduled for October, and presidential elections for late next year.

II. Exchange Rate Valuation And External Stability

10. The authorities and staff agreed that the peso is mildly overvalued (Box 4). In 2007, the peso had strengthened in line with currencies of other emerging market economies, in particular commodity exporters. The pace of appreciation accelerated in the first quarter of 2008, reflecting widening interest rate differentials with the United States. Since the central bank’s decision in April to intervene and acquire reserves (see below), the peso has depreciated by 10 percent against the U.S. dollar and is now estimated to be about 0-10 percent above a level consistent with fundamentals.

uA01fig01

Carry to risk ratios 1/

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

1/ Defined as the overnight interbank interest rate differential relative to the one-week LIBOR rate, normalized by the (unconditional) standard deviation over a 90-day moving average window.
Figure 2.
Figure 2.

Current Account and Capital Flows

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Sources: Haver and DOTS

Underlying Current Account Balance

(in percent of GDP)

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Assumes exchange rate, commodity prices and output growth at long-run equilibrium.

11. Notwithstanding the stronger peso, export growth has remained relatively robust. Exports to the United States have slowed, but overall growth in non-copper export volumes has remained positive. Chile maintained its global export market share in 2007, and increased its share of the Asian market by about 80 percent over the past 5 years. However, the current account surplus is expected to fall into deficit in 2008, partly as a result of continued strong import growth, including of capital goods.5

12. Chile’s external position is expected to remain stable, and policies are geared toward further reducing external vulnerabilities. The trade balance is projected to fall into deficit over the medium term as growth recovers and the price of copper declines in line with medium-term price assumptions. With a corresponding decline in profit remittances by mining companies, the current account is projected to adjust gradually to its underlying medium-term deficit of around 2½ percent of GDP—close to the CGER norm of about 3 percent of GDP. Staff expects such a deficit to be easily financed, including as a result of forthcoming capital market reforms, and continued adherence to the macroeconomic framework should help contain exchange rate volatility.

13. The widening of the current account deficit would be largely offset by a decline in portfolio outflows corresponding to lower government asset accumulation abroad. A drop in copper revenues would diminish both the fiscal surplus and the amount of foreign assets acquired by the government, with private capital inflows expected to pick up only gradually on a net basis. Unlike in other emerging markets, there have been few signs of speculative portfolio flows into Chile so far, in part because domestic assets are still regarded as being relatively expensive. Moreover, the liberalization of foreign investment limits for pension funds will likely lead to some outbound portfolio flows over the medium term.

14. The central bank decided in April to raise international reserves by US$8 billion (5 percent of GDP) by year’s end.6 The authorities explained that the reserves buildup was designed to provide a cushion against a broader deterioration of financing conditions for emerging market economies, and with the peso appreciating rapidly and being above its long-term equilibrium, it was the right time to intervene and shore up reserves at a relatively low cost. The intervention is being implemented in a transparent, pre-announced manner (US$50 million a day), preserving the floating exchange rate regime and the flexibility of monetary policy to react to changes in the inflation outlook. The foreign exchange purchases are being sterilized at an estimated 10-year cost of ¾ percent of GDP.

15. The increase in foreign exchange reserves is consistent with most optimal reserve estimates for Chile.7 Reserves are projected to reach about 15 percent of GDP by end-2008, equivalent to about 90 percent of imports plus short-term debt. The authorities explained that assets in the government’s Fund for Economic and Social Stabilization (FESS) were not fully comparable to reserves, in part because they had the different objective of stabilizing fiscal expenditure over time.

III. Policy Discussions

The policy discussions focused on three issues:

  • Managing supply shocks. What is the optimal policy response to supply shocks within the rules-based framework?

  • SWFs and Macroeconomic Policy. What are the implications of SWF buildup for economic policy, and how should SWFs be managed?

  • Capital market development. With pension funds free to invest more funds abroad, what measures are needed to increase depth and competition in financial markets?

A. Managing Supply Shocks in a Rules-Based Policy Framework

16. The combination of inflation targeting, a floating exchange rate, and rules-based fiscal policies remains the optimal policy framework for Chile.8 The authorities and staff agreed that the framework had helped the economy adjust well to recent shocks, and provided for sufficient flexibility in case of more adverse inflation or output developments.

