1. Our authorities would like to thank the staff for the Staff Report and Selected Issues papers and for the thorough discussions on the impact of the international crisis on the Chilean economy, as well as on the policy responses to mitigate its impact on domestic and external stability. Such discussions were undertaken in a collaborative dialogue with the Fund, which became even more relevant given the current global crisis, and reflect the permanent dialogue on policy issues that has characterized the relationship between Chile and the Fund. Given the high degree of integration of the Chilean economy with the world, the marked global downturn of the last quarter of 2008 had a direct impact, changing rapidly the outlook on domestic economic activity, employment, and inflation. However, given the changes in the outlook stemming from these shocks, Chile’s rules-based policy framework has been instrumental. It has provided high flexibility in terms of the significant policy responses undertaken by our authorities to mitigate the impact of the global crisis, so as to secure domestic and external stability under exceptionally uncertain times.

Impact of the Global Crisis

2. In 2008, Chile’s output grew 3.2 percent, below potential output. The pace over the year showed the sharp impact on confidence of the changing global conditions. During the fourth quarter of 2008, the economy showed a sharp slump, driven by the impact on expectations and confidence of the drastic worsening of the global scenario. Thus, inventory accumulation, house sales, and imports of durables all fell sharply. The tightening of credit conditions and postponements of investment projects affected industrial output and construction (although this sector has been less affected by the crisis than in previous episodes), while lower oil prices and improved hydrological conditions provided some cost relief in terms of energy costs. During the first quarter of 2009, economic activity remained contracting, and preliminary data on the second quarter confirms a moderate contraction in output for the first half of 2009. In line with these developments, unemployment has recently risen slightly above 10 percent due mostly to a significant contraction in employment since the fourth quarter of 2008.

3. In light of these developments, the Banco Central de Chile’s (BCC) output growth forecast for 2009 was recently decreased to a range between -0.75 to 0.25 percent, with the balance of risks tilted to the downside. Thus, this downward revision shows the materialization of downside risks, due to a worsening external environment stemming from the recession in the world economy as well as the unresolved complications from the financial crisis and the remaining uncertainties associated with it. The main downside risks are related to the contraction in global growth and how it will impact emerging economies, which include the size and extension of the recession in the U.S. and other trading partners, the possibility of new, unfavorable, shifts in the prices of copper and/or oil, as well as protracted global uncertainty and lack of confidence.

4. Over most of 2008, annual CPI inflation increased steadily, reaching a peak of 9.9 percent in October. However, the marked and synchronized downturn in the world economy during the fourth quarter triggered a significant shift in the inflation path, characterized by a rapid and steady decline. As a result, inflation decelerated rapidly, and it reached the 3 percent target much earlier than initially envisaged. Given that the output gap is expected to remain negative for some time as potential output is estimated by the Central Bank to be in a range of 4.5 to 5 percent, CPI inflation is expected to remain below the target range in the second half of 2009, converging back to 3 percent by 2010. In line with these developments, the BCC revised downward its inflation forecast to 0.6 percent for year on year inflation by end December 2009, and to 2.3 percent for average inflation in 2009.

5. Given the impact of the global crisis on the Chilean economy as described above, our authorities have undertaken significant and decisive policy responses in terms of monetary policy, fiscal policy, as well as policies to sustain the flow of credit to businesses and individuals in the downturn of the cycle, in order to mitigate as much as possible the direct impact of the global downturn. These policy responses have been possible due to the prevailing sound policy frameworks, which have been instrumental in providing the adequate setup to implement monetary and fiscal stimulus when needed in order to confront the worst global downturn in decades.

Monetary Policy

6. The change in the expected path for inflation, with a much faster convergence towards the target, warranted a shift in monetary policy towards an easing of the monetary policy stance. Therefore, since January of 2009, the Central Bank has aggressively lowered the monetary policy interest rate, with marked reductions in January (100 basis points), February and March (250 basis points each month), and more gradual reductions since April. In the latest meeting of the BCC’s Monetary Policy Meeting in July, the BCC lowered the monetary policy rate by an additional 25 basis points, thus lowering the policy rate by a cumulative 775 basis points, bringing it to a level of 0.5 percent in July of 2009. Such aggressive monetary stimulus is unprecedented under the existing inflation targeting framework in terms of both the speed of adjustment and the level of the policy rates. It also reflects the authorities’ views that a sizeable monetary stimulus was needed to secure the attainment of the inflation target over the policy horizon.

