Mr. Alfredo Mac Laughlin, Executive Director and Mr. Miguel Ricaurte, Advisor to the Executive Director

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.


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.

1. Our authorities would like to thank the staff for the Staff Report and Selected Issues papers and for the thorough discussions on the recovery process from the international crisis and the earthquake which occurred on February 27 of this year, as well as on the policy responses implemented to deal with these events. Such discussions reflect the permanent dialogue between the Chilean authorities and the Fund staff on policy issues which has characterized the relationship between Chile and the Fund. In early 2010, more dynamic activity and receding unemployment meant the Chilean economy was on a recovery path from the global downturn of the last quarter of 2008. This was achieved thanks to the significant policy stimulus, made possible by the credible fiscal and monetary frameworks, and incipient world recovery. However, a significant earthquake that destroyed infrastructure and disrupted productive activities altered short term prospects. The new administration acted decisively and assumed a leadership role in the reconstruction process. The costs associated with this unexpected natural disaster meant that envisaged fiscal structural balance goals had to be revised. Our authorities are committed to taking advantage of these challenges to push for pro-efficiency reforms in terms of government management and labor and financial market functioning, as well as improving the structural balance rule seeking to achieve more transparency. The final goal is to attain higher potential output growth, keeping price and financial stability always in sight.

The Global Crisis and the Earthquake

2. The degree of financial and commercial integration of Chile meant the global crisis took a large toll on the economy. Starting in the fourth quarter of 2008, output growth slowed and became negative. For eleven months following December 2008, economic activity contracted, reaching its worst point in April 2009, when the 12-month growth rate of the economic activity index was -4.9 percent. Accordingly, unemployment, measured by the new employment survey, rose to a maximum of 11.6 percent in the June-August quarter, while employment contracted 1.9 percent between the January-March and May-July quarters. Moreover, inflation rapidly decelerated during 2009, showing negative y-o-y growth during the last five months of the year, with the largest drop of 2.3 percent registered in November. In response to the impact of the global crisis, our authorities undertook significant monetary, fiscal, and pro-credit policies in order to mitigate the impact of the global downturn as much as possible.

3. As a result of these policies, as well as the incipient improvement in international conditions towards the end of 2009, the economy began to recover, with output growing at 2.1 percent in the last quarter of 2009, as well as receding unemployment. In 2009, GDP dropped by 1.5 percent (1.4, SA), compared to the 3.7 percent growth of 2008 (3.4, SA). An inventory drawdown process and falling investment played important roles in the faltering of the economy. Moreover, the prospects for recovery in 2010 looked promising as the indicator of economic activity grew at an annual rate of 3.9 percent in January and unemployment stood slightly above 9 percent, although prices continued to fall that month (headline inflation was −1.3 and core inflation, −2.2 percent).

4. Yet, on February 27, Chile was hit by an 8.8 Richter-scale earthquake and a subsequent tsunami. With considerable damage to the south-center regions of the country - important to the paper and pulp, oil refining, fishing, and iron and steel product industries - private and public infrastructure destruction, and lives lost, short-term prospects took a heavy blow. Production fell 2.3 percent in March and employment was affected, especially in the regions most hardly hit by the earthquake. The Banco Central de Chile (BCC) estimated that the earthquake destroyed 3 percent of the country’s capital stock, narrowing the output gap generated during the global crisis. Our authorities took this challenge as an opportunity to strengthen the country and its economy. The government’s share of the estimated US$30 billion cost of the reconstruction is anticipated to be US$8.4 billion (4 percent of GDP), which will be implemented between 2010 and 2013. The reconstruction plan will be funded by a temporary rise in taxes, improved expenditure efficiency and debt issuance. For this purpose, Chile placed two bonds in international markets in very favorable conditions at the end of last July. Since the earthquake, recovery has been stronger than expected. In the first quarter of 2010, output grew 1.5 percent (1.4, SA), while the second quarter saw a 6.5 percent growth rate (6.5, SA); and the unemployment rate for the May-July quarter was 8.3 percent. In light of these developments, market expectations for output growth for 2010 have increased, in line with the BCC’s current forecast of 5.0 to 5.5 percent.

5. Consumer price inflation has begun to pick up after the rapid and steady decline of 2009 and the first half of 2010, in part due to mounting international pressures and the closing of the output gap triggered by the earthquake. Headline inflation reached 2.6 percent in August, whereas core inflation was 1.9 percent. Currently, CPI inflation is expected to reach over 3 percent by the end of 2010, and to converge to 3 percent in 2011. In line with these developments, the BCC revised upward its y-o-y inflation forecast to 3.9 percent for December 2010.

