Chile
2010 Article IV Consultation-Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Chile

Chile’s economy has withstood successfully two consecutive large negative shocks—the global financial crisis and the February 2010 earthquake. The financial system has weathered the crisis well and the cyclical deterioration of credit quality has been moderate. Large-scale private and public reconstruction spending should continue to boost growth. The authorities’ intentions to enhance the supervision of the financial sector, including the planned move toward consolidated supervision of financial conglomerates, are encouraged. The prudential framework is strengthened by adopting a functional approach to regulation and supervision.

Abstract

Chile’s economy has withstood successfully two consecutive large negative shocks—the global financial crisis and the February 2010 earthquake. The financial system has weathered the crisis well and the cyclical deterioration of credit quality has been moderate. Large-scale private and public reconstruction spending should continue to boost growth. The authorities’ intentions to enhance the supervision of the financial sector, including the planned move toward consolidated supervision of financial conglomerates, are encouraged. The prudential framework is strengthened by adopting a functional approach to regulation and supervision.

I. Context

1. Since 2008, Chile’s economy has successfully withstood two large adverse shocks—the global financial crisis and a devastating earthquake in February 2010. Chile’s resilience has been underpinned by a strong policy framework (a fiscal rule, inflation targeting and exchange rate flexibility), a well-capitalized banking system, and the absence of imbalances in the private sector. In response to the economic slowdown triggered by the global crisis, the previous government implemented a sizable fiscal stimulus, cut interest rates sharply, and put in place measures to improve liquidity in the banking system.1 This response (large by regional standards) contributed to a strong recovery in real GDP growth in the second half of 2009 (text chart). After taking office in March 2010, the new administration put in place an ambitious earthquake reconstruction program, financed by a mix of temporary tax increases, reprioritization of spending, and some borrowing. With large fiscal savings accumulated over the past decade, and a proven track record of low inflation and prudent banking practices, these sizable policy responses have not compromised confidence in economic policies.

II. Outlook for 2010

2. A strong economic recovery is underway, and staff projects that real GDP will grow by 5 percent in 2010 (Figure 1 and Table 1). After contracting sharply after the collapse of Lehman, real GDP grew at an annualized rate of 7 percent in the second half of 2009. Domestic demand led the recovery, supported by the substantial easing of fiscal and monetary policies. Consumer and business confidence strengthened as the global economy stabilized and Chile’s terms of trade improved. Growth was temporarily disrupted by the end-February earthquake, but resumed in the second quarter of 2010. Strong private consumption and large private and public investment, including on inventories, are expected to sustain domestic demand growth.

Figure 1.
Figure 1.

Domestic Demand and Net Exports

(January 2005 – June 2010)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Haver Analytics Inc, Chilean Authorities and Fund Staff estimates.
Table 1.

Chile: Selected Social and Economic Indicators

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

Contribution to growth.

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).

3. With diminishing spare capacity in the economy, inflation is expected to rise to 3.7 percent by end-2010. The rapid growth of domestic demand has contributed to strong real import growth and to a rise in domestic inflation (consumer prices increased by 2.2 percent y/y in July, after falling by 1.4 percent during 2009, Figure 2). At the same time, the earthquake is likely to have caused a transitory decline in the level of potential output. Staff’s estimates suggest that Chile’s output gap would average about 2 percent of GDP in 2010, and would close in 2011 (Box 1).

Figure 2.
Figure 2.

Inflation, Labor Markets and Monetary Policy

(Through June-July 2010)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Central Bank of Chile and Haver Analytics Inc.1/ CPI weights and basket changed in December 2008.2/ The methodology for compiling labor market statistics changed in March 2010.

