## _cr07333

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---

### Executive Summary — Introduction
- Over the past fifteen years, Chile’s consistent economic reforms and prudent macroeconomic policies have delivered strong growth and low inflation.
- Per capita income tripled in U.S. dollar terms since 1990 and the poverty rate was cut by two-thirds, to about 14 percent.
- Growth was fastest during the mid-1990s, but has slowed somewhat in recent years amid stagnant employment, less FDI inflows, and declining labor productivity growth.
- Key institutional policy elements: a floating exchange rate, inflation targeting, and a structural fiscal surplus rule aimed at reducing volatility from shocks and preserving competitiveness despite copper price volatility.
- President Bachelet announced a reduction in the structural surplus target from 1 to ½ percent of GDP in 2008, with additional resources to be devoted primarily to education.

### Outlook and Risks
- Growth projections and context:
  - Growth is projected at about 5¾ percent in 2007 following a strong rebound in Q1 2007.
  - Potential growth is estimated at 5 percent.
  - The output gap is expected to close in 2008 (from around 1 percent at end-2006).
  - Inflation is expected to return to the 3 percent target.
- Drivers of growth:
  - Completion of large capital projects boosting productive capacity.
  - Strong consumer demand underpinned by favorable labor market conditions and buoyant consumer credit growth.
  - Supportive fiscal and monetary policy stance and a broad-based rise in exports.
- Risks to the outlook (broadly balanced):
  - Upside: stronger domestic momentum from improving labor market conditions; domestic demand.
  - Downside: drought conditions and interruptions in gas deliveries from Argentina affecting electricity production; rises in oil and food prices reducing disposable income; tightening global liquidity damping domestic credit expansion; exchange rate appreciation; external financial conditions.
- Inflation risks:
  - Supply shocks and diminishing excess capacity could present upside risks to inflation.
  - Strong import growth has helped contain price increases; overall labor cost growth moderate despite pickup in hourly wages.
- Financial sector resilience:
  - Banks are profitable and highly capitalized.
  - Staff analysis suggests a drop in global risk appetite to the lows of 1998 could push up Chile’s EMBI spread by a modest 70 basis points.
  - Model simulations indicate banking sector risks would remain well below 1998 levels.
- Mining and copper:
  - Chile accounts for a third of global copper production.
  - Labor disputes and technical problems slowed production in 2006; completion of labor contracts and investment projects should propel output toward a projected medium-term growth rate of 3 percent per year.
  - Water and environmental constraints could limit expansion, but deposits are deemed large enough to sustain production longer than most other non-renewable resource countries.

### Macroeconomic Policy Framework — Fiscal Policy
- Fiscal anchors and recent changes:
  - Fiscal policy anchored by the structural surplus rule.
  - Structural surplus target lowered from 1 to ½ percent of GDP as of 2008.
  - The 2008 budget is expected to be consistent with macroeconomic stability; expenditure increases to be determined mainly by the long-term reference price for copper and projected revenues at potential GDP growth.
  - Authorities noted recent weakness in VAT collections which, if sustained, would affect projected revenue and spending for next year.
- Specific fiscal commitments and actions:
  - Government intends to maintain a positive surplus target in part to fund future pension costs: committed to put between 0.2 and ½ percent of GDP per year into a public pension fund, depending on the size of the actual fiscal surplus.
  - Recapitalization of the BCC balance sheet will continue as planned (by ½ percent of GDP in each of the next three years).
  - Steps to improve public financial management: new agencies supervising public investment and education, tighter coordination over regional spending, and a new fiscal transparency law.
  - Staff proposal welcomed to shift to a medium-term expenditure framework.

### Macroeconomic Policy Framework — Monetary and Exchange Rate Policy
- Monetary stance and actions:
  - Monetary policy likely to tighten gradually as excess capacity is absorbed.
  - BCC paused a tightening cycle in 2006 and then lowered interest rates by 25 basis points in early 2007.
  - With strong recovery, policy may resume a gradual tightening course; long-term interest rates have ticked upwards.
  - BCC adjusted its inflation target in January to “around 3 percent, with a tolerance range of ± one percentage point” and set the time horizon to “around 2 years.”
  - Staff suggested periodic pre-determined reviews of the inflation targeting framework.
- Exchange rate and reserves:
  - The value of the peso is broadly in line with fundamentals; real effective exchange rate has appreciated only moderately since the copper boom in 2004.
  - Authorities confirmed commitment to a floating exchange rate and will not intervene except to counter market overreactions.
  - To ease upward pressure on the peso, the government is advancing part of the planned increase in foreign investment limits for pension funds.
  - Assets accumulated in the two funds under the 2006 Fiscal Responsibility Law have been managed by the BCC since March 2007.
  - Assessment found the BCC in observance of the IMF Guidelines for Foreign Exchange Reserve Management and having adequate institutional capacity.

