Chile: Staff Report for the 2013 Article IV Consultation
Author: International Monetary Fund. Western Hemisphere Dept.
Publication Date:
08 Jul 2013
eISBN:
9781475549836
Language:
English
Keywords:
ISCR; CR; current account; holding; SDR Department; widening current account deficit; balance of payments; private sector; foreign currency; movements well; financial system
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The staff reports for the 2013 Article IV Consultation on the Chile discuss the strong and inclusive growth over the medium term. Technocratic, rules-based, and transparent policy management; monetary policy under a floating exchange rate undertaken by a credible central bank; and prudent fiscal policy, since 2001 under a near-legendary fiscal rule, has enhanced policy clarity, reinforced Chile’s resilience to shocks, and allowed for vigorous policy responses when needed, as after the global financial crisis and the earthquake. The widening current account deficit and the increased reliance on debt financing have increased balance of payments stability risks and Chile’s exposure to sudden stops.

Abstract

The staff reports for the 2013 Article IV Consultation on the Chile discuss the strong and inclusive growth over the medium term. Technocratic, rules-based, and transparent policy management; monetary policy under a floating exchange rate undertaken by a credible central bank; and prudent fiscal policy, since 2001 under a near-legendary fiscal rule, has enhanced policy clarity, reinforced Chile’s resilience to shocks, and allowed for vigorous policy responses when needed, as after the global financial crisis and the earthquake. The widening current account deficit and the increased reliance on debt financing have increased balance of payments stability risks and Chile’s exposure to sudden stops.

The Setting

1. Chile’s economic performance in recent years has been impressive. The rebound from the 2009 global financial crisis and the 2010 earthquake was quick and strong, and the economy has outpaced most of its peers over the last 2-3 years.1 This performance reflects many factors, including the benefits of structural reforms, but two stand out:

  • Policies. Technocratic, rules-based, and transparent policy management—monetary policy under a floating exchange rate undertaken by a credible central bank, and prudent fiscal policy, since 2001 under a near-legendary fiscal rule—has enhanced policy clarity, reinforced Chile’s resilience to shocks, and allowed for vigorous policy responses when needed, as after the global financial crisis and the earthquake. Chile has the highest sovereign debt rating ever for any Latin American country.

  • External conditions. Chile has benefited from strong demand and high prices for copper, its principal export (which accounts for over half of Chile’s exports), and from easy global financial conditions. But the global copper boom appears to be coming to an end.

uA01fig01

Per Capita Income, 1980-2012

(GDP per capita in 1,000 U.S. dollars at Purchasing Power Parity-terms)

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Source: IMF World Economic Outlook database.

2. The outlook is bright but with important challenges. The key near-term challenge is to support a soft landing in the economy in the context of a widening current account deficit, swelling capital inflows, and an uncertain outlook for copper. The medium and long-term challenge is to foster sustained growth without the boost from rising copper prices and against the headwind of a stagnating working-age population. While Chile’s strong policy frameworks and investor-friendly environment will continue to support growth, further actions are needed to achieve a sustained improvement in productivity growth.

Current Conditions

3. Economic activity, which surprised on the upside in 2012, has slowed in 2013.

  • 2012. Real GDP growth came in at 5½ percent compared with 4.7 percent projected in last year’s staff report, powered by surprisingly resilient private domestic demand. Mining investment was particularly strong. Private consumption was boosted by employment and real wage growth, whereas consumer credit growth continued to moderate. Booming domestic demand and a slightly positive (and widening) output gap raised overheating concerns—especially as the current account deteriorated rapidly.

  • 2013 so far. However, growth slowed to 4.1 percent (y/y) in 2013Q1, from 5.7 percent in 2012Q4. The slowdown is apparent also in recent data on employment, construction, and consumer credit. The monthly GDP proxy (IMACEC) had a fourth consecutive weak reading in April. Still, retail sales and consumer imports remain quite brisk and the drop in copper prices (down 6 percent since end-2012) has not yet sapped consumer and business confidence, both of which remain firm. And even if recent developments do mark a turn in the cycle, supply conditions remain tight. This is most clearly evident in the labor market: unemployment has fallen markedly to a historically low 6.4 percent and there are reported shortages in agriculture, mining, and construction.

Figure 1.
Figure 1.

Chile: Past Growth Performance and Challenges Ahead

Sustained productivity growth is needed to continue Chile’s past strong performance.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: World Economic Outlook (IMF), OECD, World Development Indicators (World Bank), and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Based on Sosa, Tsounta and Kim (2013).3/ Linear interpolation used to fill in missing data.
uA01fig02

Real GDP and Domestic Demand

(y/y growth)

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Source: Haver Analytics.

