Chile
2012 Article IV Consultation
Author: International Monetary Fund
Publication Date:
11 Sep 2012
eISBN:
9781475510485
Language:
English
Keywords:
ISCR; CR; central bank; Chile; holdings exchange rate; headline inflation; trade openness; long-term debt; net export; world market share; Global
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The Selected Issues paper discusses measures taken by the Chilean government to record moderate economic growth in 2012. The easing of fiscal stance and tightening of expenditure have proved to prevent a decline in the economy. The authorities have estimated retaining a favorable economic environment to mitigate financial risks. Banks have been asked to maintain high levels of liquidity and capital to meet expansion needs. The Executive Board has commended Chilean authorities’ efforts for macrofinancial stability and management of funds.

Abstract

The Selected Issues paper discusses measures taken by the Chilean government to record moderate economic growth in 2012. The easing of fiscal stance and tightening of expenditure have proved to prevent a decline in the economy. The authorities have estimated retaining a favorable economic environment to mitigate financial risks. Banks have been asked to maintain high levels of liquidity and capital to meet expansion needs. The Executive Board has commended Chilean authorities’ efforts for macrofinancial stability and management of funds.

Backdrop: Sustained Strong Growth

1. Chile’s economy has expanded at a robust pace. The economy recovered rapidly from the global financial crisis, supported by a solid policy framework, sound banking system, and favorable commodity price developments. Real GDP grew by about 6 percent during 2010–11 on the back of exceptionally dynamic domestic demand, and strong growth has continued in early 2012 (Figure 1).

Figure 1.
Figure 1.

Chile: Domestic Demand and Net Exports

(Through May 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Haver Analytics Inc, Chilean authorities, and Fund staff estimates.
uA01fig03

Real GDP and Domestic Demand

(y/y growth)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

2. The output gap has closed and some pressures on capacity constraints have emerged. The unemployment rate has declined to a historically low level, labor shortages have been reported in some sectors, and real wage growth has been strong (Figure 2). Both labor force participation and employment increased rapidly in the last two years, although their growth rates have moderated in recent months. The surge in domestic demand fueled import growth, and the external current account balance turned negative in 2011, despite record high copper prices (Figure 3).

Figure 2.
Figure 2.

Chile: Inflation, Labor Markets and Monetary Policy

(Through July 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile and Fund staff calculations.
Figure 3.
Figure 3.

Chile: External Current Account Balance

(Through June 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile and Fund staff calculations.

3. Inflation pressures have moderated and inflation expectations remain anchored. Core and headline inflation increased rapidly in 2011, driven by rising import prices and wages. More recently, price pressures have eased as food and energy prices declined. Year-on-year headline inflation fell to 2.6 percent in June, and core inflation has moderated as well. Inflation expectations remain close to the 3-percent official target.

4. Bank credit growth has been strong. Although credit standards have tightened in recent months, loan demand remains robust. Bank credit in real terms is growing by more than 10 percent, with particularly strong growth in corporate and consumer loans (Figure 4). In contrast, non-bank consumer credit, which accounts for about 30 percent of consumer credit, has declined since mid-2011.

Figure 4.
Figure 4.

Chile: Financial Markets

(Through June 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile, Superintendency of Banking and Financial Institutions (SBIF), and staff calculations.
uA01fig04

Tradables and Non-tradables Inflation

(y/y, in percent)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

5. The real exchange rate is broadly in line with fundamentals. The real effective exchange rate has appreciated substantially over the past ten years. The appreciation has been driven by fundamentals, particularly by improving terms of trade. In recent months, the exchange rate has been close to its long-term average level. Staff estimates using IMF’s EBA and CGER methodologies suggest that the real effective exchange rate is broadly in line with fundamentals. This assessment is supported by the fact that Chile’s world market share of agricultural and industrial exports has remained broadly stable since 2003.

6. Net private capital inflows turned positive in 2011. The main contributing factor was a switch in private pension funds’ portfolio allocation from foreign to domestic assets. FDI inflows were also strong, especially in the mining sector. At end 2011, the balance of payments recorded a surplus of US$14 billion (6 percent of GDP). Chile’s net external liabilities, at 10 percent of GDP as of end-2011 (Figure 6), are relatively modest compared with other emerging market countries. Overall, Chile’s external position is broadly consistent with underlying fundamentals (Box 1).

Figure 5.
Figure 5.

Chile: Fiscal Policy

(2006-12)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Ministry of Finance and Fund staff calculations.
Figure 6.
Figure 6.

Chile: Net IIP and Capital Flows

(Through May 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile and Fund staff calculations.Note: Negative sign for outflows means residents increasing their overseas investments.