4. The rebound in growth, together with higher copper prices, will help narrow the fiscal deficit in 2010. The central government deficit is projected to decline to 1¾ percent of GDP in 2010 (from 4.4 percent of GDP in 2009), reflecting a recovery in tax revenues from both the mining and non-mining sectors and lower current expenditure (Figure 3 and Table 2). The revenue gains are being supported by efforts to restore tax compliance, which declined during 2009, as well as temporary tax increases. On the expenditure side, the end of several of the temporary stimulus measures adopted in 2009 and the government’s efforts to improve expenditure efficiency are expected to lower real expenditure growth to 9 percent (from almost 20 percent the year before). Staff estimates that the reconstruction spending would raise the structural deficit (the balance with revenues measured at potential output and the long-term trend copper price) to about4.1 percent of GDP in 2010, from 3.1 percent of GDP in 2009.2 The net financial asset position of the central government is projected to decline to 14 percent of GDP by the end of 2010, from a peak of 20 percent of GDP in 2008 (Table 3).

Figure 3.
Figure 3.

Fiscal Policy

(2001– 09)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Ministry of Finance and Fund staff calculations.
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 2009 Budget, mid-2010 budget revision, staff estimates.

As a share of non-mining GDP.

General government and Central Bank only.

Table 3.

Chile: Summary Operations of the Public Sector 1/

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Sources: Ministry of Finance (DIPRES), Central Bank of Chile, and staff estimates.

This table reflects the authorities’ revisions to historical official data to bring the fiscal accounts in line with GFSM 2001. For further details see: http://www.dipres.cl/572/articles-63318_doc_pdf.pdf

Includes the effects of valuation changes (inflation) to the stock of UF debt and accrued interest on Treasury debt; excludes administrative expenses and provisions.

On a cash basis. Municipalities hold neither sizeable financial assets nor debt.

The data reported here do not include depreciation as an expense.

5. Financing conditions have eased and credit growth is picking up. After tightening significantly in late 2008 and early 2009, credit conditions for both corporations and households have eased, and credit growth resumed (Figure 4). Lending rates have declined in the course of 2009, in line with the reduction of the policy rate. Corporate bond spreads have also declined to their pre-crisis levels. The normalization of liquidity conditions allowed the central bank to terminate in June 2010 the temporary short-term bank liquidity facility set up during the crisis.

Figure 4.
Figure 4.

Financial Markets

(January 2007 – May 2010)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Source: Central Bank of Chile, SVS, and staff calculations.

6. The central bank started raising the policy rate in June 2010 to help moderate the pace of demand growth. After three consecutive monthly increases, the policy rate stands at 2 percent in August 2010. Inflation expectations for end-2010 are above the 3 percent target, but remain anchored at target at the end of the 24-month policy horizon.

7. Chile’s external position remains strong. The net international investment position has improved by about US$30 billion since mid-2009, largely due to valuation gains on the assets held abroad by institutional investors (Figure 6). The external current account is projected to shift from a surplus of 2½ percent of GDP in 2009 to a deficit of about 1 percent of GDP in 2010, as real import growth strengthens and profit repatriations accelerate (Table 4 and Figure 5). Staff estimates, based on CGER methodologies, suggest that the real effective exchange rate is broadly line with its long term fundamentals as of June 2010.

Figure 6.
Figure 6.

Net IIP and Capital Flows

(2006Q2–2010Q2)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Central Bank of Chile and Fund staff calculations.
Table 4.

Chile: Balance of Payments

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

“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.

Updated staff forecasts, average.

Figure 5.
Figure 5.

External CurrentAccount

(2005Q1 – 2010Q1)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Central Bank of Chile and Fund staff calculations.

Chile: CGER-based Equillibrium REER Assessment

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Source: IMF Staff estimates, June 2010.

Undervaluation = “−”.

8. The financial system weathered the crisis well, with only a moderate cyclical deterioration in credit quality. Non-performing loans remain relatively low, at 3 percent of all loans. Banks are well capitalized and have a relatively stable funding base (Figure 7). Provisioning levels have strengthened, in part due to stricter provisioning requirements in place since January 2010. Annual bank credit growth to the private sector has recovered to 7.5 percent in mid-2010.

Figure 7.
Figure 7.

Banking System Developments

(January 2009 – April 2010)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Central Bank of Chile, SBIF and Fund staff calculations.