4. Meanwhile, fiscal policy has provided some dampening effect. The budget recorded a small surplus in 2012 as the government saved revenue overperformance and kept spending (notably current transfers and capital) below budget. The structural deficit improved to ½ percent of GDP, handsomely beating the authorities’ 1 percent target two years ahead of time. On this basis, the fiscal impulse—measured by staff as the change in the non-mining structural primary balance—was negative (mildly) for the third year in a row. The government thereby has clawed back much of the stimulus injected in 2009. Expenditure grew 3.7 percent y/y in real terms in 2013Q1.

5. Inflation has been surprisingly low and declining. The principal factors behind this development seem to include the peso appreciation last year, evident in tradable inflation; a sudden spurt in labor productivity in 2012 that has contained unit labor costs; and falling energy prices. Inflation dropped to 0.9 percent in May, below the official target of 3 (+/-1) percent. There is also downward bias in at least one component of the consumer price index, but this bias does not seem to materially change the picture of low and declining headline inflation.2 Inflation expectations remain anchored at 3 percent 24 months out. In this environment, the central bank has left the policy rate at 5 percent, a broadly neutral rate, since January 2012.

uA01fig03

Tradable and Non-Tradable Inflation

(Consumer prices, 12-month change in percent)

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Source: Haver Analytics.

6. The peso has appreciated in the context of swelling capital flows. The peso appreciated 7 percent against the dollar between June 2012 and April 2013, and about 5 percent in real effective terms. The peso has subsequently depreciated, along with other regional currencies, but is still stronger than the low level reached last June. Historically, the peso has moved with copper prices, but over the past year other factors appear to have also been important, e.g., lower global financial distress, QE3, and the carry trade (Box 1). The role of capital flows is less clear, though: Chile has seen a surge in gross inflows, mainly foreign direct investment but net inflows actually declined in 2012 as local pension funds reversed an increase in portfolio allocation to domestic assets in 2011. FDI and portfolio inflows and outflows remained strong in 2013Q1.

Figure 2.
Figure 2.

Chile: Cyclical Position

Strong activity has started to moderate.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Central Bank of Chile, Haver Analytics, and Fund staff calculations.1/ Core inflation excludes fuels, fresh fruits and vegetables.
Figure 3.
Figure 3.

Chile: Financial Market Developments

Despite overall strong financial performance and ample liquidity, credit conditions have tightened recently.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Bloomberg, Central Bank of Chile, and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Morgan Stanley Composite Indices.3/ Unidad de Fomento (UF) is a unit of account adjusted for inflation.
Figure 4.
Figure 4.

Chile: Fiscal Policy and Public Finances

A faster than anticipated consolidation has broadly restored the fiscal stance to its pre-crisis level; net assets remain sizeable, albeit lower than in 2008.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Ministry of Finance, Central Bank of Chile, and Fund staff calculations.1/ Change in the non-mining structural primary deficit.
Figure 5.
Figure 5.

Chile: Monetary Policy and Inflation

Amid temporary factors keeping inflation low, the monetary policy rate has been left unchanged.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

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

Capital Flows

(In billions of US$)

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Source: Central Bank of Chile.

Negative number means net inflows.

7. And the current account has deteriorated further. The current account, which shifted from a surplus in 2010 to a deficit in 2011, deteriorated further in 2012 and early 2013 (it was 4 percent of GDP in 2013Q1 (12 month basis)). Resilient domestic demand has boosted imports, while exports have suffered from the weakening of still high copper prices and torpid demand in the euro area, Japan, and in key regional partners (Argentina, Brazil). The deficit is financed mostly by foreign direct investment, though within FDI, the share of debt liabilities jumped to one third in 2012 from nil in 2007–09.

8. These developments have raised balance of payments risks. The widening current account deficit and the increased reliance on debt financing have increased balance of payments stability risks and Chile’s exposure to sudden stops. But there are mitigating considerations:

  • REER. The real effective exchange rate is still only about 10 percent above its 1996-2012 average (as of April 2013), despite Chile’s sizeable terms of trade gains over the last decade.

  • S-I. From a savings-investment perspective, there has been a decline in saving, but the major factor behind the swing in the current account is the increase in private investment, predominantly in mining and energy.

  • Exports. The bulk of the drop in Chile’s exports in 2012 was to markets with weak demand, and exports should be helped by the projected recoveries in Chile’s trading partners. Also, Chile’s non-mining exports have not lost their global market share.

  • IIP. More broadly, Chile’s international investment position (level and changes) remains robust, and the external debt is sustainable under a range of adverse scenarios (Annex I).

Saving and Investment Balances

(In percent of GDP)

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International Investment Position

(In percent of GDP)

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Peso Valuation 1/

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Sources: Central Bank of Chile and Fund staff estimates.