Monetary and Exchange Rate Policy

17. The Banco Central de Chile (BCC) remains focused on returning inflation to target over the 24-month policy horizon. Having raised interest rates by 125 basis points between August 2007 and February 2008, the BCC adopted a neutral policy bias in April. However, monthly inflation has since been accelerating, most core inflation measures remain outside the bank’s tolerance range, and world oil prices have again turned sharply upward. In response, the bank raised interest rates by an additional 50 basis points on June 10.

18. Monetary policy will need to react to any further manifestation of upside risks to the inflation outlook. Inflation remains largely driven by global commodity prices, and the BCC’s latest policy action underscores its commitment to meeting the inflation target. Nevertheless, given the strong inflation increase in May and recent jump in oil prices, the authorities and staff agreed that the decline in inflation over the coming months could be more gradual than anticipated in the last Monetary Policy Report, possibly raising the risks of second-round effects.9 In this light, the central bank should stand ready with additional policy measures, if necessary, to keep inflation expectations anchored firmly to the 3-percent target.

19. The central bank earns high marks for transparency, although communication of the inflation outlook could be improved. Given the unusual complexity related to different supply shocks, market participants have had some difficulties disentangling first and second-round price effects, and assessing the various risks to the outlook. Providing additional information on the BCC’s inflation forecast in the Monetary Policy Report, including on the propagation of shocks and monetary policy lags, could further strengthen the effectiveness of the central bank’s policies.

Fiscal Policy

20. Fiscal policy has helped mitigate the social impact of inflation. The reduction in the surplus target to ½ percent of GDP this year has provided a moderate stimulus to economic activity. This was mainly used to boost spending on education, but a pickup in nominal revenues has since provided room for ½ percent of GDP in additional spending. The government has provided targeted assistance to workers in certain export sectors, and legislation is pending to provide one-off cash transfers of $45 to the poorest 40 percent of the population and an additional $42 to low-income pensioners.

Figure 3.
Figure 3.

Inflation, Labor Markets and Monetary Policy

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Haver, Reuters.

21. While observing the surplus rule, the government has also used fiscal means to help the economy adjust to the rise in fuel prices. A two-year 25-percent reduction in the excise tax on gasoline and a $200 million (0.1 percent of GDP) injection into the fuel stabilization fund have temporarily reduced the retail price of gasoline by 10 percent since the beginning of the year. The fund has also absorbed some of the high costs of substituting diesel for gas and hydro-energy as the marginal source for electricity generation. This has smoothed the impact of recent oil price shocks and helped contain headline inflation. A further $1 billion injection was announced on June 2, after the end of the mission.10

22. Looking forward, fiscal expenditure will continue to grow in line with the surplus rule, consistent with macroeconomic stability. The government has been successful in communicating that growth of public spending beyond the limit implied by the rule risks putting renewed upward pressure on the exchange rate. The authorities emphasized that the focus of fiscal policy will be on quality and efficient implementation of spending programs.

What if the global economy turns worse?

23. Government officials were confident that economic stability could be maintained under worse global financial conditions. They emphasized that central bank reserves and the FESS provided ample room to respond in case of a financial sector crisis or an abrupt decline of government revenues, respectively. In particular, the fiscal rule had been designed to stabilize public investment and social spending in case of volatile copper revenues. The government, central bank, and financial supervisors meet regularly on financial stability issues, and the authorities have been in close contact with foreign supervisors to follow developments of common interest.

24. The staff suggested that stepping up the recapitalization of the central bank could bolster its capacity to react in a crisis. The central bank is currently undercapitalized by 2½ percent of GDP, and the cost of sterilizing foreign exchange purchases is likely to delay the bank’s return to a positive net worth. The authorities responded that they were committed to the five-year plan approved by Congress (½ percent of GDP a year, two years remaining), after which the need for additional transfers could be reviewed by future administrations.

B. Sovereign Wealth Funds and Macroeconomic Policy

25. Sustained high copper prices have led to rapid asset accumulation in Chile’s two SWFs. By end-2008, the FESS will likely contain $21 billion in assets (13 percent of GDP), and another 1½ percent of GDP are held in the Pension Reserve Fund (PRF). The central bank has managed both funds since their inception, following best-practice guidelines for reserves management.

Figure 4.
Figure 4.

Fiscal Strength and Sovereign Wealth Funds

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Chilean Authoritites and Fund Staff estimates.