7. During its Monetary Policy Meeting in July, the BCC also noted in its communiqué that the level of 0.5 percent for the monetary policy rate should be considered the lower bound for the policy rate, and highlighted that given the inflation forecast and the need to maintain monetary stimulus for some time, the policy rate will remain at this lower bound for an extended period of time. In order to reinforce this decision, and to enhance the alignment of the prices of financial assets with the current monetary policy stance, the BCC announced the introduction a new liquidity facility, the Term Liquidity Facility (TLF) to provide liquidity to banks at the current policy rate for terms of 90 and 180 days. The purpose of this new facility is to effectively extend the current monetary stance throughout the yield curve up to 6 months. The collateral required for this type of operations is the same as those used for the use of the overnight liquidity facility. In addition to the TLF, the BCC also announced an adjustment to the issuance of its short-term notes with a maturity of less than 1 year, and to suspend the issuance of bonds with a maturity of 1 year or more. The BCC also noted that these measures will remain in place as long as needed, and will remain vigilant by evaluating on a permanent basis the need of other complementary measures.

Fiscal Policy

8. In line with the implementation of the structural budget rule and due to continuing high copper prices during most of 2008, the Chilean central government posted an overall surplus of 5.2 percent of GDP in 2008, with a real decrease of 8.1 percent in revenues, while public expenditure grew 7.8 percent in real terms in the same period. In order to manage windfall revenues prudently and in consistence with the Fiscal Responsibility Law, the Chilean government continued saving the surpluses into the Economic and Social Stabilization Fund (ESSF), which as of December 2008 had accumulated USD 20.2 billion. Surpluses have also been saved into the Pension Reserve Fund, in the amount of USD 2.5 billion. The government initially submitted the 2009 budget to Congress, which provided for public expenditure growth of 5.7 percent in real terms, a slower pace relative to recent years, but effectively increasing social spending in health, education, innovation, and social housing, strongly focusing on the execution and quality of public expenditure.

9. Nevertheless, given the significant change in the macroeconomic conditions in the fourth quarter of 2008, the government implemented decisive countercyclical policy responses involving fiscal policy in three fronts: a Fiscal Stimulus Plan to support economic activity and employment; a Pro-Credit Plan to secure the flow of credit to businesses and individuals in the lower phase of the economic cycle; and, the Pro-employment Employment Accord to mitigate the impact of the cycle on employment. The Fiscal Stimulus Plan was announced in early January, with a size equivalent to 2.8 percent of GDP (USD 4 billion) with the purpose of supporting economic activity and employment. The plan included direct transfers to families and individuals, an increase in public investment of up to USD 700 million, recapitalization of Codelco by USD 1 billion to support its investment plan, tax reductions and other incentives for private investment, strengthening small and medium enterprise access to funding, and measures to protect employment. Such increase in spending stems from larger structural income, derived from the exchange depreciation relative to the level envisaged originally in the Budget and from a reduction on a temporary basis in the structural surplus target from 0.5 percent of GDP to 0 percent of GDP.

10. The Pro-Credit Plan was announced in March of 2009. It included twenty measures to stimulate the provision of credit by banks as well as non-banking financial institutions, to promote competition in the financial system, and to widen the scope of available funding alternatives. The pro-credit plan involves three broad dimensions: support to micro-entrepreneurs; measures to facilitate access to bank funding, and measures to facilitate access to non-bank funding. The overall impact of the pro-credit plan was to generate an additional USD 3.6 billion in new credit to the private sector. This plan complements the fiscal stimulus plan announced in early January. This plan also complements other previous measures taken by the government to secure the flow of credit given the downturn in the cycle. In order to enhance access to credit for businesses and individuals, in December of 2008, the government increased the capital of Banco Estado, the state-owned bank, with a USD 500 million injection to spur lending to small and medium sized enterprises by up to USD 2.6 billion, and also increased the Small Enterprise Guarantee Fund by USD 130 million, to a total of USD 200 million.

11. The Pro-Employment Accord is a tri-partite temporary agreement between employers, employees and the government which translates into six specific measures that would benefit a total of 130.000 workers. The first measure is a transitory tax incentive for the retention of workers and for the improvement of their work skills; the second is the establishment of a leave of absence for up to 5 months for the improvement of work skills, where the employee would receive 50 percent of his salary during the leave of absence, and be rehired with a greater set of skills; the third measure consists of an increase in the subsidy for the improvement of working skills for those businesses that are actively increasing hiring of new personnel; the fourth measure includes the establishment of a scholarship for working women who are heads of a household with the purpose of stimulating self-employment through small and micro enterprises; the fifth measure consists of the establishment of program of previous learning recognition which would certify the level of skill of a worker through a standardized and common evaluation; and the final measure protects family income, if the head of the household losses his or her job by enhancing the access to the Unemployment Solidarity Fund for employees with temporary contracts. This program benefits the employers as it increases the productivity of its employees, alleviates the cost of firing and the adjustment cost once the recovery is in place, and also the employees, as they increase their human capital, allowing for better expectations in terms of wages and better skills to improve the chances of finding a job. All the measures included in the Accord were approved by Congress in record time.

12. In addition to the measures described above, in her annual address to Congress on May 21, President Bachelet announced an additional transfer to four million low-income households, bringing forward the benefits of the Pension Reform, the establishment of an insurance plan to cover the mortgage payments of those families whose heads of household loses his or her job, and the expansion of the New Millennium Scholarship Program. All of these measures implied an additional government spending of USD 330 million in 2009.