External Balance Assessment (EBA) and Consultative Group on Exchange Rate Issues (CGER) are methodologies developed by the IMF to assess real exchange rate. Exchange Rate Assessments: CGER Methodologies, IMF, 2008.

Figure 6.
Figure 6.

Chile: External Stability

Despite the recent widening of the current account deficit, there are no immediate stability or sustainability risks.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Central Bank of Chile and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Assessing Reserve Adequacy, IMF, February, 2011.

On balance, staff’s view, corroborated by EBA and CGER estimates, is that the peso is on the strong side, but not clearly overvalued. The main concern is the current account deficit, though it is not large enough to present immediate stability or sustainability risks.

9. Macro-financial risks are contained. There are no clear signs of generalized asset price or credit bubbles:

  • Banks. While credit growth remains quite strong across all loan categories, it is on a declining trend and staff analysis does not find evidence of a “credit boom.”3 Nonperforming loans are low and fully provisioned, and indicators on bank capital adequacy, liquidity, and profitability remain healthy. That said, mid-sized banks (about one-third of system assets) are expanding rapidly, particularly in cyclical sectors like real estate, and with a relatively high reliance on wholesale funding.

  • Nonbanks. The major players are insurance companies and pension. The solvency of the insurance sector (mainly annuities) appears adequate, according to the Superintendence of Securities and Insurance, and the sector’s investment returns improved in 2012. The privately-managed pension system does not in itself pose financial stability risks, and pension funds’ investments appear diversified both as regards fixed versus variable income and domestic versus foreign.

  • Households/corporates. Household indebtedness has remained broadly stable in recent years at about 55 percent of disposable income, while firms have taken advantage of easy liquidity conditions to increase their indebtedness to about 90 percent of GDP. Neither level seems high from an international perspective. For firms, currency mismatches have remained limited, but profits and liquidity conditions have worsened compared with pre-crisis, especially in construction and trade sectors that have the largest share of commercial debt.

  • Real estate. Real estate activity (supply and demand) has been dynamic. While residential housing prices in aggregate do not suggest bubbles, these averages hide considerable variation and some regions have seen substantial price increases that could spill over to other parts of the country. One sign of incipient froth in the housing market is the jump in average loan-to-value ratios to above 85 percent since late 2011, as highlighted in recent central bank financial stability reports. Another issue is the above-mentioned worsening in construction companies’ financial strength. As for construction, while residential housing activity seems to be cooling off, commercial real estate (for which data are spotty) remains hot with a substantial amount of office space being completed in 2013-14.

Financial Soundness Indicators

(In percent)

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

For 2012, end-August.

Financial System Structure

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Sources: Superintendence of Banks and Financial Institutions, Superintendence of Pensions, and Superintendence of Securities and Insurance.

Assets under management

Includes mutual funds and investment funds.

Figure 7.
Figure 7.

Chile: Macro-Financial Stability

Chile’s large financial system is generally robust but some aspects warrant continued vigilance.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, World Development Indicators (World Bank), Financial Stability Indicators (IMF), and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Other LA6 includes Brazil, Colombia, Mexico, and Peru.3/ Other LA6 includes Brazil, Colombia, and Mexico.
Figure 8.
Figure 8.

Chile: Real Estate Developments

There are no clear signs of significant misalignment with fundamentals.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, Chilean Chamber of Construction, Global Property Guide, and Fund staff calculations.1/ Compiled by the Central Bank of Chile controlling for home characteristics.2/ Compiled by the Chilean Chamber of Construction using the hedonic price methodology.3/ Includes purchase commitments.4/ Apartments located in the center of the most important city of each country.

Outlook and Risks

10. Barring unpleasant surprises, the baseline outlook is for a deceleration in domestic demand and activity in 2013. Staff projects growth at 4.6 percent in 2013 and thereafter, broadly in line with potential growth. Private investment will cool after three years of high growth, in part as post-earthquake reconstruction winds down, while private consumption will lose pace in line with recent employment and consumer credit developments. The fall in copper prices will also impart a dampening effect although overall exports are poised to benefit from a gradual recovery in partner countries. Staff sees fiscal policy injecting some stimulus in 2013. The current account deficit would rise further in 2013 (to 4½ percent of GDP) and decline thereafter. Inflation will move toward 3 percent by 2014, in line with market expectations.