7. The monetary policy stance is broadly neutral. The central bank raised the policy rate by 475 basis points to 5¼ percent from mid-2010 to June 2011. Since a one-off easing in January 2012, amid uncertain global financial conditions, the policy rate has been kept at 5 percent. The central bank completed the pre-announced US$12 billion foreign exchange purchases program in December 2011, strengthening reserve adequacy measures.

8. Spillovers from volatility in global financial markets have been limited thus far. Stock market prices have moved broadly in line with prices in other emerging markets. Despite some increase since mid-2011, bank funding costs remain well below their levels after the Lehman crisis. A rise in liquidity pressures in domestic money markets in December 2011 was successfully contained with temporary liquidity measures.

9. The withdrawal of fiscal stimulus continued in 2011, but some easing of the policy stance is projected for 2012. The structural fiscal deficit (which adjusts for the economic and copper price cycles, see Annex I) narrowed by about 1½ percentage points of GDP in 2011, as expenditure growth slowed down and a temporary corporate tax increase gave a boost to revenue. The non-mining structural primary balance in percent of non-mining GDP (a metric which captures better the economic effects of fiscal policy in commodity-producing countries) also showed significant fiscal withdrawal (Table 2).1 However, an increase in education and other social spending in 2012 will result in some easing of the fiscal policy stance in 2012. Real government expenditure is projected to grow at 6½ percent, more than real GDP growth, and the non-mining primary structural deficit is projected to widen.

Table 1.

Chile: Selected Social and Economic Indicators

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

Contribution to growth.

The methodology to compute the unemployment rate changed in 2009.

The estimate of the structural balance is based on staff estimates of the output gap, and may differ from the authorities’ estimate.

Table 2.

Chile: Summary Operations of the Central Government

(In percent of GDP; unless otherwise indicated)

article image
Sources: Ministry of Finance (DIPRES) and Fund staff estimates and projections.

Based on the authorities’ medium-term fiscal projections in the 2012 Budget Law, adjusted for staff’s GDP and copper price projections. Effects of the authorities’s tax reform proposal are not included.

Based on staff’s output gap estimates and WEO copper prices.

In percent of non-mining GDP.

uA01fig05

Chile: Public expenditure growth

(real annual percentage change)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Ministry of Finance, and Fund staff estimates and projections.

10. A tax reform, expected to yield about 0.3 percent of GDP in additional revenue, has been recently proposed by the government. The reform will make permanent the increase in the corporate tax rate from 17 to 20 percent.2 There would be offsetting reductions in taxes on personal income and financial transactions. The net increase in revenues relies in part on the elimination of tax loopholes and improvements in tax collection (see Annex II for details). The bill was submitted to Congress in August; if approved, it will take effect in late 2012.

11. The authorities’ macroeconomic policies over the past year have been broadly in line with Fund advice. As recommend by staff, an ambitious fiscal withdrawal in 2011 helped reduce domestic demand pressures and build up fiscal assets. However, the authorities chose to leave their medium-term structural deficit target unchanged at 1 percent of GDP, instead of aiming for continued gradual fiscal consolidation. Progress has been made in strengthening the regulatory and supervisory framework of the financial sector and reducing information gaps.

Outlook And Risks

12. Looking forward, growth is expected to moderate. Staff’s central scenario assumes no escalation of tensions in the euro area and moderate global growth (in line with the July 2012 WEO projections). In this context, real GDP growth for 2012 is expected to be around 4¾ percent, broadly in line with staff’s estimate of Chile’s potential growth. Private consumption growth is projected to slow down as employment growth moderates. Demand for durable goods has already slowed from high post-earthquake levels. Machinery and equipment investment growth would also moderate, although construction and engineering works investment would remain robust, supported by large mining and energy projects. Net exports should have a smaller negative contribution to growth compared to 2011, as real import growth converges to the rate of growth of domestic demand. In spite of this, the external current account deficit is projected to widen further (to about 3 percent of GDP), due in part to less favorable terms of trade. Both core and headline inflation rates are expected to remain close to the target as domestic demand growth moderates and import prices remain subdued.

13. Large risks surround the baseline scenario. On the upside, domestic demand may grow faster than expected, supported by strong wage growth and positive consumer and business confidence. With the output gap already closed, additional pressures on capacity constraints would put upward pressure on inflation and on the external current account deficit. Further widening of the current account deficit would increase Chile’s exposure to external shocks. There are two key downside risks:

  • Renewed escalation of financial tensions in the euro area. Although direct bank funding exposure to the euro area is small, an intensification of tensions in Europe could have negative effects on confidence, affecting the availability and cost of funds for Chilean banks and corporations.3

  • Sharp growth deceleration in China. Copper accounts for more than half of all exports and China is Chile’s main trading partner. A significant slowdown in China’s economic growth, accompanied by a decline in world commodities demand, could prompt a sharp fall in copper prices, affecting Chile’s current account and growth prospects.

