A worker in Los Lagos, Chile: the IMF says the country is putting in place important reforms to lift growth and reduce inequality (photo: EFE/Camilo Tapia)

New Realities Shaping Chile's Outlook

December 9, 2016

  • Potential growth in Chile has slowed
  • Modest recovery expected, but risks lie ahead
  • Considerable scope to enhance financial sector resilience

While Chile’s economic policies are strong, potential growth has slowed in recent years, partly due to a less dynamic external environment, the IMF said in its annual assessment of the Chilean economy.

Plagued by lower dynamism in key trading partners, which has reduced export demand, and permanently lower copper prices, Chile’s GDP growth has averaged just 2 percent since 2014, well below rates of about 4 percent in previous years. Still, considering the large external shocks to which the economy is adjusting, Chile’s recent performance has been solid—supported by a flexible exchange rate, credible inflation-targeting, disciplined approach to fiscal policy, and recently enacted structural reforms. By comparison, the average growth rate of Latin America’s six largest economies has been just 0.3 since 2014.

Although a recovery is under way, IMF estimates suggest that an important portion of the recent slowdown will be hard to reverse, as it is due to weak potential growth. The IMF report therefore recommends a policy mix that supports short-term growth and emphasizes building on an already-strong structural reform agenda capable of boosting the economy’s medium-term growth potential.

Risks at home and abroad

As a small, open, commodity-producing country, Chile is vulnerable to external shocks. Chief among these would be any unexpected slowdown in China, which could both lower copper prices and demand for other exports (directly and indirectly). In addition, weaker growth in the region, and a faster-than-anticipated increase in interest rates in the United States are risks. On the upside, the recovery could be more robust if a fiscal expansion in advanced economies raised external demand—this could both boost the demand for exports and increase copper prices, thereby improving Chile’s terms of trade.

Domestically, consumer and business confidence is depressed, standing near levels not seen since the global financial crisis. Although difficult to isolate the causes of weak confidence, some improvement is expected due to the passage of parts of the reform agenda. However, this projected improvement in confidence could be dampened by legal ambiguities in the new labor bill, or by difficulty in implementing the new corporate tax code.

If downside risks were to materialize, high debt levels among nonfinancial corporations and strong sector-specific balance sheet interlinkages could enhance the impact on the Chilean economy through financial spillovers. To illustrate the importance of this channel, the IMF report estimates that a 100 basis point increase in Chile’s Emerging Market Bond Index spread—associated with a tightening of domestic credit provision—could reduce GDP growth by about 0.3 percentage points within the first year.

Policies to support the recovery

Given that Chile’s economy is in a position of excess capacity, with previous inflationary pressures having subsided, short-term demand support is needed. Over the medium term, additional structural reforms could help boost potential growth, and the financial sector’s regulatory framework requires significant upgrades, which would strengthen the resilience of the economy. Finally, pension reforms are a priority, as these have the ability to produce more stable life-time incomes across broader segments of the population—a priority given Chile’s elevated income inequality (the highest in the region). Policies to address these issues are outlined below (see box).

Setting the stage for stronger growth in Chile

The IMF recommends the following policy actions:

Provide short-term demand support

· Monetary policy should remain supportive, easing further if disinflation pressures become broader

· Fiscal consolidation is appropriate to maintain credibility, but this can proceed slowly

Increase potential growth

· The creation of a new Infrastructure Fund—geared to attract private capital—should be fast-tracked

· Workers’ skills should be enhanced further, through more targeted professional and vocational training

· Ongoing efforts are needed to help small and medium-sized enterprises to grow and increase productivity

Enhance the regulatory framework

· Prioritize adoption of key Basel III regulations

· Implement risk-based supervision for Chile’s insurance sector

Pension reforms to reduce life-time income inequality

· Gradually increase contribution rates to 15 percent

· Increase female retirement age to 65

· Increase both pension and solidarity pillars for current retirees

· Fund a portion of increased benefits with indirect taxes

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