Chile: Financial Soundness Indicators

(In percent, unless otherwise indicated)

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Sources: SBIF.

As of March 2010.

Nonperforming loans are based on IFRS accounting rules starting in 2009 (data in bold).

III. Medium term Outlook and Risks

9. Real GDP growth is expected to accelerate to about 6 percent in 2011, and thereafter converge to the potential output growth rate of about 4½ percent (Table 4). The staff baseline scenario assumes that the overall position of the central government will return to virtual balance by 2014, and its net financial assets will remain close to 15 percent of GDP. The current account deficit is expected to stabilize at around 2¼ percent of GDP, financed mainly by continued net foreign direct investment. Net international reserves are projected to remain stable, given central bank commitment to exchange rate flexibility.

10. While near term risks are broadly balanced, Chile remains vulnerable to global economic shocks over the medium term. In the near term, strong consumer and business confidence, underpinned by large reconstruction spending and still easy financing conditions, could translate into a greater-than-expected boost to demand and a faster than envisaged narrowing of the output gap. However, as a highly open and financially integrated economy, heavily dependent on copper exports and oil imports, Chile remains vulnerable to volatility in world commodity prices, global growth, and capital markets (see chart).

IV. Policy Discussions

11. The authorities are committed to preserving macroeconomic stability, strengthening further the policy framework, and creating incentives to boost productivity. They noted that the fiscal rule in place since 2001 had been critical in helping the government effectively manage the effects of the global financial crisis and the 2010 earthquake. However, recent experience with implementation of the rule showed that certain aspects of it could be improved, and for that purpose the government convened a high-level commission with the task of recommending reforms to the fiscal rule. The authorities also stressed that a key priority of the new government is to create conditions to accelerate productivity growth. Key initiatives in this area include increasing the efficiency of the public sector, and securing legislative approval for comprehensive capital market reforms.

Fiscal Policy

12. The authorities emphasized that expenditure restraint would anchor fiscal policy over the medium term. They noted that, even with the additional spending on reconstruction in 2010–12, they aimed to reduce the structural deficit to 1 percent of GDP by 2014, which would require a cautious expenditure policy. Staff and the authorities agreed that to ensure a consistent policy mix and moderate exchange rate appreciation pressures, a gradual withdrawal of fiscal stimulus should start in 2011, while still allowing room for reconstruction expenditure. Detailed fiscal plans for 2011 and for the medium term will be released in September, when the draft 2011 budget is sent to Congress. The authorities estimated that the government’s share of the estimated total reconstruction costs of about US$30 billion would be on the order of US$8.4 billion (4 percent of GDP) over 2010–13, which would be financed through insurance reimbursements, improved efficiency and reallocation of spending, temporary tax increases, and debt issuance. The authorities noted that the temporary tax increases would help avoid a compression of spending in the near term, and would be combined with a productivity-enhancing extension of the reduction in the stamp tax on financial transactions and some tax breaks for small and medium sized enterprises (text table). In July the government placed a US$1 billion 10-year bond at a spread of 90 basis points, and sold a US$500 million peso-linked bond to international investors at an interest rate of 5.5 percent.

Government Net Reconstruction Costs, 2010–13

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Sources: Ministry of Finance and staff calculations.

13. Staff supported the authorities’ goal of narrowing the structural deficit to 1 percent of GDP by 2014. It noted that attaining this goal would entail keeping the growth of government spending below the growth rate of output for most of this administration (assuming broadly an unchanged tax burden and stable long-term copper prices). Staff discussed a scenario where the headline central government deficit declines from 1.7 percent of GDP in 2010 to 0.5 percent of GDP in 2011, and real government expenditure grows by 9 percent and 5 percent, respectively. The central government’s headline position would gradually move to virtual balance by 2014, as expenditure would decline to about 22 percent of GDP—near its level prior to the global financial crisis. (Table 5). In this scenario, the structural deficit would remain about 3 percent of GDP in 2011, and gradually fall to a deficit of 1 percent of GDP by 2014. This fiscal profile would result in a gradual withdrawal of the 2009 fiscal stimulus between 2011 and 2014, which would help avoid undue compression of expenditure at the end of the period. While staff supported the fiscal target for 2014, it stressed that it would be prudent to return the structural position to balance over a longer horizon, say by 2016, to signal the intention to keep fiscal policy neutral over the long term and preserve the net financial position of the government on a sustained basis. To this end, staff suggested that any rise in the structural revenues caused by upward revisions in the long-term copper price could be used to reduce the structural deficit faster than currently planned. The authorities noted that the current institutional framework required the government to formulate goals for fiscal policy only during its term.