Heightened volatility of capital flows is another risk. In the near term, bouts of increased global investors’ risk aversion may trigger capital outflows. Over the medium term, the prospect of a prolonged period of low interest rates in advanced economies may induce new waves of capital flows to fast-growing emerging markets like Chile, fueling credit growth and raising the risk of asset price bubbles.4

14. The authorities broadly agreed with the outlook and the characterization of the key risks. They noted that, historically, domestic pension funds have provided a natural hedge against capital outflows, increasing their purchases of domestic assets in times of rising global risk aversion. They also emphasized that the flexible exchange rate is an effective shock absorber, and would help mitigate the effect of external shocks on the current account deficit. They also noted that the recent deterioration in the current account balance had been driven in part by higher foreign investment in the mining sector, which would help support future exports.

Policy Discussions

Discussions focused on policies to preserve macroeconomic stability and reduce vulnerability to external shocks. In particular, discussions centered on the appropriate policy mix under the baseline and various risk scenarios; the importance of maintaining strong fiscal buffers; measures to preserve financial sector stability; and the challenge of raising productivity growth.

A. Near-Term Policy Mix

15. Staff argued that it would be desirable to maintain tight control of fiscal expenditure in the remainder of 2012. The withdrawal of fiscal stimulus in 2011 helped reduce overheating pressures, contain the rise in consumer prices, and increase net public assets. However, there is some easing of the fiscal stance in 2012, despite a favorable cyclical position. Staff suggested keeping tight control on expenditure in the remainder of the year and allocating any savings to improve the fiscal balance, as was done in 2011. Fiscal restraint also would help contain the deterioration of the external current account. The authorities responded that there is limited flexibility to deviate from the expenditure level approved in the Budget.

16. There was agreement that monetary policy should remain responsive to global and domestic shocks. Staff saw the current neutral stance as appropriate, given the prospect of a slowdown in output growth towards potential and volatile global financial conditions. With domestic risks mostly on the upside, staff and central bank officials agreed that wage developments, credit growth, and other indicators of capacity constraints pressures had to be monitored carefully. The authorities reiterated their commitment to respond quickly if any of the downside risk scenarios were to materialize.

B. Coping with Risks

17. A sharp deterioration of external financing conditions should trigger resolute actions to maintain confidence and ensure orderly functioning of domestic markets. There was agreement that the authorities should be prepared to use measures similar to those deployed in Chile after the Lehman crisis to contain liquidity pressures, including expanding repo operations, broadening the range of accepted collateral, and setting up dollar swap auctions. Staff emphasized that a good communication strategy would also be important to preserve confidence. With inflation near the target and well-anchored inflation expectations, there is ample space to ease monetary policy, if necessary. Automatic fiscal stabilizers would also provide support. Staff indicated that temporary fiscal stimulus should be considered only as a last resort, if there is evidence of a sharp decline in activity. The authorities agreed and noted that they have prepared a crisis contingency plan, including measures to maintain employment and temporary fiscal stimulus, but that it will be put in action only in case of a large negative shock to output.

18. There was agreement that exchange rate flexibility would help mitigate the economic impact of a sharp decline in the external terms of trade. Depending on the size of the shock, temporary easing of macroeconomic policies could also be appropriate to help smooth the adjustment. It would be important, however, to avoid a large permanent decline in government net assets.

19. Staff and the authorities concurred that exchange rate flexibility would also remain the first line of defense if capital flows volatility were to increase. Staff noted that the flexible exchange rate has helped contain speculative investment in the past by reducing one-sided bets on the currency, and should remain the main tool to limit capital flow pressures. If strong inflows resume, raising the risk of credit and asset price bubbles, macroeconomic policies may need to be adjusted accordingly. There was broad agreement that macroprudential policies could also be considered, if necessary. The choice of measures would depend on the specific issues that arise. Staff suggested including the option of setting time-varying capital buffers in the revised General Banking Law to increase the range of available macroprudential instruments. The authorities noted that Chilean banks typically keep capital buffers well above the required minimum, so using countercyclical capital buffers as a macroprudential tool may be difficult.

