Public Information Notice No. 99/8

Public Information Notice: IMF Concludes Article IV Consultation with Chile

February 3, 1999

On January 25, 1999, the Executive Board concluded the Article IV consultation with Chile¹.

Background

Chile’s overall economic performance in the period 1990–97 was very strong. During these years, real GDP grew at an annual average rate of 7.7 percent, inflation declined gradually from 27 percent to 6 percent, and social indicators improved significantly. This performance was based on important structural reforms, strong financial sector supervision, an open trade regime, and prudent macroeconomic policies. During this period, the authorities implemented a stable policy framework under which they preannounced a gradually declining year-end inflation target, adjusted short-term real interest rates to keep domestic demand in line with that objective, maintained fiscal surpluses, managed the exchange rate within a sliding band, and administered a set of controls on capital flows. However, macroeconomic management was complicated by large changes in Chile’s terms of trade, mainly reflecting changes in world copper prices.

The main macroeconomic challenges faced by Chile in 1998 were a widening of the external current account deficit and a slowdown in capital inflows. Pressures on the current account resulted from a large deterioration of Chile’s terms of trade (reflecting mainly a sharp drop in copper prices related in part due to the crisis in Asia), and from strong domestic demand in the first part of the year. In addition, starting in late 1997, some erosion of investor confidence associated with the turbulence in international financial markets and the increasing current account deficit led to a weakening in short-term capital inflows and to recurrent pressures on the peso.

Chile’s economic policies in 1998 aimed at addressing this weakening of the external accounts while making further progress in reducing inflation. To contain domestic demand, the authorities tightened credit policy and reduced public expenditure from budgeted levels. At the same time, they allowed for some depreciation of the currency, while avoiding a large depreciation which could have jeopardized their inflation target. They also relaxed controls on capital inflows, issued debt instruments indexed to the U.S. dollar, and on three occasions modified Chile’s sliding exchange rate band system. By September 1998, the trade deficit had started to decline and inflation was converging to the official target of 4.5 percent.

The relatively high interest rates prevailing in average during 1998 and the weak global economic environment led to a marked slowdown in the growth of domestic demand and economic activity, and an increase in the rate of unemployment in the second half of the year. Also, reflecting mainly lower fiscal revenues resulting from the drop in world copper prices and despite the reductions in public expenditure from budgeted levels, the nonfinancial public sector balance is estimated to have moved from a surplus of 1 percent of GDP in 1997 to a small deficit in 1998. Central bank losses in 1998 are estimated at 0.9 percent of GDP, similar to their level in 1997. During the year, there was some deterioration of banks’ loan portfolio but indicators of financial solvency of the banking system remained robust.

For 1998 as a whole, the economy showed a slowdown in economic growth, a decline in inflation, and a widening of the external current account deficit. Real GDP growth slowed from 7 percent in 1997 to 3.5–4.0 percent in 1998, while inflation declined from 6 percent at end-1997 to 4.7 percent (very close to the official target of 4.5 percent) at end-1998. The external current account deficit is estimated to have increased from 5.3 percent of GDP in 1997 to 6.3 per-cent of GDP in 1998, with this increase reflecting essentially a decline in Chile’s terms of trade of around 11.5 percent. International reserves declined in the year, but at end-1998 still stood at the equivalent of about 9 months of imports of goods and services and 53 percent of broad money.

During 1998, the authorities also made progress in the area of structural reforms (including privatization, judicial reform, and education reform), although some of these reforms advanced more slowly than originally envisaged, including because of budgetary reasons. In 1998, congress also approved a gradual reduction in Chile’s uniform external tariff from 11 percent to 6 percent, with the tariff rate declining by one percentage point per year, starting in January 1, 1999.