11. But the outlook is surrounded by considerable uncertainty and risk relating to the twists and turns of the global economy and the strength of the cyclical changes in Chile:4

  • Copper prices. The policy frameworks and the floating currency have reduced Chile’s vulnerability to copper prices. Still, a large and lasting copper price fall, e.g., triggered by a fall in investment in China (which consumes 40 percent of world copper) would have major effects on the current account and foreign direct investment, public finances (14 percent of central government revenue comes directly from copper in 2012), and medium-term growth prospects. Staff analysis suggests that a 10 percent decline in copper prices reduces GDP by 0.8 percent over 8 quarters.5

  • European financial stress. Spillovers via Spanish bank subsidiaries, which have a large presence in Chile, have thus far not been important and the banking system’s direct funding exposure to European banks is small. That said, intensified euro area distress could have a major effect on confidence and funding for banks and corporations.6 A slump in Europe would also hurt Chile’s exports (about 15 percent of Chile’s exports go to the euro area).

  • Sudden stop. The current account deficit and the gross external financing requirement (18 percent of GDP in 2013) expose Chile to sudden-stop risks (e.g., triggered by a disorderly exit from unconventional monetary policy in advanced economies). Short-run effects could involve sizable depreciation—though balance sheet effects would be contained by the lack of important currency mismatches in the economy—and the above-mentioned effects on funding. At the same time, foreign direct investment, which is the dominant type of capital inflow to Chile, tends to be less susceptible to abrupt reversal than short-term capital but would be affected by a fall in copper prices.

  • Overheating. Although this risk has lessened recently, a sustained moderation in domestic demand is not yet assured. Demand could surprise on the upside, fueled by capital inflows, credit expansion, and real wage growth. In such a scenario, the real exchange rate would appreciate, inflation rise, and the current account deficit widen further—increasing further Chile’s exposure to external shocks.

Risk Assessment Matrix

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Figure 9.
Figure 9.

Chile: Spillovers and Exposures

Chile remains exposed to global conditions both through financial and real channels.

Citation: IMF Staff Country Reports 2013, 198; 10.5089/9781475549836.002.A001

Sources: Central Bank of Chile, Superintendence of Banks and Financial Institutions, and Fund staff calculations.1/ Other LA6 includes Brazil, Colombia, Mexico, Peru, and Uruguay.2/ Response to one standard deviation shock to copper prices (10 percentage points) ± 1.5 standard errors.3/ Response to one standard deviation shock to the VIX (4.1 units) ± 1.5 standard errors.

12. The authorities broadly agreed with the contours of the staff’s views on the outlook and risks. However, they considered that the current slowdown in activity has materially diminished both the overheating risk and those associated with a sudden stop. The authorities noted that the floating exchange rate is a key shock absorber and would help mitigate the effect of external shocks, e.g., further declines in copper prices, on the current account deficit.

Policy Discussions

A. Supporting the Soft Landing

13. To support the ongoing moderation in activity, staff suggested that the authorities stay the course with broadly neutral fiscal and monetary policy. This strategy, which implies no major shift in policy stance from last year, stands the best chance of supporting a deceleration in economic activity toward trend without triggering additional capital inflows, undue currency appreciation, and further widening in the current account deficit.

14. For fiscal policy, this would mean a tighter stance than implied by the 2013 budget. The 2013 budget, if executed in full, would increase spending by about 8 percent in real terms and inject a fiscal impulse (measured by the non-mining structural primary balance in percent of non-mining GDP) equal to about ½ percent. Given that the economy is moderating toward trend, staff sees no justification for an expansionary fiscal stance this year. Rather, the staff recommended that the government seek to ensure a broadly neutral stance by keeping spending below the budget ceiling as in the last two years (while protecting infrastructure and social spending). This would bring the structural balance closer to zero. The authorities took note of the staff’s view and reiterated their commitment to a structural deficit equal to 1 percent of GDP in 2013, but noted that, as in the past, they would save any revenue overperformance.

15. Monetary policy considerations are finely balanced. Staff and the central bank agreed that a broadly neutral stance is appropriate and that this might call for a rate cut if inflation and inflation expectations remain low, domestic demand weakens faster than expected, or the external outlook deteriorates. In this context, the authorities and many analysts also noted that Chile’s policy rate (at 5 percent) is high among emerging markets. At the same time, staff noted that if domestic demand does not cool as envisaged, a policy rate increase might be needed, despite the likely effect on peso appreciation.

B. Coping with External Spillovers

16. Chile is in a strong position to deal with external shocks even though buffers are smaller than before Lehman. Chile’s stellar macro-financial performance in response to the double-shock of the global financial crisis and the earthquake attests to the economy’s resilience—supported by vigorous fiscal and monetary policy responses, though the recovery was also helped by the rebound in copper prices.

Selected Indicators: Pre-Lehman and Latest

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Sources: Haver Analytics and Fund staff calculations.

17. It was agreed that there is ample room for a robust policy response, if needed.

  • Exchange rate. The floating exchange rate (and Chile’s demonstrated lack of fear of floating) is a key shock absorber, including in a tail risk scenario with a sharp and lasting drop in copper prices or a sudden stop. Foreign exchange reserves could be used to avoid excessive currency depreciation, if needed.