26. The government is developing policies for managing the SWFs with a longer time horizon. The bulk of SWF assets will be kept in highly-rated fixed-income securities, but a more diversified portfolio will also include instruments with variable and longer duration. All investments remain limited to marketable instruments, managed subject to high professional standards and full transparency.

27. The authorities have been working with other member countries and Fund staff on developing best practices for SWFs. Fund technical assistance has focused on the strategic asset allocation for both funds, taking into account their assumed asset and liability structures. Significant progress has been made on the risk management framework, while the authorities agreed that performance measurement and risk management infrastructure still need to be improved.

28. The SWFs will provide additional resources for public spending over the medium-term. Eventually, the FRP will contribute about one quarter of the costs of the new pension system. FESS income from asset returns—considered structural revenue under the surplus rule—is projected to rise from ¾ percent of GDP to close to 1½ percent of GDP over the next few years, including as a result of the proposed shift in the portfolio structure. The President announced in May that $6 billion are to be transferred from the FESS to a new Bicentennial Fund, with the revenue used to finance scholarships to study abroad for up to 30,000 students in the next 10 years.11

29. The staff recommended including only the funds’ structural asset income in the structural revenue calculations for the budget. As the assets and their yield grow, the cyclicality of asset returns—especially from exchange rate fluctuations—could lead to unwanted volatility in the size of the annual budget. The authorities noted that, in practice, a similar result was currently achieved by using stable and relatively standard assumptions in projecting the funds’ income in the annual budget exercise.

30. The staff also suggested that the FESS’ investment objectives be embedded in a long-term fiscal framework. A comprehensive analysis of the structure of long-term public assets and liabilities could inform a decision whether the FESS should primarily be a stabilization or a saving fund. In this context, it would be helpful to assess the size of Chile’s mineral deposits, for which no official estimates are available.

C. Capital Market Development

31. The ongoing liberalization of foreign investment limits for pension funds has provided an impetus for further financial sector reform. Chile’s corporate debt, equity, and foreign exchange markets are well developed compared to most emerging market peers. However, markets have been dominated by pension funds and other large buy-and-hold investors, and there has been little participation of foreign investors. With pension funds being allowed to invest up to 80 percent of their portfolios abroad by October 2009 (up from 30 percent until last year), the government has been planning to make domestic markets more attractive for foreign investors.

32. The authorities remain committed to promoting the participation of foreign investors in domestic markets. The government is reviewing options to reduce registration and tax requirements for foreign investors in order to foster financial market integration. Staff noted that permitting the use of the peso in settling capital account transactions with nonresidents would be key for developing Chile’s small derivatives markets.

33. A new package of financial reforms aims to boost the internationalization of the peso, increase market depth, and enhance market access for SMEs. This package would include measures to encourage non-residents to issue peso-denominated debt in Chile, further facilitate derivatives trading, and provide a framework for the securitization of SME loans. A separate bill to establish a central counterparty for clearing and settlement purposes is already pending in Congress. The authorities expect the measures to be implemented during 2009.

34. The staff emphasized the importance of strengthening public debt management, including by consolidating sovereign paper into fewer benchmark issues.12 The authorities have made progress in developing benchmark issues, and the central bank and government are coordinating closely on debt management. Staff cautioned that debt issuance was still relatively fragmented, reflecting the varied objectives of maintaining both a nominal and inflation-indexed yield curve and providing long-duration assets for institutional investors.13

35. Supervisors were confident of the financial system’s capacity to withstand financial turbulence. Banks had appropriately tightened lending standards, capital adequacy remained strong, and bank supervisors remained in close contact with foreign counterparts to monitor cross-border activities. They have stepped up the monitoring of banks’ asset quality, liquidity, and risk management, and are working toward strengthening the bank resolution framework. The authorities agreed that the scope for further market reforms and implications for financial sector stability could usefully be discussed in the context of an FSAP Update, and that market integrity could be enhanced further by providing supervisory and regulatory bodies with operational and budgetary independence.

The Government’s Policy Agenda

Objective: Attain GDP per capita of $20,000 (on PPP basis) by 2020.

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Source: Presentation by Finance Minister Velasco to Sofofa on October 17, 2007, and Ministry of Finance, Chile.

D. Other Structural Issues

36. The government’s pension reform has been approved by Congress (see Country Report No. 07/333). The reform passed broadly unchanged, with a net cost of about one percent of GDP per year.