Table 5.

Chile: Medium-Term Framework

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

Medium term projections are consistent with potential growth of 4.5 percent for 2013–2015.

Contribution to growth.

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).

IMF staff forecasts, average

14. Staff welcomed the government’s decision to establish a commission to review the fiscal rule. In late August 2010, the commission published its interim report and recommended revisions to the methodology for calculating the structural balance. The final report (due by November 2010) will consider the scope for broader reforms to the rule, possibly including proposals to modify its countercyclical role and strengthen its institutional basis. Staff noted that the rule in place since 2001 has helped stabilize spending growth and accumulate sizable net financial assets during the copper price boom, but could be improved in several aspects. Staff analysis, drawing on best international practices (Annex 1), suggests the following points to consider in reviewing the design of the rule:3

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    Make the calculation of the structural balance more transparent and easy to replicate.

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    Introduce an explicit escape clause to allow for discretionary countercyclical policy in the case of large shocks.

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    Complement the rule with a medium-term policy framework that would extend beyond the 4-year presidential term to provide a clear path for returning to the fiscal target after temporary deviations.

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    Minimize unintended procyclicality. An expenditure growth ceiling could help prevent procyclical increases in public spending in the event of a significant increase in the long-term copper price.

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    Expand the role of the expert committees to include an ex-post assessment of the implementation of the rule and consider the adoption of a full “fiscal council” system to increase further fiscal transparency and accountability.

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    Complement the rule with an indicative target for the government’s long-term net financial assets, taking into account contingent liabilities.

The authorities agreed with the recommendations in the interim report but wanted to carefully review the final report before offering any views on possible reforms to the rule.

15. Staff encouraged the fiscal authorities to continue the recapitalization of the central bank. Between 2006 and 2008, the government reduced the estimated capital shortfall of the central bank to ½ percent of GDP, but these transfers were suspended in 2009.4 Completing the recapitalization of the central bank would help strengthen further its credibility, without affecting the overall asset position of the general government. The authorities replied that they would review a report on the capital position of the central bank before deciding on the next steps.

Monetary Policy

16. Monetary policy has appropriately moved to a tightening stance since June. The strengthening economic outlook calls for further tightening in the coming months, as envisaged in the latest Monetary Policy Report. Market expectations suggest that the policy rate will increase to 5.5 percent by early 2012.

17. Staff noted that the widening of interest rate and growth differentials with major advanced economies could trigger capital inflows. Staff and the authorities agreed that in the event of a surge of capital inflows, the first line of defense should be to allow nominal exchange rate appreciation, possibly accompanied by macroprudential policies to limit excessive growth in credit. Staff suggested that possible prudential measures could include higher bank reserve requirements, countercyclical provisioning or capital requirements, and limits on loan-to-value and loan-to-deposit ratios. Limits and/or higher capital requirements on banks’ forward foreign exchange positions could also be considered in the case of excessive exchange rate volatility. The authorities noted that there were a wide range of macroprudential measures that could be considered, and the choice would be tailored to the specific situation and coordinated with the supervisory agencies. In some cases, these measures would require legislative approval. Staff agreed with the central bank’s view that intervention in the foreign exchange market would be warranted only in the case of extreme exchange rate misalignments, accompanied by the risk of disruptions in domestic financial markets, in line with the framework for sterilized interventions in place since 2000.5