C. Medium-Term Fiscal Policy

20. Staff emphasized that maintaining strong fiscal buffers should remain a key priority. Chile’s high dependence on volatile commodity income and vulnerability to adverse global financial developments and natural disasters make large fiscal buffers particularly important. The 2009 financial crisis illustrated the sensitivity of Chile’s net asset position to large external shocks. Central government net assets stood at 8.7 percent of GDP at the end of 2011 (compared to almost 20 percent in 2008), and are projected to decline as a share of GDP in the medium term.

uA01fig06

Chile: Central Government Net Assets

(in percent of GDP)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Ministry of Finance and Fund staff estimates and projections

21. Staff recommended targeting a structural balance by 2015, and weighing the benefits of targeting a small structural surplus thereafter. A structural surplus target would help maintain significant fiscal buffers, which would increase policymakers’ flexibility to respond to adverse shocks in the future and would prepare the country better to meet longer-term fiscal challenges related to population aging. The authorities agreed that maintaining strong fiscal buffers is important, and that it would be desirable to aim for structural surpluses further out, but noted that the planning horizon of the current administration ends in 2014. They reiterated their commitment to attain a structural fiscal deficit of 1 percent of GDP by 2014, and to keep the growth rate of public expenditure below GDP growth on average over the term of the administration. Staff supported the commitment, but argued that a faster pace of consolidation would be desirable if economic conditions remain favorable.5

22. The authorities agreed with staff that new permanent spending commitments should be matched with permanent revenue increases. The tax reform proposed by the government aims to finance the increase in education spending envisaged in the budget. Staff noted that to achieve the targeted increase in tax collection, further improvements in tax administration may be necessary. The authorities pointed out that tax collection has already improved in the last two years.

23. Staff suggested that work to strengthen further the medium-term fiscal framework should continue. Staff welcomed recent improvements in the medium-term fiscal expenditure forecasting framework, implemented with the help of Fund experts. Drawing on the recommendations of the advisory commission of the fiscal rule set up by the government in 2010, staff supported the establishment of an independent Fiscal Council. The authorities responded that they expect to set up a Fiscal Council in the coming months. In addition, staff suggested incorporating long-term fiscal projections and an assessment of key fiscal risks in the regular budget discussions to inform policymaking and help anchor medium-term fiscal targets. These long-term projections should take into account expenditure changes related to demographic developments, as well as potential pressures on the revenue side (including the rise in copper extraction costs). The authorities noted that they plan to extend the annual report on long-term fiscal trends to include projections of health care and education spending.

D. Maintaining Financial Stability

24. Chile’s banks remain well capitalized and profitable. Both regulatory and Tier 1 capital levels are high (above 14 percent and 10 percent respectively). Bank liquidity ratios are also relatively high. Returns on assets and equity are comfortable (see text table), and non-performing loans are low, at about 2½ percent of total loans. The share of external financing in total bank financing remains below 10 percent. Moreover, since late 2010, banks have diversified geographically their external funding sources (Figure 7).

Figure 7.
Figure 7.

Chile: Banking System

(Through July 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile, SBIF, SVS, SuSeSo, SP, and Bloomberg, Inc.1/Institutional Investors [Inst. Invest] include mutual funds and pension funds. Own resources [Own res.) include tier 1 capital, provisions, net value of derivative instruments and earnings. Bonds include mortgage, senior and subordinated bonds.

25. So far, bank deleveraging in Europe and strains in the Spanish banking system have had limited effect on Chile’s banks. Subsidiaries of Spanish banks have substantial presence in Chile (see chart). In November 2011, Santander Spain sold 7.8 percent of its shares in Santander Chile. The sale caused a temporary drop in the stock price, but had no notable effect on system-wide credit.

uA01fig07

Market shares of foreign banks (loans)

(In percent)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

article image
Source: SBIF

Introduction of IFRS in 2009; pre-2009 figures not comparable

26. Household leverage has remained broadly stable and house price growth has been moderate (Figure 9). Household debt has grown broadly in line with disposable income since 2008, and debt service as a share of income also has remained broadly stable. A recently released index of house prices suggests that real annual price increases have been fairly modest since 2004. Loan-to-value ratios for new mortgage loans average about 80 percent. A potential area of concern is the rate of growth of bank consumer loans, which remains high despite some deceleration in recent months.

Figure 8.
Figure 8.

Chile: Equity Return Pairwise Correlation, Chilean and Spanish Banks 1/

(January 2006-July 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Datastream, LLC and Fund staff calculations.1/ Corresponds to the correlation between the daily equity return (in annual terms) of Chilean and Spanish banks, calculated in Chilean pesos. An increase indicates a rise in the correlation.
Figure 9.
Figure 9.

Chile Real Estate Prices, Household and Nonfinancial Firm Leverage

(Through March 2012)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile, SBIF, SVS, SuSeSo, and SP.1/ Household financial burden measures the payments that households must make to fulfill their consumer and mortgage loan commitments, as a percentage of their available income.