  • Monetary policy. The low inflation and well-anchored inflation expectations would allow a forceful monetary policy action, as in 2009.

  • Fiscal policy. The rude health of public finances—gross public debt (including debt of the central bank and non-financial public enterprises) at 34 percent of GDP and a net asset position for the central government, even if less than half the size than pre-Lehman in percent of GDP, at an enviable 7 percent of GDP—provides room for the operation of automatic stabilizers and (as a last resort) for fiscal stimulus if output falls (Box 2).

  • Liquidity operations. Finally, as post-Lehman crisis and in late 2011, the authorities should be prepared to deploy measures to contain liquidity pressures, including expanding repo operations, broadening the range of eligible collateral, and introducing dollar swap auctions.

C. Medium-Term Fiscal Policy

18. Staff encouraged the authorities to consider a modest structural surplus over the next couple of years to ensure sizable fiscal buffers. A modest surplus would stabilize government net assets as a share of GDP on current copper price and growth projections. Achieving and maintaining a small surplus will be challenging, though, since unlike in the past, the spending room under the fiscal rule is unlikely to benefit from increases in structural copper price and revenue—and the authorities may even have to confront a decline in structural copper revenue for the first time in the life of the fiscal rule. It will be important that permanent spending commitments are matched with permanent revenue increases. The authorities broadly agreed with staff’s considerations but noted that it would be for the next administration to define the structural balance target for its term. The staff also welcomed the authorities’ work to incorporate long-run expenditure and revenue projections into the budget framework

19. The staff welcomed the creation of a Fiscal Council in April 2013. The Fiscal Council, created in April this year, will advise the Minister on the implementation and operations of the fiscal rule, and on any methodological changes to it. The Council, whose views will be made public but not binding, will help enhance the rigor and transparency of the rule.

D. Reinforcing Financial Stability

20. Chile’s financial system is generally robust but it also presents challenges. As discussed, banks and nonbank financial institutions are well-capitalized and liquid. In the central bank’s stress-tests, the banking system is solvent even under extreme scenarios.7 Importantly, financial sector developments and risks are subject to close monitoring and proactive supervision by the central bank and the three supervisory agencies (Superintendence of Banks and Financial Institutions (SBIF), Superintendence of Pensions (SP), and Superintendence of Securities and Insurance (SVS)) and the proactive Financial Stability Council (created in 2011). Nonetheless, given its size (assets equal to 200 percent of GDP), its exposures to global and euro area tail risks, and the important presence of financial conglomerates, the financial system merits continued robust monitoring.

21. Staff welcomed the authorities’ ambitious policy agenda to strengthen regulation and oversight further. Many of the reforms follow advice of the 2011 FSAP (Annex II).

  • Progress: Key recent achievements include the strengthening of the SBIF (18 percent more staff) with a growing focus on nonbank institutions; efforts (including within the Financial Stability Council) to identify and quantify the systemic importance of conglomerates; and the revised credit card norm, which strengthens capital and liquidity requirements and levels prudential regulation between bank and nonbank issuers. As part of the intended adoption of a risk-based supervisory system for the insurance industry, SVS has issued for public consultation its first risk-based capital model.

  • Reforms under way. The following legislation is under preparation or in Congress: the law that introduces risk-based supervision of insurance companies; legislation to expand the credit registry to include comprehensive credit history from banks and nonbanks; and a revised corporate bankruptcy law. Further, the General Banking Law is being revised, focusing on adopting Basel III capital standards (Box 3). The revisions will not address 2011 FSAP recommendations on strengthening SBIF independence and the legal framework for bank resolution; the staff encouraged the authorities to tackle these issues as soon as feasible. Finally, the staff commended the work to improve supervision of conglomerates, and encouraged continued effort on a legal framework for consolidated oversight.

22. As for macro-prudential policies, though there are no systemic risks that warrant immediate action, some modifications could be considered. Staff welcomed the decision to strengthen the Financial Stability Council’s legal underpinning by establishing it in law. This law would also enhance information sharing among the Financial Stability Council members and information collection with regard to conglomerates. Although there is no urgent need for macro-prudential policy changes, in view of the recent rise in average loan-to-value (LTV) ratios to about 85 percent (high by international standards), staff recommended that some form of LTV and debt-to-income (DTI) regulation be applied to all mortgages: currently the so-called non-endorsable mortgages, which have grown rapidly and now account for 85 percent of mortgages, are the only ones without LTV or DTI caps (Box 4). Other macro-prudential measures could be considered as needed. The authorities agreed that some form of LTV measures could be useful, perhaps linked to provisioning requirements.