Strengthening the Financial System

18. Staff and the authorities agreed that domestic credit risks would diminish further as the recovery firms up. The earthquake could have a limited temporary impact on credit risk in the affected zones, as indicated in the latest financial stability report of the central bank. However, for the banking system as a whole, this effect is expected to be offset by the rebound of economic activity and lower unemployment. Stress tests conducted by the central bank suggest that banks’ capital ratios will remain above minima, even if economic conditions deteriorate and the cost of financing increases relative to the baseline projections. Staff and the authorities also agreed that the risk of financial contagion from Europe appeared to be contained, as the large domestic banks that are subsidiaries of Spanish and U.S. banks have a stable domestic funding base (Figure 8 and Box 2).6 As of April 2010, external funding was only 9 percent of total liabilities and most of it was long-term debt.

Figure 8.
Figure 8.

Equity Return Pairwise Correlation, Spanish and Chilean Banks

(2005– 2010)

Citation: IMF Staff Country Reports 2010, 298; 10.5089/9781455208371.002.A001

Sources: Primark Datastream LLC and Fund staff calculations.

19. The authorities remain committed to continue financial sector reforms. These reforms are intended to further strengthen the prudential framework and deepen domestic capital markets, which should be beneficial for productivity growth. The third capital market reforms law (MKIII), approved by Congress in May 2010, broadens the universe of authorized financial instruments, including exchange-traded funds and mortgage bonds; facilitates the process of securitization; and extends tax exemptions on selected fixed income instruments to foreign institutional investors. In addition, the government is developing another set of reforms (the bicentennial capital market reform or MKB) to improve further the liquidity of financial markets and update the institutional framework, especially in the areas of consolidated supervision and corporate governance of the financial supervisors (Box 3).

20. The staff fully supported these initiatives, and suggested possible additional measures to strengthen further the regulatory and supervisory framework.7 These included: (i) adopting a functional approach to regulation and supervision to limit regulatory arbitrage and facilitate systemic risk assessment; (ii) formalizing cooperative supervisory arrangements among the three supervisory agencies, including by setting up a systemic risk council; (iii) strengthening cross-border coordination with international counterparts; (iv) addressing information gaps to help identify vulnerabilities and price misalignments; and (v) using a regulatory benchmark model and common assumptions to assess the adequacy of dynamic loan loss provisions. The authorities agreed with the staff’s view that a functional approach, similar to the one currently applied to investment funds and mortgage financing, would broaden the perimeter of regulation to currently unregulated entities and improve the uniformity of regulatory standards. They added that the three main supervisory agencies—the SBIF (banking), the SVS (securities and insurance), and SP (pensions)—are currently implementing a pilot exercise on consolidated supervision of financial conglomerates, with a view to setting up a formal framework for cooperation. They also agreed that addressing information gaps is important and noted that they are expanding the set of data collected from financial conglomerates. Staff supported the planned adoption of dynamic provisioning, and suggested that it could be complemented by the introduction of countercyclical capital buffers to reduce macroprudential risks associated with procyclical credit expansion.

Enhancing Productivity Growth

21. Staff also supported the government’s other initiatives to enhance productivity growth. In 2010, Chile ranked 49th in the World Bank’s Doing Business Indicators, reflecting relatively high costs for starting a business, inefficient bankruptcy procedures, and labor market regulations that favor short-term subcontracting. The government is planning reforms aimed at increasing competition, facilitating the entry of new firms, making credit more accessible to small and medium-enterprises, and improving bankruptcy regulations. It also plans to establish a specialized stock market to facilitate initial public offerings for startups and increase the availability of venture capital. Staff agreed with the authorities that replacing the current high severance payment system with a more comprehensive unemployment insurance scheme could help increase labor market mobility and encourage greater investment in education and on-the-job training. Increasing the share of skilled workers in the labor force could also help reduce income inequality.8 Staff also noted that relatively high minimum wages in Chile—45 percent of the average wage compared to the OECD average of 40 percent—could increase youth unemployment and contribute to the growth of the informal sector.