27. Corporate debt as share of GDP has increased somewhat since 2010. The pace of growth of credit to corporates has been above trend since mid-2011, although it remains below thresholds that have been associated with a credit boom in the literature. The rise in leverage is concentrated in certain sectors, including construction and retail, which could increase their vulnerability to a slowdown in economic activity. New data on commercial real estate show that price growth has been broadly in line with fundamentals, despite some acceleration in 2011. The share of external debt has remained broadly unchanged, at about 30 percent of total corporate debt. Central bank data suggest that there are no large currency mismatches in the corporate sector.

uA01fig08

Chile: Real Bank Corporate Credit

(Index, Jan. 2006=100)1

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Datastream; and Fund staff calculations1 Threshold based on Mendoza and Terrones (2008)

28. Despite its strength, Chile’s financial system remains exposed to sudden changes in global financial conditions. An escalation of tensions in the euro area is likely to affect financial conditions in Chile. Staff analysis suggests that the cost of bank funding in Chile is positively related to measures of global financial stress, and that both real and financial external shocks affect Chile’s economic performance (Box 2). Some small and medium-sized banks, which rely more heavily on foreign financing or wholesale funding, could be particularly affected. Nonetheless, staff agreed with the authorities that spillovers to European bank subsidiaries should be contained if depositor confidence is preserved. Foreign bank subsidiaries rely mostly on domestic deposits for funding, and financial links with parent banks are strictly limited by local regulations.6 European bank subsidiaries in Chile currently have higher ratings than their parent banks, reflecting the strength of their balance sheets.

29. Staff also noted that negative output shocks could lead to a cyclical deterioration of credit quality. Staff argued that a sharp global slowdown, accompanied by sustained declines in commodity prices, will affect Chile’s output and employment and could push up non-performing loans. Non-bank credit card lenders also would see a rise in defaults since they typically focus on higher-risk low-income borrowers, who are more vulnerable to an economic slowdown.

30. In light of these risks, staff argued that the focus of prudential policy should be to reduce vulnerabilities. The authorities agreed with staff that banks should continue to maintain high levels of liquidity and capital to minimize the risk of contagion from an intensification of financial tensions in the euro area. Banks should also continue to diversify external funding sources to reduce reliance on a few large global financial institutions. On the asset side, banks and non-bank creditors may need to tighten lending standards further to limit risk taking in the current favorable economic environment. Staff also suggested that supervisors should continue to monitor carefully the rise in corporate indebtedness and the growth of consumer loans.

31. The authorities agreed with staff’s characterization of financial sector risks and with the need for continued vigilance. They discussed similar risks in the central bank’s Financial Stability Report (FSR) in June. At the same time, they pointed out that banks’ strong capital buffers should help limit potential vulnerabilities. Stress test results, presented in the Central Bank’s FSR suggest that capital adequacy ratios will remain above regulatory requirements for the large majority of banks under a risk scenario of negative output growth in the second half of 2012, temporary peso depreciation, and higher short-term interest rates.

E. Strengthening the Prudential Framework

32. The mission welcomed the strengthening of the institutional set up for monitoring and managing systemic risks. In 2011, the government created a Financial Stability Council (FSC), with a mandate to monitor and manage systemic risks and facilitate coordination among the supervisory agencies, including in the area of the supervision of financial conglomerates. The FSC comprises the Minister of Finance and the heads of the three financial supervisory agencies (overseeing banks, insurance and securities, and pensions). The central bank Governor is not a formal member of the FSC (because of the legal independence of the central bank), but he attends all meetings and participates actively in the Council’s deliberations. The Council has initiated work on developing methodologies to assess stability risks related to financial conglomerates. In addition, the authorities have enhanced the powers of the National Consumer Service (Sernac) in the area of financial services, which should help strengthen consumer protection in that area. Finally, staff noted that the recent publication of housing and commercial real estate price data would allow better monitoring and identification of risks.

33. The authorities and staff concurred that several legislative initiatives, currently before Congress, would make an important contribution to enhancing prudential oversight. The proposed law on risk-based supervision of insurance companies would enhance significantly the assessment and management of insurers’ risk and increase the enforcement powers of supervisors. Proposed legislation to expand the existing credit registry to include comprehensive credit history information from banks and non-banks would help improve the evaluation and pricing of credit risk. The corporate bankruptcy law under discussion will streamline the bankruptcy process and facilitate business restructuring.