13. Given the size and scope of the countercyclical fiscal policy measures, public expenditure is expected to grow 14.5 percent in real terms. This represents an increase with respect to what was initially projected in the Budget Law (5.7 percent), and 5.0 percent is due to increased spending committed in the Fiscal Plan of January; 0.9 percent corresponds to additional spending committed in the Pro-Credit Plan, the Pro-Employment Accord and May 21 announcements; 2.9 percent is due to the drop in average 2009 inflation projected for 2009, which was estimated at 5.2 percent in January and is now only expected to reach to 2.3 percent. Therefore, a fiscal deficit of 4.1 percent of GDP is projected for 2009. This is 1.2 percentage points higher than what was projected in January. The difference in projection is broken down into 0.2 percent of GDP of increased spending and 1.0 percent of GDP of lower revenues. Such deficit is the natural outcome of the decisive countercyclical fiscal policy, whose very own definition is to incur deficits during years of contraction of the global economy and to accumulate surpluses in years of boom.

14. Having saved the surpluses derived from the windfall gains in the price of copper of previous years, the Sovereign Wealth Funds has provided plenty of fiscal room for the government to implement countercyclical fiscal policy under current circumstances, as funding of the fiscal stimulus plan will come from the Economic and Social Stabilization Fund. Therefore, the government announced initially that it would withdraw an equivalent of USD 4 billion from the ESSF, of which USD 1 billion will finance investment and expenditure directly in USD, while the other USD 3 billion will finance investment and expenditure in local currency (pesos). In order to conduct the foreign exchange operation, the Ministry of Finance instructed the Central Bank, as a Fiscal Agent, to conduct a program of competitive bids for the sale of USD 50 million on a daily basis since March 27, 2009. By mid-June, the government announced its financing strategy for the rest of 2009, which would include and additional withdrawal of USD 4 billion from the ESSF, to be sold through the Fiscal Agent through competitive bids for the sale of USD 40 million on a daily basis starting in July 1, 2009, and the issuance of USD 1.7 billion in the 5-year and 10-year domestic bond markets. We highlight that the issuance of the bond markets was coordinated directly with the Central Bank, so as to avoid any disruption in the 5 and 10-year segments of the yield curve.

15. Our authorities would like to reiterate that the significant fiscal stimulus undertaken for this year has been possible due to the existence of the structural fiscal rule which has been instrumental in providing plenty of fiscal space to the authorities to conduct countercyclical fiscal policy, while also providing a clear and credible anchor for fiscal policy over the medium term. As such, Chile’s fiscal rule has proven to be a fundamental pillar of the existing macroeconomic framework to secure domestic and external stability. In fact, the financial position of the government will remain sound even after factoring in the significant fiscal stimulus undertaken in 2009, and such strong fiscal financial position will be the legacy of this administration based on the implementation of the fiscal rule.

Financial Sector

16. Chile’s sound regulatory framework has contributed to securing the stability of the financial system, and, therefore, insulating the domestic market from the global turmoil. The financial sector has continued to perform well during the crisis, with the banks adequately capitalized so as to withstand potential credit losses stemming from the downturn. The latest available survey of the Central Bank on the overall situation of banking credit up to June 2009 indicates that the number of banks reporting more restrictive credit conditions has been reduced for two consecutive quarters, thus suggesting a sustained improvement in the supply of credit to the economy. In line with this development, the survey shows a marked rebound in the demand of credit by businesses and individuals. Therefore, the flow of credit is on its way to the pre-crisis levels.

17. Our authorities’ views are that Chile’s regulatory framework has proven to be effective in securing financial stability against the backdrop of the global financial turmoil and the global downturn resulting from it. Therefore, improvements to the framework should be considered as enhancements to an already sound regulatory framework, in line with what could be considered best practice in terms of regulation. In particular, the issue of expanding the perimeter of regulation is an issue that our authorities might consider as potentially relevant for the FSAP Update which will be conducted in 2010, and should not be considered as a necessary modification to the framework to enhance the framework’s capacity to deal with potential credit risks, as suggested by the staff. Moreover, steps in the improvement of coordination among regulators have already been taken, as a Memorandum of Understanding (MoU) was signed in late June by the members of the Committee of Superintendents, which includes the banking, pensions, and securities supervisors, in order to formalize the cooperation and coordination channels between them.

Conclusion

18. In light of the unprecedented external shocks stemming from the global downturn, coupled with financial turmoil, our Chilean authorities took decisive and unprecedented policy measures in order to mitigate as much as possible the impact of the crisis on Chile’s domestic and external stability, as growth is expected to resume in the second half of 2009 in response to the stimulus already underway. Chile’s sound rules-based policy framework has provided enough flexibility in terms of monetary and fiscal policy to respond to these shocks, as it has been recognized by the credit rating agencies, as Chile was recently upgraded by Moody’s to A1 from A2, based on the solid fundamentals of its fiscal budget, low debt, and strong macroeconomic management.