### Bridging the Income Gap With Advanced Economies — Structural Reform Priorities
- Strategic focus:
  - Chile aims to raise long-term growth to close the income gap with industrialized countries.
  - Structural reform agenda includes education, pensions, innovation, and the financial sector.
  - Integrating Chile’s financial system more closely with global capital markets is expected to strengthen competitive forces and catalyze reforms in other sectors.
- Emphasis areas in policy:
  - Policies to raise long-term growth prospects focus on education, job-specific human capital, and innovation.
  - Financial sector reforms aim to increase depth and competition and further integrate Chile into the global financial system.

### Education, Pension, and Innovation Initiatives
- Education:
  - Most of the freed-up funds from the structural surplus target reduction will be used to raise the value of student vouchers.
  - An education reform bill submitted to Congress aims at raising quality and improving access especially for low-income households.
  - Specific planned education reallocations include USD 650 million to education: a 15 percent rise in education voucher for mainly state-funded schools, increased preferential subsidy targeting vulnerable children, a family library program for four hundred thousand low-income families, expansion of scholarship programs for technical careers, and support to municipal schools’ capabilities.
- Pension reform (overview):
  - Major objectives: raise benefits, improve coverage, increase returns to saving, encourage participation in the formal labor market.
  - Proposed core design features include a universal public pension pillar (Basic Solidarity Pension, BSP), a minimum pension for Chileans over 65 equal to about one fifth of the average wage, means-tested subsidies, subsidies for initial contributions by women and the young, and gradual enforcement of participation among the self-employed.
  - Investment limits for pension fund assets: plan to raise limit gradually from 30 to 80 percent of pension fund assets; in May, government announced legislation to raise the limit to 45 percent.
  - Fiscal cost expectations: authorities confident additional cost net of maintaining the current system will be kept to a maximum of one percent of GDP per year; staff preliminary cost estimates broadly in line.
  - Implementation timeline: Congressional debate expected to last into 2008; government goal to start paying basic solidarity pensions by mid 2008.
- Innovation and SME support:
  - Government launched initiatives to improve the climate for entrepreneurship and innovation, particularly for SMEs.
  - Measures include venture capital incentives, facilitating SME access to finance, and entrepreneurship support via Chile Invest Plan.

### Financial Sector and Capital Market Reforms
- Recent and planned reforms:
  - A second round of capital market reforms was passed into law in late May (Capital Markets II, June 2007 law).
  - Planned additional 2007 measures: steps to internationalize the peso, further develop local markets, strengthen corporate governance, and facilitate foreign investment.
- Potential market effects:
  - Broadening portfolio options for AFPs and raising foreign investment limits could reduce excess demand for high-quality domestic assets, expose domestic borrowers to stronger competition, and help develop local markets.
  - Authorities plan gradual liberalization dependent on financial stability considerations and AFPs’ capacity to manage complex assets.
- Capital Markets II highlights:
  - Promoting access to venture capital and funding for SMEs, tax exemptions on capital gains from venture capital investments, simplification of legal framework for venture capital, redesign of collateral system, and extension of tax benefits on newly listed stocks.
  - Strengthening financial market security through centralized licensing review, improved legal protection for supervisors, higher custody requirements, professional trader requirements, and dematerialized issuance of securities.
  - Promoting market deepening via Basel-II-aligned reserve requirement changes, authorization of derivatives netting in bankruptcy, increased investment limits for insurance companies, modernization of off-shore stock market, collective action clauses for bond issuance, and a new tax benefit for mutual fund investors.