34. Staff emphasized that efforts to strengthen the financial regulatory and supervisory framework should continue, as recommended by the 2011 FSAP. Staff welcomed the authorities’ plans to update the General Banking Law and review the legal framework for bank resolution. Given the large presence of conglomerates in Chile’s financial system, it will be important to establish a legal framework for consolidated supervision. The authorities agreed in principle, and noted that they are making progress in this area under the direction of the FSC. Staff noted that strengthening the corporate governance structure of the financial supervisory agencies would enhance their operational independence and improve accountability (see Annex IV for progress on other FSAP recommendations).

F. Raising Productivity Growth

35. There was agreement that raising productivity growth remains an important challenge. Staff noted that over the last decade rising employment has been a key driver of Chile’s rapid growth, however, labor productivity growth has slowed down (see Box 3). While there is room to increase further female and youth labor force participation rates (which are below OECD averages), future growth would have to rely increasingly on productivity increases. Staff welcomed the approval of the new poverty-reduction program Ingreso Etico Familiar, which aims to foster female labor participation and reward academic achievement of children from low-income families. Staff also commended recent initiatives to reduce the time it takes to incorporate a business, improve intellectual rights protection laws, and strengthen competition.

36. Staff urged the authorities to persist in their efforts to achieve consensus on measures to increase labor market flexibility and efficiency. In line with OECD recommendations, staff suggested that labor market efficiency could be enhanced by moving away from the system of high severance payments for workers, increasing the flexibility of working hours, and improving the efficiency of training programs. The authorities agreed that it is desirable to improve labor market efficiency, although building consensus on specific measures has been difficult. They are now in the process of evaluating training programs and discussing options to improve their effectiveness. Staff noted that the ratio of minimum-to-average and minimum-to-median wages is higher in Chile than in most OECD countries, which could hinder formal employment growth and increase the informal sector. In addition, Chile faces higher energy prices than most OECD economies and neighboring countries. Staff and the authorities agreed that high energy prices have a negative effect on potential output and could reduce competitiveness. Measures to facilitate private investment in the generation and transmission of electricity would help increase supply and reduce prices.

Staff Appraisal

37. After two years of robust expansion, output growth is expected to moderate to trend levels. Real GDP is projected to grow at 4¾ percent in 2012. Private consumption growth is moderating in line with employment growth. Private investment is also expected to decelerate, and import growth would converge to the lower growth rate of domestic demand. The external current account deficit is projected to widen further largely due to deteriorating terms of trade. Core and headline inflation are expected to remain close to the target.

38. Chile’s key near-term challenge is to preserve macroeconomic and financial stability. There are substantial risks to the outlook, stemming from heightened global uncertainty. The key downside risks are a sharp intensification of financial tensions in the euro area and the possibility of a significant slowdown of economic activity in China resulting in a sharp drop in commodity prices.

39. Monetary policy should remain responsive to changing economic conditions. The current neutral stance is appropriate, given the prospects of a gradual convergence of domestic output growth towards potential and anchored inflation expectations. With the output gap closed and tight labor markets, wage developments, credit growth, and asset prices should be monitored carefully.

40. In case of a sharp deterioration of financing conditions, decisive actions should be taken to ensure orderly market functioning. Efforts should focus on containing liquidity pressures. A good communication strategy would also be important to maintain market confidence. With anchored inflation expectations and inflation near the target, there is ample space to ease monetary policy, if needed. Automatic fiscal stabilizers would also provide support, however, discretionary fiscal stimulus should be considered only in the case of a sharp decline in economic activity.

41. Exchange rate flexibility remains an important buffer against volatile capital flows and terms of trade shocks. It has played an important role in limiting speculative capital inflows and in facilitating adjustment to large terms of trade changes. In case of renewed capital inflow pressures, macroeconomic policies may need to be adjusted to limit the risk of credit and asset price bubbles. Macroprudential policies could also be considered to help maintain stability.

42. Public expenditure restraint in the remainder of 2012 would be desirable. The withdrawal of fiscal stimulus in 2011 helped contain overheating pressures, but the fiscal stance was eased somewhat in 2012. Despite the favorable cyclical conjuncture, public expenditure growth is likely to exceed GDP growth. It would be advisable to maintain a tight control on fiscal spending in the remainder of the year and allocate the savings to increase net fiscal assets, as was done in 2011. Staff welcomes the authorities’ intention to increase tax revenue to match the permanent increase in education expenditure.

43. Staff urges the authorities to achieve structural fiscal balance by 2015, and consider targeting a small surplus thereafter. Maintaining strong fiscal buffers will enhance Chile’s resilience to external shocks, and would allow the government to cope better with long-term fiscal challenges related to population aging. Staff supports the authorities’ commitment to meet their 1 percent structural fiscal deficit target by 2014. If economic conditions remain favorable, more ambitious frontloaded deficit reduction would be desirable.