E. Fostering Strong and Inclusive Growth over the Medium term

23. Reinforcing the prospects for strong and inclusive growth requires concerted actions on two fronts.

  • Productivity. Over the past decade, growth and rising real incomes have benefited from high copper prices (directly and via large mining investments) and employment growth. Total factor productivity performance has lagged the region as well as Chile’s past performance but this reflects in part declining productivity in the mining sector.8 With the global copper boom winding down, investment already at high levels, and the scope for employment growth curbed by low unemployment and slowing growth in working-age population (to 0.9 percent a year by 2020, from 1.7 percent in 2010), growth will depend on a sustained reinvigoration of productivity growth, including in mining. It is unclear what explains the jump in productivity in 2012 but it would be premature to assume it heralds a major shift in the economy’s performance.

  • Inclusiveness. There is also scope to make growth more inclusive. Chile has the most skewed income distribution among OECD countries and its Gini index has declined only modestly to 0.52 in 2011 from 0.56 in 2003.

Alternative Scenarios for Medium-Term Growth

(Average annual percentange change)

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Sources: Central Bank of Chile and Fund staff estimates.

Capital and TFP growth at their 2001-2012 average.

TFP growth at its 2012 level.

24. The staff commended the authorities on recent efforts and it was agreed that important challenges remain. By most metrics, Chile has the best investment climate in the region. Recent initiatives to reduce international trade costs and shorten the time it takes to start a business (to one day) should improve the climate further. The staff also welcomed the efforts to update Chile’s bankruptcy procedures. Key areas where further action is needed include:

  • Energy. Strengthening Chile’s energy generation and infrastructure is crucial for medium-term growth prospects. The authorities’ plan to connect the two main electricity grids is an important step but more action is needed to tackle costs and foster investment in the sector.

  • Education; social policies. More equal access to high-quality education and training would help improve productivity and income inequality, while well-targeted transfer programs would improve social mobility and skill-formation among low-income groups. The efforts to establish an education quality assurance system, improve access to education through scholarships and reduced costs of state-guaranteed loans, and strengthen Conditional Cash Transfer programs are welcome.

  • Labor market. Recent measures, including subsidies to low-income women and an extended maternity leave scheme, can help encourage higher female labor participation which in turn would help with growth and income equality. In line with OECD recommendations, a reconsideration of the relatively high severance payments and the rigid working hours, and strengthened training programs could help ensure efficient labor allocation.

25. The authorities broadly concurred with the staff’s views. They agreed that achieving a sustained increase in productivity is important and they were encouraged by the rebound in productivity in 2012 that they considered mostly a trend increase. They also noted the difficulty in reaching political consensus on labor market reforms and large hydroelectric power projects.

F. Other Issues

26. Chile has a long record of high-quality statistics and data are adequate for surveillance. Recent months have seen controversy surrounding the 2012 population census and certain sub-components of the consumer price index. The staff urged prompt, transparent, and credible resolution to these controversies. They welcomed the authorities’ announcement of a speedy audit of the population census with the involvement of an expert committee, as well as the plans to address methodological issues in the consumer price index in a timely manner. Furthermore, the staff supported the idea of strengthening the National Institute of Statistics’ independence, as is being proposed.

Staff Appraisal

27. Growth in recent years has been strong, led by domestic demand, but a slow down appears underway. Growth surprised on the upside in 2012 and on the downside in the first quarter of 2013. These ups and downs appear to be part of a bumpy transition toward a more sustainable rate of expansion in economic activity. The moderation in activity is also reflecting a shifting outlook for copper prices.

28. The main cloud over the strong performance is the rapid shift in the current account. The ballooning current account deficit and the increased reliance on debt financing have raised balance of payment risks. Still, staff’s assessment is that the peso is on the strong side but not clearly overvalued.

29. Macroeconomic policies have been prudent. In recent years, fiscal policy has provided a welcome dampening effect on demand, thereby helping prevent overheating and a more substantial real appreciation and current account deterioration. Monetary policy has been on hold since early 2012 and is broadly neutral.

30. And macro-financial risks appear contained thanks in large part to the authorities’ active supervision and monitoring. There are no clear signs of broad asset price or credit bubbles. Liquidity and solvency indicators and stress tests suggest that the financial sector is generally healthy and robust. That said, some mid-sized banks are expanding fast, with relatively high reliance on wholesale funding. As for real estate, aggregate price developments do not suggest bubbles but continued close monitoring will be important, including of commercial real estate construction which remains very dynamic.

31. The near-term priority is to support the ongoing moderation in domestic demand and activity, amid swelling capital inflows and a widening current account deficit. In this context, a neutral fiscal stance would be desirable and can be achieved through a tight grip on spending in the remainder of the year, and saving any revenue over performance. This would bring the structural balance closer to zero.