### Labor Market Findings and Recommendations
- Labor market performance:
  - Employment growth has picked up, but greater labor market flexibility would facilitate factor reallocation in response to external shocks and competitive pressures.
  - Authorities building consensus to strengthen social protection of workers and improve the unemployment insurance system.
- Staff observations and recommendations:
  - Separation costs appeared high.
  - Instruments facilitating part-time employment were not being widely used.
  - There is room to make labor markets more flexible and to strengthen incentives to participate in the labor market.
- Minimum wage:
  - Increase in minimum wage of 6.7 percent with a forward-looking clause: if actual growth (4th quarter of 2006 to 3rd quarter of 2007) exceeds 5.8 percent in real terms, the minimum wage increases by an additional 0.7 percent.

### Statistical Issues and Data Quality
- General assessment:
  - ROSC Update: Chile’s macroeconomic statistics are generally timely and of good quality.
  - Mission encouraged improvements in coverage of surveys on labor costs, capacity utilization, and prices.
- Specific issues identified:
  - Labor market: Genuine unit labor cost data not available; time series on wages by sector discontinued in 2005; monthly indices of average compensation and hourly labor cost published; major unemployment surveys could be improved.
  - National accounts: Inventories and inventory prices are erratic and often estimated as residuals; recommended shift to chain price indexing to reduce base-year distortions and improve treatment of copper price fluctuations.
  - Producer data and price statistics: Capacity utilization time series not yet available; CPI has limited geographic coverage and an outdated basket and weight structure; PPI lacks quality adjustments and carries forward missing prices.
  - Fiscal data: Adoption of GFSM 2001 is a major improvement; reconciliation of fiscal balance with changes in government net debt could be improved; timely high-frequency data on tax revenue by type would help analysis; gaps remain in coverage of military debt.
  - Capital account data: Chile provides monthly portfolio investment flows and assets/liabilities; more detailed breakdown of portfolio flows, including gross and geographical basis, would assist analysis.
- Data dissemination:
  - Chile subscribes to the Fund's Special Data Dissemination Standard.

### Macroeconomic Outlook, Projections, and Monetary-Fiscal Interactions
- Growth and inflation:
  - Economy projected to expand by around 5¾ percent in 2007.
  - Inflation expected to rise toward the BCC’s 3-percent target; inflation surprised on the upside in May and June and is slightly above the 3 percent target.
  - Medium-term inflation expectations remain firmly anchored at 3 percent.
- Monetary policy actions and outlook:
  - BCC cut policy rate by 25 basis points in January 2007, then lifted it by 25 basis points to 5¼ percent on July 12, citing global supply shocks and reduced slack.
  - With strong output growth, monetary stimulus likely to be withdrawn in coming months.
  - BCC stands ready to act if inflation forecast exceeds the 3 percent target over a 24 month period.
- Fiscal position and assets:
  - Central government overall surplus of 7.7 percent of GDP in 2006; 2007 central government expected surplus around 7.1 percent of GDP in one account and "over 7 percent of GDP" in another update.
  - Invested government financial assets now exceed 10 percent of GDP, more than twice central government debt.
  - Government transferred $736 million (½ percent of GDP) to the BCC in late June; first annual payment made in December 2006.
  - FRL created two funds: Economic and Social Stabilization Fund (ESSF) and Pension Reserve Fund (PRF); initial and end-April 2007 assets noted (ESSF initial deposit USD 6 billion; assets under management USD 7.2 billion at end-April 2007; PRF initial deposit USD 600 million; assets under management USD 617 million at end-April 2007).
- Policy interactions:
  - Fiscal policy remains well anchored by the structural surplus rule.
  - A modest reduction in the surplus target is justified by improvement in government’s net debt position.
  - Authorities intend—supported by the rules-based system—to keep public expenditure increases consistent with macroeconomic stability and to maintain a positive surplus target to cover future pension liabilities.
  - Ensuring high-quality public spending remains critical; establishing a medium-term expenditure framework recommended.

### Staff Recommendations and Next Steps
- Maintain macroeconomic stability while addressing social issues and implementing structural reforms to boost long-term growth.
- Continue gradual liberalization of pension fund investment limits, contingent on financial stability and AFP capacity.
- Ensure public expenditure increases remain consistent with stability; focus on high-quality, transparent spending and a medium-term expenditure framework.
- Improve labor market flexibility and strengthen incentives to participate in the labor market.
- Enhance statistical coverage and quality for labor costs, capacity utilization, prices, and fiscal and capital account breakdowns.
- It is recommended that the next Article IV consultation take place on the regular 12-month cycle.