37. An ambitious public sector reform agenda is moving forward. The agenda includes plans to strengthen expenditure management and reform public procurement. Staff has encouraged the authorities to move toward a formal medium-term expenditure framework (MTEF) which would help to further improve treasury management and expenditure control, and to complete passage of a public transparency bill.

38. The authorities have initiated legislation to modernize the governance of public enterprises in line with the OECD’s Public Enterprise Code. The bill brings most public enterprises under the umbrella of the securities regulator, subjecting them to private sector accounting and transparency standards. At the same time, legislation is being introduced to strengthen corporate governance of private enterprises, including by mandating the presence of independent board members.

39. A high-level commission report provides a roadmap for labor and social reform. The commission, established by President Bachelet in 2007, proposed the introduction of a subsidy for low-income workers, in many respects similar to the principles of a negative income tax. This proposal, as well as a suggested reform of the unemployment insurance system, appear to enjoy a relatively broad political consensus. In other areas covered by the commission, such as labor relations and collective bargaining, the report provides a useful basis for further discussion.14

IV. Staff Appraisal

40. Chile’s adherence to a prudent, rules-based macroeconomic policy framework has delivered important social and economic rewards. Chile has rightly set its sights on eliminating poverty and closing the income gap with industrialized economies. The policy framework has been instrumental for managing the copper boom in recent years, and helped mitigate the impact of severe supply shocks experienced over the past 12 months.

41. Despite the moderate slowdown of growth, inflation risks continue to pose a challenge. Reflecting recent shocks, output growth is projected at about 4¼ percent in 2008, and then to recover in 2009 toward potential. While inflation is projected to decline in the second half of the year, the upward momentum in global oil prices suggests that supply shocks could prove longer-lasting, and risks have shifted to the upside.

Policy Recommendations by the Presidential Commission on Labor and Social Equity1

(Meller Commission)

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The group was commissioned to suggest policies to foster a more efficient labor market and reduce income inequality.

42. Monetary policy has been appropriately geared toward meeting the 3-percent target over the 2-year policy horizon. Although real wage increases remain moderate, near-term inflation expectations have risen and core inflation measures are outside the bank’s tolerance range. The central bank’s recent increase in interest rates has underscored its commitment to minimize second-round inflation effects, and it should stand ready to tighten monetary policy further, if necessary, to keep inflation expectations firmly anchored to the target.

43. While the peso is estimated to be moderately overvalued, domestic policies remain consistent with external stability. The central bank’s decision to augment foreign exchange reserves by 5 percent of GDP has been prudent, and is being implemented consistent with Chile’s commitment to a floating exchange rate. Given the additional costs of sterilization, the government could consider extending the program to recapitalize the central bank.

44. Fiscal policy remains well anchored by the structural surplus rule, which helps keep expenditure increases consistent with macroeconomic stability. Staff welcomes the focus on improving the already high quality of public spending, including by increasing efficiency and strengthening governance in the public sector. The temporary use of fiscal means to alleviate the impact of higher food and energy prices is appropriate, and the staff recommends to keep the measures targeted at the most vulnerable segments of the population.

45. The government’s efforts to further strengthen the management of Chile’s SWFs are well placed. Staff welcomes plans to invest parts of the Pension Reserve Fund and Fund for Economic and Social Stabilization into assets with variable returns, as well as Chile’s contributions to developing sound practices for SWFs. An evaluation of Chile’s long-term copper wealth would assist in formulating a long-term investment strategy.

46. To enhance the efficiency of Chile’s capital markets, the authorities plan to boost competition and increase the attractiveness of local markets to foreign investors. Consolidating public debt issuance into fewer benchmark issues and lowering regulatory and tax barriers for foreign investors would increase market liquidity. An FSAP Update could help in identifying financial vulnerabilities and further reform priorities.

47. The mission encouraged the authorities to consider further labor market reforms, building on recent recommendations by a presidential commission. Preserving labor market flexibility remains key in helping the economy adjust to major changes in relative prices.

48. It is recommended that the next Article IV consultation take place on the regular 12-month cycle.

Inflation and Exchange Rate Developments in Perspective

Chile’s inflation rate has recently increased more than in other countries. A strong interest rate response since mid-2007 has contributed to a larger appreciation than elsewhere.