44. Efforts to continue strengthening Chile’s fiscal framework are welcome. The planed creation of a Fiscal Council would help strengthen policy assessment and accountability. Plans to extend the long-term fiscal projections to include health care and education spending also are welcome. Discussion of other fiscal risks, including potential pressures on the revenue side, would also help inform policy decisions.

45. Although financial soundness indicators remain strong, continued vigilance is warranted. An escalation of financial tensions in the euro area is likely to affect financing conditions for Chilean banks and corporations. To protect against this risk, banks should maintain high levels of liquidity and capital, and continue to diversify external funding sources. A negative output shock could lead to a deterioration of credit quality. Bank and non-bank creditors may need to tighten lending standards further to limit risk taking in the current favorable economic environment. The rise in debt in certain business sectors warrants close monitoring.

46. Staff supports the authorities’ efforts to strengthen further the prudential framework of the financial system. The recently established Financial Stability Council would strengthen the monitoring and management of systemic risk, and facilitate coordination in times of crisis. Several current legislative initiatives, including the law on risk-based supervision of insurance companies, the corporate bankruptcy law, and the proposal to expand the credit registry, would also make an important contribution to enhancing prudential oversight. Plans to update the General Banking Law and review the legal framework for bank resolution are also welcome. As recommended by the 2011 FSAP Update, it will be important to establish a legal framework for consolidated supervision of financial conglomerates.

47. Increasing productivity growth remains Chile’s key medium-term challenge. Staff welcomes recent government initiatives to foster female labor participation, streamline business incorporation and bankruptcy process, and strengthen competition. Labor market flexibility could be further enhanced by reforming high severance pay for employees, increasing the flexibility of working hours and the efficiency of training programs. Chile’s relatively high ratio of minimum-to-average wages could hinder employment growth and contribute to growth of the informal sector. To contain this risk, minimum wage increases should be consistent with productivity growth. Measures to facilitate investment in the energy sector would help improve the competitiveness of Chilean firms.

48. Staff recommends that the next Article IV consultation takes place on the standard 12-month cycle.

Assessment of Chile’s External Position

Chile’s real effective exchange rate (REER) has fluctuated around its long-term average in recent years. The REER strengthened in the mid-2000s alongside a copper price boom. In the last two years, it has hovered around its average value of the previous 15 years. Despite the appreciation, Chile’s non-mining export growth over the last decade has been relatively robust. In addition, Chile’s world market share of agricultural and industrial exports has remained broadly stable since 2004.

uA01bx01fig01

Exchange rates and copper price 1/

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

1/ An increase in the exchange rates indicates an appreciation.

Chile’s ability to maintain robust non-mining exports is attributable to a number of factors. The structure of Chile’s industrial exports played a role: resources-based exports such as food and wood products account for two thirds of Chile’s industrial exports. Chile was therefore able to avoid competing with manufacturing powerhouses such as China. In addition, since 2003, Chile has ratified free trade agreement (FTA) with all of its major trading partners.

uA01bx01fig02

Non-mining exports

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

CGER estimates suggest that the real effective exchange rate is broadly in line with fundamentals (see table). However, the new External Balances Assessment’s current account approach (explained in IMF’s Pilot External Sector Report, July 2012) suggests that the current account balance is about 2 percentage points below the estimated norm under desirable policies, implying a small overvaluation of the real exchange rate (about 7 percent). The current account deficit is driven in part by imports related to higher investment in mining and energy, which should support future exports. More ambitious fiscal consolidation, consistent with staff advice, would also help reduce the current account deficit.

REER Gaps Based on CGER Methodologies 1/

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Positive values indicate overvaluation.

The macroeconomic balance (MB) approach calculates the difference between the medium term CA balance and a CA “norm”, which is a function of fundamentals (fiscal balance, old-age dependency, NFA, oil balance, real GDP per capita, and real GDP growth). The ERER is a function of fundamentals (NFA, relative productivity differentials, the TOT, and trade restrictions). The ES approach calculates the difference between the actual and NFA-stabilizing CA balances. The real exchange rate adjustment will bring the CA in line with its NFA-stabilizing level. For more detail on the CGER methodology, see Lee et al., “Exchange Rate Assessments: CGER Methodologies,” IMF Occasional Paper No. 261, April 2008.

Looking at the financing side, the external current account deficit is financed mostly by FDI. FDI inflows are much larger and more stable than portfolio and other investment inflows. FDI inflows are expected to remain strong in the medium term, especially in the mining sector. Net external liabilities stood at 10 percent of GDP in 2011, relatively low compared to other emerging markets.