V. STAFF APPRAISAL

22. Chile’s economy has shown remarkable resilience in the past two years. The economic recovery is fully underway, helped by appropriate policy responses to the two large adverse shocks. The recent success in tapping international capital markets on very favorable terms attests to the strong market confidence that macroeconomic stability will be preserved.

23. Fiscal policy played a critical countercyclical role, drawing on the public savings accumulated prior to the global crisis. The 2009 fiscal stimulus helped support an early recovery of economic activity. The planned withdrawal of the fiscal stimulus was delayed by the demands on government spending placed by the devastating earthquake of February 2010. The government has adopted a prudent approach to financing the emergency spending through reprioritization of other expenditure, temporary tax increases, efficiency gains, and some debt issuance. The government’s commitment to firm expenditure restraint starting in 2011 is important to ensure that fiscal policy helps reduce the risk of overheating and limit exchange rate appreciation pressures.

24. Staff supports the authorities’ goal of reducing the structural deficit of the central government to 1 percent of GDP by 2014. The target is challenging, as it implies firm expenditure restraint over a number of years. However, over a longer horizon, it would be advisable to return the structural position of the central government to balance in order to keep the government’s discretionary fiscal policy neutral while preserving its net financial assets. Thus, any increase in the long-term copper price could be used to reduce the structural deficit even faster. Staff encourages the government to renew its commitment to fully recapitalize the central bank.

25. The government’s decision to review the fiscal rule is welcome. While the rule has worked well and is one of the main pillars of Chile’s policy framework, its design can be refined to make the rule even more effective. Areas for improvement include making the rule more transparent and easier to replicate; introducing an explicit escape clause and features to limit unintended procyclicality in spending; complementing the rule with an explicit medium-term policy framework that extends beyond the term of each government; and strengthening accountability through ex-post assessment of compliance. Once the commission has issued its final report, the government could limit any uncertainty by outlining a clear timetable for adopting any revisions to the rule.

26. Staff supports the recent shift of monetary policy to a tightening stance. Diminishing spare capacity in the economy calls for continuing withdrawal of monetary stimulus to bring inflation in line with the target by the end of the 24-month policy horizon. The implementation of monetary policy could become challenging, however, if the widening interest rate and growth differentials with major advanced economies lead to a surge in capital inflows. Staff supports the central bank’s intention to rely on exchange rate flexibility as the first line on defense to mitigate the risk of excessive inflows, and notes that the central bank has intervened in the foreign exchange market only on three occasions since 2000 under exceptional conditions. It also supports the central bank’s willingness to consider macroprudential measures to help prevent excessive growth in credit.

27. The financial system has weathered the crisis well, but a further strengthening of the prudential framework would be beneficial. The planned introduction of consolidated supervision of financial conglomerates will allow a more comprehensive assessment of risks. In addition, it would be important to adopt a functional approach to regulation and supervision, which would facilitate a broadening of the perimeter of supervision to include nonbank credit providers. Other important reforms that could enhance systemic risk surveillance include formalizing cooperation arrangements among the supervisory agencies, strengthening cross-border coordination with international counterparts, and addressing information gaps to help identify potential vulnerabilities. The cooperation arrangements should also include the consumer protection agency, once it becomes operational.

28. Staff supports the authorities’ focus on fostering faster productivity growth. Government initiatives to reduce the cost of doing business by increasing competition, facilitating the entry of new firms, making credit more accessible to small and medium enterprises, and reforming the corporate bankruptcy procedure are welcome. Increasing labor market efficiency should be another key objective. Replacing the current high severance payment system with a more comprehensive unemployment insurance scheme, for example, would increase labor mobility and encourage greater investment in education and on-the-job training.

29. Staff proposes that the next Article IV consultation be held on the standard 12-month cycle.

Measuring Chile’s Output Gap1/

Staff estimates suggest that Chile’s output gap was about 2– 3 percent as of end-2009. The results, obtained using several different estimation methods, suggest that the ongoing recovery should close the output gap by mid-2011.