32. There is a great deal of uncertainty and risks surrounding the outlook stemming both from real and financial channels. The main downside risks to the outlook are a sharp and lasting drop in copper prices, re-emergence of financial stress in the euro area, or a sudden stop in capital inflows. At the same time, there is also a chance that domestic demand does not abate as envisaged, raising overheating risks.

33. Monetary policy should be ready to respond to changes in the economic outlook and fiscal automatics stabilizers should be allowed to operate unimpeded. As a last resort, there is ample space for fiscal stimulus if output falls. The floating currency provides a natural buffer against external shocks and the ample reserves could be used to avoid excessive depreciation.

34. Further strengthening of the medium-term fiscal framework is appropriate. Staff recommends aiming for a small structural surplus over the next few years, as this would help maintain strong fiscal buffers while stabilizing net assets as a share of GDP. The establishment of the Fiscal Council is welcome as it further strengthens the transparency of the fiscal framework. Staff also commends plans to incorporate long-run expenditure and revenue projections into the budget framework.

35. The staff applauds the authorities’ proactive work on financial stability issues. Recent progress in strengthening supervision of nonbanks and financial conglomerates is welcome. Current legislative initiatives, notably the General Banking Law, the law on the Financial Stability Council, the law on risk-based supervision of insurance companies, the legislation to expand the credit registry, and the corporate bankruptcy law, will strengthen prudential oversight. Looking ahead, the broad-based banking regulation reform scheduled for this year will be an important improvement. However, addressing pending FSAP recommendations, including a legal framework for consolidated oversight of financial conglomerates, should remain a priority. And while there are no systemic risks that warrant immediate action, the authorities should consider extending some form of loan-to-value and debt-to-income regulation to all mortgages.

36. The medium-term challenge is to foster sustained and inclusive growth. Boosting productivity and labor force participation will be needed to sustain growth without the benefit of the tailwind of rising copper prices and with slowing growth of working-age population. To this end, key areas for further reform include: make access to high-quality education and training more equal, and consider well-targeted social transfers to spread growth benefits; promote investments in the energy sector to ensure sufficient and competitive energy supply; and make the labor market more flexible.

37. A prompt and transparent resolution of the recent statistical controversies would protect Chile’s long tradition of high quality data. Staff welcomes authorities’ outreach efforts among local analysts and data users, and their plans to obtain advice from international experts.

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

What Explains the Peso Movements?1/

The Chilean peso usually moves in tandem with copper prices, but there have been episodes when it deviates, e.g., in the period July 2012-May 2012 when the peso appeared stronger than what could be explained by copper prices (in recent weeks the gap has narrowed). This episode prompted focus on the role of other factors, including carry trade and unconventional monetary policy in advanced economies. While it is notoriously difficult to explain short-term exchange rate movements, this box looks at factors that influence the nominal dollar/peso rate using a simple error-correction model based on weekly data from October 1999 to May 2013.

The following explanatory variables are used: copper price, relative U.S./Chile CPI, the spread between the yields on 90-day Chilean and U.S. government bills, and VIX (the implied volatility of S&P 500 index options)–a common measure of global financial distress. The regression also includes dummy variables to capture the last two foreign exchange interventions by the Central Bank of Chile (April-December 2008 and January-December 2011) and the balance sheet of the Federal Reserve to capture the effect of quantitative easing (QE).

The model fits the in-sample dollar/peso exchange rate movements well. A 10 percent increase in copper prices would strengthen the peso by about 1.7 percent against the dollar over the long run. Higher Chile-U.S. interest spread would strengthen the peso. Higher global financial distress, in contrast, would lead to a stronger dollar. The Central Bank’s interventions in 2008 and 2011 did seem to help weaken the peso, although only by about 3½ and 2½ percent, respectively. The result also suggests that QE3 could lead to an appreciation of the peso against the dollar by about 2 percent.

1 See Selected Issues Paper What Explains Movements in the Peso/Dollar Exchange Rate?, by Y. Wu.

The Strength of Government Finances

The Chilean central government is a net creditor. The net asset position at end-2012 equaled about 7 percent of GDP. The average net position among emerging markets is negative 24½ percent of GDP. Chile’s consolidated public sector has a net asset position of some 2 percent of GDP.

Gross assets include the two sovereign wealth funds (SWFs) as well as other instruments. The stabilization fund (ESSF) currently stands at about 5½ percent of GDP and represents a flexible fiscal buffer that can be used to cover deficits and amortizations. The pension reserve fund (PRF) stands at about 2¼ percent and is earmarked to cover a fraction of pension related outlays starting in 2016. Further, the government currently holds about 3½ percent of GDP in other liquid foreign currency denominated assets which will be in part used in the near term to strengthen the ESSF and establish a US$4bn (1.5 percent of GDP) Education Fund.

