Public Information Notice No. 04/83

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Chile

August 5, 2004

On August 4, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Chile.¹

Background

Over the past two decades, Chile has adhered to a sound and consistent policy framework. Its policy mix has been based on open trade and exchange rate flexibility and, in recent years, inflation targeting and achievement of a fiscal structural balance rule—requiring a cyclically-adjusted, central government fiscal surplus of 1 percent of GDP. During 2000-03, the actual overall balance of the central government registered a deficit of just below 1 percent of GDP and, in 2004, the accounts of the central government are expected to register a surplus of 1.5 percent of GDP.

Real GDP growth averaged 3½ percent a year during 2000-03. Since the beginning of 2004, economic activity has picked up, in the context of a favorable external environment. The global economic recovery has helped boost export demand, particularly copper, the price of which has nearly doubled since end-2002. Chile has also benefited from low world interest rates. Reflecting in part these developments, real GDP grew by 6½ percent in seasonally-adjusted terms during the first quarter, the strongest quarterly growth in 3 years, and the World Economic Outlook projects a rate of growth of 5 percent for the year as a whole. Despite steady, albeit modest, job gains, the unemployment rate has remained relatively high, at about 8½ percent.

The improvement in terms of trade registered in late 2003 and early 2004 contributed to an appreciation of the peso which, in turn, led to downward pressure on domestic prices. As a result, twelve-month inflation temporarily fell below the 2-4 percent inflation target range. In response to downward pressure on prices, and to provide stimulus to the economy, the central bank cut its policy interest rates twice, by 50 basis points on each occasion, in December 2003 and January 2004.

External conditions remain favorable. However, Argentina's decision to sharply cut natural gas exports is forcing domestic electricity generation to switch from relatively cheap natural gas to more costly diesel-generated power. At the same time, increases in petroleum import prices have raised costs further and dampened disposable income growth.

In the period ahead, the economy is expected to continue to gather momentum, and GDP is projected to grow by about 5 percent a year in 2004 and 2005. Reflecting a supportive external environment, high copper prices, and low interest rates, investment is expected to rebound in the second half of 2004. As a result of moderate above-trend growth, the output gap would close slowly, and inflation is expected to gradually return within the central bank's target band. High copper prices would help the external current account to register a surplus of about 1 percent of GDP in 2004.

Executive Board Assessment

Executive Directors commended the Chilean authorities for their continued implementation of sound policies, centered on a prudent fiscal policy, a successful inflation targeting framework, and trade integration. These policies, together with a robust financial system, have led to sustained economic growth and contributed to a sharp reduction in poverty, and constitute a good example for other countries. Directors also noted that strong fundamentals allowed Chile to weather the recent global downturn and should enable it to take full advantage of the rebound in copper prices and increased global demand for its exports, contributing to a long-delayed rebound in investment. Directors pointed to manageable risks associated with higher global interest rates, oil prices, uncertainties regarding natural gas supplies, and possible changes in copper prices.

Directors praised Chile's commitment to a prudent fiscal policy, reinforced by adherence to a structural balance rule, which calls for a surplus of 1 percent of GDP in the central government's fiscal accounts. They commended the authorities for reallocating spending to social priorities, and for restraining overall spending, despite higher revenues from the surge in copper prices. They supported the decision to use surpluses accrued in the Copper Stabilization Fund to selectively prepay government debt. Directors commended the authorities for improving transparency in the fiscal accounts and for publishing previously off-budget accounts, especially with regard to military spending. Going forward, they welcomed the inclusion of an estimate of the structural fiscal position in the budget. In this regard, several Directors recommended that the authorities formalize the structural balance rule into a law, while several other Directors thought that formalizing this rule would unnecessarily constrain the scope of countercyclical fiscal policy.

Directors noted that the authorities' proposal to introduce a royalty in the mining sector could raise revenue and aid Chile's management of its non-renewable resources, though they cautioned that if introduced, it should be done in a manner that does not negatively impact foreign investment.

With regard to monetary policy, Directors recognized the success of Chile's inflation targeting framework in anchoring inflation expectations. They viewed the current stance of monetary policy as appropriate and as having provided adequate stimulus to the economy. Looking forward, with inflation gradually returning to the mid-point of the central bank's inflation target band of 2-4 percent, they advised only a gradual removal of monetary stimulus, given the large output gap and the persistence of a still high unemployment rate.

Directors agreed with the thrust of the central bank's debt management strategy. They supported the central bank's ongoing process to deepen domestic financial markets by introducing long-term peso-denominated bonds. They agreed with the central bank's plans to gradually redeem part of its dollar-indexed debt with foreign exchange reserves. Directors encouraged the authorities to recapitalize the bank, which would contribute to resolving the bank's on-going quasi-fiscal deficits. A few Directors pointed to the need to link more explicitly the structural balance rule to the quasi-fiscal deficit of the central bank.

Directors observed that the floating exchange rate regime has benefited the economy and allowed it to adjust smoothly to external shocks. They commended the central bank for a policy of nonintervention in the foreign exchange market, despite the sharp appreciation of the peso in late 2003.

Directors welcomed the authorities' intention to follow the recommendations of the Financial System Stability Assessment. They agreed that the financial system is sound and has withstood well a large range of shocks over the past several years, and emphasized the important role of sound regulations and strong supervision, particularly in the banking system. They noted, however, the need to reduce risks in the insurance industry and strengthen regulation and supervision of the securities industry. They also saw a need to improve further Anti-Money Laundering/Combating the Financing of Terrorism legislation.

Directors agreed that there was scope for improving the financial system's efficiency. They suggested that investment restrictions on pension funds could be judiciously liberalized, to take advantage of economies of scale and increased competition. Directors highlighted the need for the regulatory system to adapt to the increasing sophistication of financial markets, where distinctions between entities had become more blurred, by moving to a high-quality risk-based regulatory system that would take into account the interconnections between different components of the financial system. They also noted that there was room to further improve competition regarding the financing of small and medium-sized enterprises. To that end, Directors welcomed the reforms contained in the new Capital Markets II draft law.

Looking to the medium-term, Directors praised the authorities' on-going public debate on how to sustain higher rates of growth while reducing income inequality. To that end, Directors supported the recent laws to implement the Pro-Growth Agenda. In this context, they noted the importance of liberalizing labor market laws and strengthening the educational system to improve employment opportunities. Directors also praised the authorities for their social policies, including Chile Solidario, which they viewed as an important example of a well-targeted program to help reduce extreme poverty.

Directors underscored Chile's leadership role in opening markets through comprehensive and sustained trade and financial market liberalization. They welcomed the implementation of recent bilateral trade agreements and also encouraged the authorities to continue their efforts at multilateral trade liberalization. They observed that Chile's exposure to external debt shocks remained contained, since much of this debt resides with the private sector, which has access to financial hedges, and external public debt ratios remain low.

Directors recognized that the data received by the Fund are of good quality, timely, and adequate for surveillance purposes. They commended the authorities for making important strides in bringing the fiscal statistics more closely in line with international standards and urged that the authorities take the steps needed to close the relatively small gaps in coverage. They also welcomed Chile's decision to participate in the pilot project to evaluate public investment and Public-Private Partnerships.