### Box 1 — Reforming the Pension System (core points)
- Objectives and motivations:
  - Address shortcomings of Chile’s 26-year old pension system: relatively low coverage ratio, many women left without incomes in old age, constrained investment options.
  - Reform developed by a high-level commission in a broad consultative process.
- Core design features:
  - Introduction of the Basic Solidarity Pension (BSP) creating a universal pillar.
  - Minimum pension for Chileans over 65 equal to about one fifth of the average wage.
  - Means-tested subsidies targeted to the poor; subsidies for initial contributions by women and the young; gradual enforcement for the self-employed.
- Marginal returns under the new system:
  - Workers currently receiving the minimum pension guarantee: marginal return would increase to 62.5 cents per dollar saved.
  - Workers currently receiving more than the minimum pension guarantee: would face a marginal return of 62.5 cents per dollar saved (unless their pension income exceeds CLP 200,000 per month); this is lower than the 100 cents return under the current system.
- Competition and market-structure measures:
  - Liberalizing investment rules for AFPs, auctioning the right to serve new entrants, and allowing domestic banks to enter the pension fund market.
- Fiscal cost and financing:
  - Government estimate of reform cost: around 1 percent of GDP per year, partly funded from returns on a pension fund accumulated with structural government surpluses.
- Implementation:
  - Congressional debate expected to last into 2008.

### Annex I — Analytical Work and Technical Assistance (selected items)
- Ongoing analytical work:
  - Chile's Structural Fiscal Balance Rule: Model-based evaluation using the IMF GIMF to assess parameters that minimize inflation and output volatility.
  - Application of Contingent Claims Analysis to Chile: risk indicators for seven major Chilean banks, linking bank asset returns to macro variables; heterogeneity in bank responses to shocks.
  - Credit Cyclicality: cross-country comparison using VARs for 19 emerging markets and advanced countries.
  - Trade Performance and Competitiveness: VECM using quarterly data for 1990-2006 to analyze non-copper exports and imports.
- Technical assistance and recent cooperation:
  - BCC and Fund staff collaboration on contingent claims analysis and reserves management assessment; MCM mission assessed BCC compliance with reserves management guidelines in April 2007.
- Past selected issues papers (2005–2006) listed on topics including data and forecasting, liquidity in fixed-income markets, public sector debt and market development, poverty reduction, pension shortfalls, banking competition, private external debt, and public-private partnerships.
- Supplementary update highlights (as of July 13, 2007):
  - Monthly GDP indicator annualized growth above 6 percent so far in 2007.
  - WEO projections for copper prices raised since staff report issuance, raising projected current account and fiscal surpluses.
  - BCC policy rate lifted to 5¼ percent on July 12.
  - 2007 central government surplus projected at over 7 percent of GDP in the update; invested government assets exceed 10 percent of GDP.

### Key statistics and indicators (selected figures cited in the text)
- Government transfer to BCC: $736 million (½ percent of GDP).
- Timing of transfers: first annual payment in December 2006; additional transfer in late June (2007).
- Expected GDP growth (2007): 5¾ percent.
- Estimated potential growth rate: around 5 percent.
- Central bank policy rate (July 12): 5¼ percent (raised by 25 basis points).
- Inflation target benchmark: 3 percent (inflation remains close to this level).
- Nominal fiscal surplus (2007 expected): over 7 percent of GDP.
- Invested government financial assets: now exceed 10 percent of GDP.
- Structural fiscal surplus target change: from 1 percent to ½ percent of GDP beginning in 2008.
- Projected cost ceiling for pension reform: one percent of GDP.
- Pension fund investment limits: planned raise from 30 to 80 percent; government announced legislation to raise limit to 45 percent.
- Education reallocation from surplus target change: approximately USD 740 million on a permanent basis; USD 650 million earmarked for education measures.
- Minimum wage increase: 6.7 percent; conditional additional increase: 0.7 percent if growth exceeds 5.8 percent (4Q2006–3Q2007).

*IMF staff appraisal and mission findings as presented in the content unit.*

### Executive Summary ......................................................................................................