Chile’s headline inflation rate was 8.9 percent in May 2008, driven by larger food and energy price increases than elsewhere. Inflation was more than double the inflation target (3 percent), and the highest level over the past twelve years. The contributions of food and fuel prices to the rise in inflation in 2007 were more than three times as large as in other Latin American countries, and even larger compared to advanced inflation-targeting countries.

uA01fig02

Contributions to headline inflation change

in percent – 2007Q1-Q4

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

The severity of the impact on Chile relative to elsewhere has two main explanations. First, the shares of food and fuel prices in Chile’s CPI (27 and 4 percent, respectively) are large relative to other countries, especially advanced countries, and the absence of subsidies implies that there is high pass-through to domestic prices of these goods. Second, Chile experienced a set of additional, largely weather-related shocks to food and energy supply at home.

uA01fig03

Changes in Policy Rates June 2007 - June 2008

hundreds of bps

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

uA01fig04

Changes in NEER June 2007 - May 2008

in percent

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

The Central Bank of Chile’s response to higher inflation since June last year was among the most aggressive by inflation-targeting peers. This helped keep long-term inflation expectations anchored around the 3 percent target. In combination with resurgent copper prices, monetary tightening also contributed to the stronger appreciation of the peso compared to some other inflation targeters’ currencies.

An Alternative Global Scenario

Economic developments in Chile are closely linked to the world economy, and less to a specific trading partner. Yet, the economy appears fairly resilient to a global downturn.

The staff employs a Bayesian VAR (B VAR) model to incorporate the impact of real and financial sector linkages between Chile and the global economy into its forecasts. The BVAR relates domestic growth to world GDP, the interest rate on U.S. high-yield debt, copper prices, domestic investment, and the exchange rate.1

In the baseline scenario, model simulations show a strengthening of the economy after the unwinding of recent financial and commodity price shocks. Using the assumptions underlying the Spring 2008 Regional Economic Outlook (REO), the model produces a growth path similar to the staff’s baseline forecast of 4½ percent growth in 2008 and 2009.

uA01fig05

GDP growth under baseline forecast 1/

in percent, y/y

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

1/ Conditional path for the first 8 quarters of the forecast period; estimation sample 1994Q1 - 2007Q4.

Risks to this forecast are highlighted by a global downside scenario. Adopting the “severe downside” scenario presented in the REO, world GDP in 2008 is assumed to grow by only 2½ percent. Copper prices would drop 30 percent, and interest in high-yield debt would rise 250 basis points above the baseline. Growth in Chile could drop to below 3 percent in 2008–09 before returning gradually to trend growth. Yet, the probability of a severe recession would still appear low as the macroeconomic framework would provide for a significant countercyclical stimulus through domestic short-term interest rates, the exchange rate, and fiscal policy combined.

uA01fig06

Alternative scenario 1/

in percent, y/y

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

1/ Conditional path for the first 8 quarters of the forecast period; estimation sample 1994Q1 - 2007Q4.
1 See Österholm, P., and J. Zettelmeyer, 2007, “The Effect of External Conditions on Growth in Latin America,” IMF Working Paper No. 07/176, for a description of the model.

Participation of Foreign Banks in Chile’s Banking System

Foreign-owned banks account for about 40 percent of total outstanding credit in Chile, historically higher than in most of its neighbors. The concentration among parent countries creates a channel for the transmission of country-specific shocks.

uA01fig07

Credit by foreign-owned banks

in percent of total credit; end-year 1/

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Sources: National authorities; and IMF staff estimates.1/ For 2007, rates are based on latest available data.
uA01fig08

Latin American Banks: Foreign Liabilities

in percent of total liabilities

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Sources: IMF, International Financial Statistics

Cross-border claims of foreign banks on Chile rose by more than half to $34 billion (21 percent of GDP) over the past two years. While two thirds of the change reflect exchange rate fluctuations, there has been some increase in borrowing by domestic banks recently as pension funds are likely to shift parts of their deposits abroad. Subsidiaries of foreign banks hold $50 billion in credit on local counterparts, but the overall share of foreign bank liabilities remains low at 7 percent.

The presence of foreign banks in Chile does not appear unduly large. Although foreign banks account for a large share of the banking system, Chilean corporates have access to financing through a well-developed domestic bond market. Partly as a result, claims by foreign banks account for a smaller share of GDP than in much of emerging Europe, and are of an order of magnitude comparable to countries such as Korea and South Africa.