Central Government Financial Position

(End 2012; in percent of GDP)

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Sources: Ministry of Finance and Fund staff estimates.

Central government gross debt is relatively low (equal to 12 percent of GDP), and would remain comfortable under various shocks (see Annex I). Also, recent Fund research finds that Chile could withstand tail event-type of shocks—even responding with expansionary policies—without putting fiscal solvency at risk (debt would remain below 40 percent of GDP).1/

Contingent liabilities are relatively small. The net present value of contingent liabilities amounted to 3.7 percent of 2012 GDP (or 0.02 percent of GDP on an annual flow basis).2/

1 See G. Adler and S. Sosa (2013), External Conditions and Debt Sustainability in Latin America, IMF Working Paper 13/27.2 Budget Directorate (2012), Informe de Pasivos Contingentes, Ministry of Finance.

Chile and Basel III

The capital and liquidity requirements within the Basel III framework are due to be implemented over 2015-19. Estimations carried out by the central bank and the supervisor of banks and financial institutions, and liquidity and solvency stress tests carried out by the 2011 FSAP show that these requirements would not be particularly difficult for Chilean banks to meet. The authorities are working to adopt the main elements of Basel II and III, but no formal road map for Basel III has been announced.

Formally, Chile’s capital adequacy requirements follow Basel I standards, with complementary central bank regulation bringing in elements of Basel II and III. There are no specific capital charges for operational risk, but some capital (based on the 1996 Market Risk Amendment of the Basel I Capital Accord) must be held in respect of market risk. Preliminary estimates by the central bank show that capital levels are above the minimum level agreed under Basel III and it therefore appears that the new capital standards would not be overly restrictive for Chilean banks.1

Banking System Capital Adequacy

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Source: Superintendence of Banks and Financial Institutions (SBIF).

Title VII article 66 General Banking Law.

Effective capital to credit risk-weighted assets plus estimated risk exposure to market risks times 12.5.

Estimates by the SBIF.

The legal framework already includes a leverage ratio (Basel III includes a leverage ratio but details are yet to be finalized). The system’s leverage (as measured by Tier 1 capital to assets) has always exceeded 6 percent over the last decade.

For the liquidity standards, the Chilean regulatory framework establishes 30- and 90-day mismatch limits in domestic and foreign currencies. The liquidity stress tests for the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR), conducted in the context of the 2011 FSAP Update show that the banking system is well positioned to meet the LCR by 2015 and the NSFR by 2019.2

1 Regarding systemic capital surcharges, a higher capital adequacy ratio (from 10 to 14 percent) is temporarily required (for no less than one year) when a merger or acquisition would result in a bank with a market share above 15 percent.2 In 2012, the Basel Committee on Banking Supervision agreed on a revised framework for the Liquidity Coverage Ratio with an extended phase-in period. The design of the Net Stable Funding Ratio is under discussion.

Recent Developments in Mortgage Financing

Mortgage debt equals about 21 percent of GDP and represents 57 percent of household debt (as of 2012Q3). Banks provide some 90 percent of mortgage credit and banks’ mortgage credit stands at about 24 percent of total bank credit (up from 13 percent in 1990).

Mortgage bonds were introduced in October 2012, as a new type of instrument to finance mortgages. These bonds are so called covered bonds–in case the bank becomes insolvent, the mortgage is earmarked to cover the bond—and they are eligible for the central bank repo window. The originating bank absorbs the credit risk of the mortgages which remain on its balance sheet. The new mortgage bond is expected to represent an attractive way to fund mortgages by eliminating some of the restrictions in mortgage bills as it would allow to finance pools of mortgages; Mortgage bonds will be also subject to loan-to-value (LTV) and debt-to-income (DTI) caps. The first issuance is expected shortly.

Bank Mortgages

(in percent of total mortgage credit)

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Sources: Superintendence of Banks and Financial Institutions

Up to 100 percent for highest rated customers and banks

Only for loans under US$150,000 (UF$3,000)

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 and projections.

Contribution to growth.

The methodology to compute the unemployment rate changed in 2009.

Headline balance adjusted for the economic and copper price cycles.

In percent of non-mining GDP.

Table 2.

Chile: Summary Operations of the Central Government

(In percent of GDP; unless otherwise indicated)

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Sources: Ministry of Finance and Fund staff estimates.

Based on the authorities’ medium-term fiscal projections in the 2012 Budget Law, adjusted for staff’s GDP and copper price projections.

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

In percent of non-mining GDP.

Table 3.

Chile: Summary Operations of the Public Sector 1/

(In percent of GDP)

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Sources: Ministry of Finance and Fund staff estimates.

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.