### Executive Summary

### Introduction
- Over the past fifteen years, Chile’s consistent economic reforms and prudent macroeconomic policies have delivered strong growth and low inflation.
- Per capita income tripled in U.S. dollar terms since 1990 and the poverty rate was cut by two-thirds, to about 14 percent.
- Growth was fastest during the mid-1990s, but has slowed somewhat in recent years amid stagnant employment, less FDI inflows, and declining labor productivity growth.
- Key elements of policy institutionalization: a floating exchange rate, inflation targeting, and a structural fiscal surplus rule aimed at reducing volatility from shocks and preserving competitiveness despite copper price volatility.
- Domestic consensus on the policy framework remains solid; President Bachelet announced a reduction in the structural surplus target from 1 to ½ percent of GDP in 2008, with additional resources to be devoted primarily to education.

### Outlook and Risks
- Growth projections and context:
  - Growth is projected at about 5¾ percent in 2007 following a strong rebound in Q1 2007.
  - Potential growth is estimated at 5 percent.
  - The output gap is expected to close in 2008 (from around 1 percent at end-2006).
  - Inflation is expected to return to the 3 percent target.
- Drivers of growth:
  - Completion of large capital projects boosting productive capacity.
  - Strong consumer demand underpinned by favorable labor market conditions and buoyant consumer credit growth.
  - Supportive fiscal and monetary policy stance and a broad-based rise in exports.
- Risks to the outlook (broadly balanced):
  - Upside: stronger domestic momentum from improving labor market conditions; domestic demand.
  - Downside: drought conditions and interruptions in gas deliveries from Argentina affecting electricity production; rises in oil and food prices reducing disposable income; tightening global liquidity damping domestic credit expansion; exchange rate appreciation; external financial conditions.
- Inflation risks:
  - Supply shocks and diminishing excess capacity could present upside risks to inflation.
  - Strong import growth has helped contain price increases; overall labor cost growth moderate despite pickup in hourly wages.
- Financial sector resilience:
  - Banks are profitable and highly capitalized.
  - Staff analysis suggests a drop in global risk appetite to the lows of 1998 could push up Chile’s EMBI spread by a modest 70 basis points.
  - Model simulations indicate banking sector risks would remain well below 1998 levels.
- Mining and copper:
  - Chile accounts for a third of global copper production.
  - Labor disputes and technical problems slowed production in 2006; completion of labor contracts and investment projects should propel output toward a projected medium-term growth rate of 3 percent per year.
  - Water and environmental constraints could limit expansion, but deposits are deemed large enough to sustain production longer than most other non-renewable resource countries.

### Macroeconomic Policy Framework
- Fiscal policy:
  - Anchored by the structural surplus rule.
  - Structural surplus target lowered from 1 to ½ percent of GDP as of 2008.
  - The 2008 budget is expected to be consistent with macroeconomic stability; expenditure increases to be determined mainly by the long-term reference price for copper and projected revenues at potential GDP growth.
  - Authorities noted recent weakness in VAT collections which, if sustained, would affect projected revenue and spending for next year.
  - Government intends to maintain a positive surplus target in part to fund future pension costs: committed to put between 0.2 and ½ percent of GDP per year into a public pension fund, depending on the size of the actual fiscal surplus.
  - Recapitalization of the BCC balance sheet will continue as planned (by ½ percent of GDP in each of the next three years).
  - Steps to improve public financial management: new agencies supervising public investment and education, tighter coordination over regional spending, and a new fiscal transparency law.
  - Staff proposal welcomed to shift to a medium-term expenditure framework.
- Monetary and exchange rate policy:
  - Monetary policy likely to tighten gradually as excess capacity is absorbed.
  - BCC paused a tightening cycle in 2006 and then lowered interest rates by 25 basis points in early 2007.
  - With strong recovery, policy may resume a gradual tightening course; long-term interest rates have ticked upwards.
  - BCC adjusted its inflation target in January to “around 3 percent, with a tolerance range of ± one percentage point” and set the time horizon to “around 2 years.”
  - Staff suggested periodic pre-determined reviews of the inflation targeting framework.
  - The value of the peso is broadly in line with fundamentals; real effective exchange rate has appreciated only moderately since the copper boom in 2004.
  - Authorities confirmed commitment to a floating exchange rate and will not intervene except to counter market overreactions.
  - To ease upward pressure on the peso, the government is advancing part of the planned increase in foreign investment limits for pension funds.
  - Assets accumulated in the two funds under the 2006 Fiscal Responsibility Law have been managed by the BCC since March 2007.
  - A recent assessment found the BCC in observance of the IMF Guidelines for Foreign Exchange Reserve Management and having adequate institutional capacity.