6. In the midst of these changing economic conditions, a new administration took office in March, facing extraordinary challenges in terms of economic policy. Our authorities acknowledge that the responses in terms of monetary, fiscal, and credit policies started by the previous administration were possible thanks to sound policy frameworks that allowed the government to save resources needed not only to fund the fiscal stimulus and reconstruction packages, but to add credibility to the incoming government programs. Nevertheless, the new administration is aware that more needs to be done and, therefore, is working to introduce significant reforms seeking to improve government, regulatory, and productive efficiency and restore fiscal balance lost during the global crisis.

Monetary Policy

7. Following the unraveling of the global crisis, the BCC aggressively decreased the monetary policy rate 775 basis points in seven months, bringing it down to 0.5 percent in July 2009. This was consistent with the view that a massive monetary stimulus was necessary to attain the inflation target in the policy horizon. The BCC indicated that 0.5 was the lower bound rate and complementary funding measures were adopted in order for the market to incorporate the BCC’s stance into their expectations. Once the economy showed signals of recovery, the BCC board announced in the November 2009 Monetary Policy Meeting communiqué that the term funding facility would be phased-out by May 2010, and that the policy rate would be kept at its minimum at least up to the second quarter of 2010.

8. The policy rate was left unchanged at 0.5 percent until May. The BCC considered that the short-term impact of the earthquake was larger than initially assessed and inflation remained subdued. However, new information showed that the earthquake had a very transient impact on the economy, which began to recover rapidly. Since June, the monetary policy rate has been hiked by 50 basis points each time, currently standing at 2.0 percent. Although headline inflation rose in July, the BCC authorities highlight transitory shocks as the sources behind this surge, while underlying measures remain contained. Although there is higher uncertainty regarding the international environment as recovery of developed economies has not materialized in a definite manner, the outlook for Chile remains favorable. Therefore, the BCC authorities informed in the September monetary policy report that the monetary stimulus would continue to be withdrawn at a pace that depends on the evolution of internal and external macroeconomic conditions. Private sector expectations are consistent with this stance.

9. While the nominal exchange rate has fluctuated due to market developments, the real exchange rate broadly remains aligned with its long-term fundamentals. Our authorities are committed to maintaining the flexible exchange rate regime in place since late 1999. Nevertheless, this framework does not preclude intervention during extraordinary circumstances.

Fiscal Policy and Productivity-Oriented Reforms

10. The government’s fiscal position deteriorated as the country faced the global crisis and the earthquake. The new administration is not only committed to improving fiscal accounts, but has the goal of increasing the efficiency of the government apparatus which, alongside other labor market and financial reforms, will contribute to enhancing Chile’s potential growth rate over the next four years.

11. The structural budget rule and the Fiscal Responsibility Law resulted in the Chilean government saving the windfall gains in the copper price surpluses during the commodity price boom into the two Sovereign Wealth Funds: the Pension Reserve Fund and the Economic and Social Stabilization Fund (ESSF), the latter of which had accumulated US$ 20.2 billion as of December 2008. The ESSF served the country well when resources were needed during the global crisis to fund the countercyclical policy responses involving 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 2009, with a size equivalent to 2.4 percent of GDP (US$4 billion). As additional resources were needed, withdrawals from the ESSF continued to be made amounting to a total of US$9.3 billion in 2009. By the end of the year, public expenditure had grown 18.2 percent in real terms, surpassing initial estimates.

12. In 2010 the real growth rate of government expenditure is expected to decrease to 9 percent. To finance government expenditure, our authorities sent a comprehensive funding package to Congress which included temporary tax increases, redirecting the share of government-owned Codelco revenues intended for the armed forces towards the central government’s budget, and a proposed increase in the mining royalty regime to take advantage of currently high commodity prices. All measures, except the royalty to the mining sector, were approved by Congress and the authorities had to look for alternative sources of funding, including an alternative royalty scheme reform recently sent to Congress. In late July, Chile issued two bonds, one denominated in US dollars and another linked to pesos in the international markets. Both were heavily overwritten, reflecting the positive position Chile has in international markets in spite of the tough conditions it has faced in the last two years. The US$1 billion dollar bond paid a 90 basis points premium, the best conditions an emerging market has been able to achieve under similar circumstances. The peso-linked bond of US$500 million was issued at a 5.5 percent interest rate.

13. One of our authorities’ main goals is to return to structural balance once the fiscal stimulus package and reconstruction spending are phased out. This requires resetting a clear structural balance goal. Our authorities acknowledge the fact that the fiscal rule applied in Chile between 2001 and 2008 proved to be a fundamental pillar of the existing macroeconomic framework to secure domestic and external stability. However, the rule did not allow for the type and magnitude of counter-cyclical policies needed in 2009 to deal with the global crisis. The authorities’ plan originally contemplated a reduction, on a temporary basis, in the structural surplus target from 0.5 to 0 percent of GDP, which finally became a 1.2 structural deficit as the conditions warranted a larger fiscal stimulus. In response to this event, the current administration is seeking to perfect the rule in order to deal with exceptional situations, keeping in mind it is a key instrument for macroeconomic stability. For this purpose, a Committee of Advisors on the Structural Balance Rule was assembled.