Using linear filters, the output gap is estimated about 2– 3 percent in Q1-2010. The top chart shows the results from a piece-wise linear trend, the Hodrick- Prescott filter (HP), the Baxter and King band-pass filter (BK), and the Christiano- Fitzgerald (CF) method. The results are similar to those obtained using a linear trend model (LT).

Kalman filter estimates give a similar range. The three lines in the second chart correspond to estimates from a backward-looking Phillips curve (M1), with inflation deviations positively linked to the output gap, a backward-looking IS curve model (M2), and an Okun’s law approach (M3) relating the output gap and deviations of the unemployment rate from NAIRU.

The results are similar when using econometric methods. Applying the production function approach, a structural vector-auto-regression procedure (SVAR), and IMF’s Global projection model give a similar range of estimates of the output gap (third chart). Two production function aproaches (PFA-1 and PFA-2) yield similar results.

1/

See Selected Issues Paper “Revisiting the Estimation of the Chilean Output Gap,” by N. Magud and L. Medina.

Too-Connected-to-Fail (TCTF) Risk in the Chilean Banking System 2/

Proper systemic surveillance requires the assessment of too-connected-to-fail risk in the banking system. Any banking system is vulnerable to negative spillovers from the failure of individual institutions. The spillovers could be transmitted through direct exposures (such as losses incurred from claims on the defaulted institution or the sudden withdrawal of funding from a creditor), indirect exposures (such as mark-to-market losses due to declining asset prices from asset fire sales prompted by the default), or a combination of both.

Balance sheet network analysis suggests that, within Chile’s banking system, TCTF risk from direct exposures is small. Balance sheet data from the banking supervisory agency (SBIF) suggests that interbank exposure, relative to banks’ capital, is relatively small. This suggests that Chilean banks are relatively insulated from credit shocks (losses on claims on a defaulted bank) and funding shocks (sudden withdrawal of funds by a creditor). In the worst case, some banks would experience an average loss of 6-10 percent of their capital.

The main source of TCTF risk in Chile is associated with funding from domestic non-bank financial institutions and foreign banks. A sudden withdrawal of funding from foreign banks could induce an average capital loss of 17 percent, and up to 22 percent if combined with a credit shock. If domestic non-bank financial institutions were to withdraw their funding, the average capital loss would exceed 40 percent of the capital of the banking system. The likelihood of such event, however, is very small.

2/

See selected issues paper by J. Chan-Lau for details.

Bicentennial Capital Markets Reform (MKB)

The new financial markets reform initiative, announced on May 5, 2010, rests on the following seven pillars:

Updating the institutional framework, including implementing consolidated supervision of financial conglomerates; strengthening of the corporate governance of the securities and insurance supervisory agency; increasing the autonomy of the banking supervisory agency, and updating the bankruptcy law for non-financial corporations.

Reducing credit procyclicality and upgrading the solvency and liquidity requirements for financial institutions.

Enhancing information and transparency in the financial system through further integration of securities exchanges, improved price information in exchange markets, minimum professional certification requirements for financial sector employees, and the use of “Chinese walls” to prevent the misuse of inside information.

Reforming the taxation framework to simply the value added tax on investment funds and the tax treatment of fixed income instruments and derivatives products.

Creating a financial consumer protection agency.

Improving market access for middle class households and small and medium enterprises through increased banking services to households, reduction of initial public offering costs, and further incentives for venture capital.

Developing new markets and financial products to reduce financing costs, including the development of a high yield bond market, better access to foreign exchange hedging by small firms, and the provision of a sound legal framework governing microfinance institutions.

Table 6.

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.

Includes amortization of medium/long-term debt due during the following year but not trade credits.

Morgan-Stanley Capital International index (Dec/1987=100).

Table 7.

Chile: External Debt and Debt Service

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

Original maturity basis; end of period basis.

At current prices and exchange rates.