Chile’s international reserve position is adequate based on various reserve metrics. International reserve stood at US$40.3 billion at end-June 2012, which is close to 100 percent of short-term debt at residual maturity. The reserve level is also considered adequate when measured relative to imports, broad money, or using the new IMF metric.

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Chile: International Reserve Adequacy

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Central Bank of Chile and IMF staff estimates.1/ Metric proposed in “Assessing Reserve Adequacy” (SM/11/31); the suggested adequacy range is 100-150 percent.

Financial and Real Spillovers to Chile

As a small open economy, Chile is exposed to external shocks. Chile’s trade openness and international financial integration are significant. Chilean banks and corporations are net borrowers in world markets, so the cost and availability of domestic financing are affected by global factors. In addition, subsidiaries of foreign banks account for a large share of bank assets. Staff analysis based on a vector autoregression suggests that global financial and demand shocks, and shocks to copper prices have an important impact on Chile’s output.

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Chile: Cumulative Response of Output to External Shocks 1

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Source: Selected Issues Paper1 Cumulative response of Chile’s GDP to one standard deviation shock. Time horizon in quarters.

More detailed analysis shows that global financial shocks affect bank funding costs in Chile. The analysis presented in the selected issues paper finds that interbank and bank bond spreads are highly correlated with measures of global financial stress. Independent variables include global variables such as the composite CDS spread of the largest European banks, VIX, foreign interbank spreads, and domestic liquidity variables. During the Lehman crisis, the US interbank market spread explained the bulk of the movement in the Chilean interbank spread; while the last two years, domestic bank funding costs have been positively correlated with European bank CDS spreads and the VIX. Despite these links, spillovers from global financial stress have been limited. In the last two years, average funding spreads have been low, at around one percent, and bank credit growth has been very strong.

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Interbank Spread

(In percent)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

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Bank Bond Spread

(In percent)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Labor Productivity

Labor productivity gains in Chile moderated over the last decade. Average annual labor productivity growth declined from 4.8 percent in the 1990s to 1.5 percent in 2006–2011. Some of the decline is explained by lower productivity in the mining sector related to declining ore grade. However, non-mining labor productivity gains also declined (from 4.5 percent per year in the 1990s to 2.4 percent in the last five years).

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Chile: Growth Decomposition

(percentage points)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: National authorities and Fund Staff estimates
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Chile: Labor Productivity

(annual percentage change)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: National authorities and Fund staff estimates

Following the 2009 crisis, output growth has been underpinned by strong employment growth. Labor force participation increased 4 percent per year driven by rising female participation, while employment growth averaged 6 percent per year. After declining in 2010, labor productivity grew 1½ percent in 2011. Although there is still room to raise female and youth participation rates which are below the OECD average, output growth going forward will depend increasingly on productivity gains.

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Chile: Labor market trends

(Labor force participation (LFP) in percent of population 15 years and older)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: Chile’s National Statistics Institute.Data starting in March 2010 correspond to the new employment survey. March for 2012.
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Chile: Youth and Female Labor Participation

(youth in percent of 15-24 population; female in percent of 15-64 population)

Citation: IMF Staff Country Reports 2012, 267; 10.5089/9781475510485.002.A001

Sources: OECD, Labour Force Statistics Database

Raising productivity growth has been at the center of the authorities’ reform agenda. The conditional cash transfer program for low-income families, Ingreso Ético Familiar, includes transfers conditional on educational achievement of children as well as work-subsidies for women. In addition to increasing female labor participation, the program would also help reduce poverty and income inequality further (recently released data show that income inequality has declined in 2011, although it remains at a high level, with a Gini coefficient of 0.52), The recent education reform has emphasized improved access to tertiary and preschool education. The authorities are also pressing ahead with reforms to improve intellectual property rights and streamline procedures for business incorporation and bankruptcy. As noted by recent OECD reports, however, there is a need to further enhance the flexibility of Chile’s labor market and improve the quality of human capital.

Table 3.

Chile: Summary Operations of the Public Sector 1/

(In percent of GDP)

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

This table reflects the authorities’ revisions to historical official data to bring the fiscal accounts in line with GFSM 2001.

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

Includes the effects of valuation changes (exchange rate).

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

Table 4.

Chile: Balance of Payments

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

In 2010 reflects insurance payment associated with the earthquake.

“Other” variations in reserves largely reflect changes in deposits by commercial banks and the government with the central bank.

Updated staff forecasts, average.

Table 5.

Chile: Monetary Survey

(In billions of pesos; unless otherwise indicated)

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Sources: Central Bank of Chile and Haver Analytics.

Banking system.