However, geographical concentration among foreign banks could provide a possible transmission channel for financial shocks. In recent years, Spanish banks have significantly increased their presence in Chile, and European institutions now account for about 80 percent of consolidated claims on Chile. Hence, there may be a risk that tighter credit or liquidity conditions in Europe would be transmitted—possibly through local subsidiaries—into the Chilean market.

Claims by Foreign Banks

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Source: BIS.

Origin of Foreign Claims on Chile

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Source: BIS.

Assessing Chile’s Exchange Rate

The IMF’s multilateral CGER approach finds the peso valued at about equilibrium. Other models by the authorities and staff estimate the peso to be about 0-10 percent above a level consistent with fundamentals.

uA01fig09

Nominal Exchange Rates

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

On a real effective basis, two factors have added to the appreciation of the peso in recent months. First, the rise in Chile’s inflation differential with its trade partners has made domestic goods relatively more expensive. Second, Chile’s trade with Asia has increased. With price levels in Asia below those in Chile, the United States, and Europe, the peso has become less competitive.

Both factors are captured in a real effective exchange measure developed by the U.S. Federal Reserve Board.1 The Weighted Average Relative Price (“WARP”) is calculated using relative purchasing powers and shifting trade weights—and is thus well suited for a country like Chile. According to this measure, the peso has appreciated by around 19 percent since early 2002.

uA01fig10

Comparison of Real Exchange Rates

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

In estimating a WARP-based equilibrium exchange rate approach, using variables similar to those in the CGER model, we find that terms of trade shifts (particularly higher copper prices) account for most of the appreciation in recent years. As of May 2008, the peso was valued at about 8 percent above the level predicted by fundamentals. This estimate is within the range of model outcomes obtained of the authorities.

uA01fig11

WARP Real Exchange Rate and Predicted Equilibrium Exchange Rate

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

1 Thomas, C.P., J. Marquez, and S. Fahle, “Measuring U.S. International Relative Prices: A Warp View of the World,” FRB International Finance Discussion Paper No. 917, 2008.
Figure 5.
Figure 5.

Domestic Demand and Net Exports

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Haver, Chilean Authorities and Fund Staff estimates.
Figure 6.
Figure 6.

Energy Supply: Tight and Expensive

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Chilean Authorities
Figure 7.
Figure 7.

Yields, Spreads, and Credit

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Bloomberg, Haver, Credit Suisse, BEL and Chilean Authorities.
Figure 8.
Figure 8.

Developments and Key Players in Financial Markets

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Bloomberg, Bankscope, Bank of International Settlements, IFS, World Federation of Exchange Rates and Fund Staff estimates.
Figure 9.
Figure 9.

Healthy Banking Indicators

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: Fund Staff estimates; Moody’s KMV; Chilean Authorities.
Figure 10.
Figure 10.

Investment Climate: Sunny, Only a Few Clouds

Citation: IMF Staff Country Reports 2008, 240; 10.5089/9781451807684.002.A001

Source: World Trade Organization, KPMG, CD Howe, World Bank Doing Business Data.
Table 1.

Chile: Selected Economic Indicators 1/

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

As of June 12, 2008

Defined as potential minus actual output, divided by potential output

End of period; INS definition of the real effective exchange rate. A decline indicates a depreciation of the peso

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

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

Table 2.

Chile: Summary Operations of the Central Government

(In percent of GDP)

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

Based on the 2008 Budget and updated staff estimates.

Change in nonmining structural balance (-) as a share of GDP excluding extractive activities.

Excludes interest payments and income from government assets.

General government and Central Bank only.

Table 3.

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. Municipalities hold neither sizeable financial assets nor debt

Table 4.

Chile: Indicators of External Vulnerability

(In percent; unless otherwise indicated)

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

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, but not trade credits.

Morgan-Stanley Capital International index (Dec/1987=100). 2008 data averaged up to end-March.

Table 5.

Chile: Balance of Payments

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

“Errors and Omissions” from Haver balance the Current and Capital Account.

“Other” variations in reserves largely reflect changes in deposits by commercial banks and the government with the central bank, as well as the repayment of foreign currency bonds, completed in 2006.

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

Updated staff forecasts.