Executive Board Assessment

Executive Directors commended Chile’s long record of sound economic policies, which had resulted in strong economic growth and a gradual decline in inflation during this decade. Directors further commended the authorities for their continued commitment to prudent macroeconomic policies, as demonstrated by their prompt response to the challenges posed in1998 by the deterioration in the external environment, and by surging domestic demand in the first part of the year, which resulted in pressures on the peso. They observed that by tightening credit policy, reducing public expenditure below budgeted levels, and allowing some adjustment of the exchange rate, the authorities had succeeded in limiting the deterioration in the fiscal and current account balances while achieving their inflation objective.

Directors considered that Chile’s sound economic fundamentals, strong banking system, comfortable level of international reserves, and generally favorable debt indicators should help the country deal with the ongoing turbulence in international financial markets. However, Directors cautioned that the country’s economic prospects remained subject to risks arising from a possible worsening of global and regional conditions, with adverse net effects on Chile’s external terms of trade and on market sentiment. In their view, it was important for the authorities to stand ready to strengthen policies if some of those risks were to materialize.

In this regard, Directors supported the authorities’ economic objectives for 1999, which included further progress in reducing inflation and a narrowing of the external current account deficit, while maintaining positive—albeit more moderate—growth, even in the context of a worsening of the external environment. They noted that interest rates had already been reduced from very high levels, and considered that the current weakness in domestic demand would allow for further reductions without compromising the authorities’ objective for the external current account, under current fiscal policies. Nevertheless, several Directors welcomed the authorities’ assurances that—consistent with past corrective actions—additional fiscal measures to support the monetary tightening will be considered should the external environment deteriorate further. Several Directors noted that the level of aggregation of the public accounts in the staff report for Chile, in which the operations of the general government are combined with the accounts of the public enterprises and the Central Bank, potentially understated the strength of the fiscal position. Directors called on the staff to study the appropriate methodology to be used in the fiscal analysis.

Directors considered that Chile’s exchange rate band provided useful flexibility in responding to external shocks, particularly under the present unsettled circumstances in international financial markets, and welcomed the authorities’ decision to continue the gradual widening of the exchange rate band. They thought that, depending on the evolution of external conditions, this flexibility may need to be used in order to achieve the desired decline in the current account deficit over the medium term. Some Directors expressed the view that the temporary narrowing of the band in mid-1998 may have sent mixed signals about exchange rate policy and may have weakened confidence in the sustainability of the band.

Directors welcomed the authorities’ intention to keep the stock of medium-term central bank bonds indexed to the U.S. dollar at a moderate level. They observed that this policy will help to ensure that instrument is not used as a substitute for adjustment measures that might be needed, or to hamper the authorities’ efforts to reduce indexation in the financial system.

A number of Directors considered that Chile’s one-year unremunerated reserve requirement on capital inflows had favored medium- and long-term inflows over short-term inflows and thus hadcontributed to reducing the country’s vulnerability to sudden changes in capital flows. A few Directors, however, felt that the effectiveness of the reserve requirement in discouraging short-term capital inflows tended to diminish over time. They believed that continued strong fundamentals and a sound financial system should be at the core of countries’ efforts to reduce their vulnerability to changes in short-term capital inflows.

Directors commended the authorities for the progress achieved on structural reforms, and urged them to continue with their efforts in the areas of privatization, education, and judicial reform, within the limits imposed by available fiscal resources. Directors praised the authorities’ decision to continue with Chile’s process of unilateral trade liberalization through a gradual reduction of its uniform external tariff. Some observed, however, a recent proposal to introduce safeguard clauses, and, while noting that such clauses were more limited than allowed by the WTO rules, urged the authorities to be cautious in their use. Directors considered that indicators of banks’ financial health continued to be strong, despite some deterioration arising from the high domestic interest rates and the slowdown in economic activity. They encouraged the authorities to continue with strict supervision practices, and to advance in the introduction of supervision of consolidated balance sheets of financial holdings, and the recapitalization of the Central Bank.

Directors noted that Chile’s statistical information on macroeconomic variables is generally good, and for the most part is provided to the Fund on a timely basis. They welcomed the authorities’ efforts to clarify the discrepancies that exist between official and BIS data on Chile’s short-term external debt.