14. The Committee will give a final report containing specific recommendations on the structure of the rule, as well as its governing legal framework later in the year. However, in mid-August, it presented a preliminary report, which evaluates the current stance and provides guidance for the 2011 budget. In general terms, the Committee recommended using the rule as it currently stands for next year’s budget, but suggested: (1) reversing the correction for transitory tax measures; reversing the cyclical adjustment of (2) the “other income” account and (3) the interest earned on the treasury’s financial assets; and (4) re-estimating the elasticity of health insurance contributions. Applying the revised methodology to historical data results in larger structural deficits as percentage of GDP for 2008 (−0.6 vs. 0.0) and 2009 (−3.1 vs. −1.2). Since the authorities have adopted the Committee’s preliminary methodology for the 2011 budget, they have revised the outlook to a 3.2 percent deficit for 2010 and to a 1 percent structural deficit target (instead of structural balance) for 2014. Our authorities want to stress the fact that underlying conditions have not changed, but rather, these modifications clarify what constitutes expenditures and income under a neutral stance of GDP with the goal of improving transparency on the structural balance situation of Chile.

15. Beyond mere expenditure control measures, the authorities are seeking to gain efficiency in the state apparatus by improving institutional governance, as well optimizing expenditure. Currently, government programs are being audited in order to identify their social returns so that resources can be aimed at those from which society benefits the most. Additional gains are sought from labor legislation reforms aimed at making the labor market more flexible, favoring indefinite versus fix-term contracts, as well as labor force participation. Our authorities expect to favor training and human capital accumulation under indefinite contracts, once large firing costs are substituted by a more comprehensive unemployment insurance scheme. Moreover, pro-investment policies seeking to favor small-and medium-size enterprises, along with the above mentioned reforms, are expected to yield an additional 1 percentage point to potential GDP growth rate. All in all, it is this administration’s goal to attain a 6 percent potential growth rate for Chile.

Financial Sector

16. Chile’s sound regulatory framework has proven to be fundamental in securing the stability of the financial system, and therefore insulating the domestic market from the global turmoil. The financial sector performed well during the crisis, with banks capitalization remaining well above minimum regulatory requirements. The financial sector has also proven resilient to the earthquake and the recent period of financial turmoil triggered by events in Europe. The most recent bank lending conditions survey shows that banks are easing credit conditions–which is consistent with the recent recovery in credit growth.

17. Our authorities are committed to further enhancing the financial regulatory framework. The most recent financial market reform approved, the MKIII, broadens the range of authorized financial instruments, facilitates securitization, improves conditions for foreign institutional investors and expands the set of long-term financing alternatives for banks. Moreover, the current administration is working on a comprehensive reform agenda, denominated the Bicentennial Capital Markets reform, or MKB, which would further improve market liquidity, update corporate governance of supervisors, improve information sharing and, ultimately, move towards a comprehensive reform of the supervision scheme. Progress has also been made in strengthening the supervision of financial conglomerates. The first steps were taken in June 2009 when a Memorandum of Understanding (MoU) was signed 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. This committee is currently conducting a pilot oversight project for conglomerates, under a lead supervisor model. Additionally, the strengthening of the consumer protection agency’s role in financial products is under discussion in Congress. Finally, concrete steps have been taken to strengthen securities clearing and settlement infrastructure.


18. Following the effect of global crisis on Chile’s economy, a comprehensive stimulus package was put forward to minimize its adverse effect, financed with resources saved during the commodity price boom. Chile’s economy had begun to recover when the February 27 earthquake hit the country. Nevertheless, the new administration took a decisive stance to use these challenges as opportunities to push for significant reforms aimed at reconstructing lost infrastructure, restoring fiscal balance and, ultimately, attaining higher potential output growth for Chile. Funding for reconstruction will come from, among other sources, temporary increases in taxes and borrowing. Moreover, learning from the last crisis, the authorities are seeking to enhance the fiscal balance rule to cope with extreme situations as the one lived in 2009 as well as improving the transparency of fiscal balance goals. Chile is currently on a solid recovery path, with output growing at healthy rates and decreasing unemployment. Our country’s strong institutions and policy frameworks have been instrumental in the process of becoming a member of the OECD, which culminated in May of 2010 with the accession to the organization as an official member.

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
Author: International Monetary Fund