### Bridging the Income Gap With Advanced Economies
- Strategic focus:
  - Chile aims to raise long-term growth to close the income gap with industrialized countries.
  - Structural reform agenda includes education, pensions, innovation, and the financial sector.
  - Integrating Chile’s financial system more closely with global capital markets is expected to strengthen competitive forces and catalyze reforms in other sectors.
- Emphasis areas in policy:
  - Policies to raise long-term growth prospects focus on education, job-specific human capital, and innovation.
  - Financial sector reforms aim to increase depth and competition and further integrate Chile into the global financial system.

*IMF staff executive summary of consultation findings and assessments.*

### 19.      Education will be the prime beneficiary of the reduced fiscal target. Most of the

### _cr07333 - 19.      Education will be the prime beneficiary of the reduced fiscal target. Most of the

### Education, fiscal target, and innovation initiatives
- Most of the freed-up funds will be used to raise the value of student vouchers.
- An education reform bill submitted to Congress aims at raising quality and improving access especially for low-income households.
- The government has launched initiatives to improve the climate for entrepreneurship and innovation, particularly for small and medium-sized enterprises (SMEs).
- Staff appraisal: Improving education and reducing skills gaps will be key to raising long-term growth prospects.

### Pension reform: design, objectives, and fiscal cost
- Major pension reform objectives:
  - Raise benefits.
  - Improve coverage.
  - Increase returns to saving.
  - Encourage participation in the formal labor market.
- The proposed reform includes a universal public pension pillar and aims at boosting participation of low-income groups and the self-employed.
- Investment limits for pension fund assets:
  - Under the pension reform plan, the investment limit is to be raised gradually from 30 to 80 percent of pension fund assets.
  - In May, the government announced legislation to raise the limit to 45 percent.
- Fiscal cost expectations:
  - Authorities were confident that the additional cost of the new system, netted against the cost of maintaining the current system, will be kept to a maximum of one percent of GDP per year.
  - Staff preliminary cost estimates are broadly in line with the authorities’ calculations.
- Staff appraisal: The proposed reform addresses main shortcomings while maintaining many pioneering basic features; a key goal is to increase pension coverage and equity.

### Financial sector and capital market reforms
- A second round of capital market reforms was passed into law in late May.
- Planned additional measures for 2007 include:
  - Steps to internationalize the peso.
  - Further develop local markets.
  - Strengthen corporate governance.
  - Facilitate foreign investment.
- Potential benefits of pension reform for markets:
  - Broadening portfolio options for Pension Fund Administrators (AFPs) and raising foreign investment limits could reduce excess demand for high-quality domestic assets, expose domestic borrowers to stronger competition, and help develop local markets.
  - Authorities plan a gradual approach to liberalization, with pace depending on financial stability considerations and AFPs’ capacity to manage more complex assets.
- Staff note: Providing smaller borrowers, including SMEs, with improved capital market access could unlock productive capacity and benefit innovation; care is needed to avoid imposing effective ceilings on SMEs’ size.

### Labor market findings and recommendations
- Employment growth has picked up, but greater labor market flexibility would facilitate factor reallocation in response to external shocks and competitive pressures.
- Authorities are building consensus to:
  - Strengthen social protection of workers.
  - Improve the unemployment insurance system.
- Staff observations:
  - Separation costs appeared high.
  - Instruments facilitating part-time employment were not being widely used.
- Staff appraisal: There is room to make labor markets more flexible, and to strengthen incentives to participate in the labor market.

### Statistical issues and data quality
- ROSC Update results: Chile’s macroeconomic statistics are generally timely and of good quality.
- Mission encouraged improvements in coverage of surveys on labor costs, capacity utilization, and prices, as well as other statistical data in line with industrialized economies.
- Specific statistical issues noted:
  - Labor market: Genuine unit labor cost data not available; time series on wages by sector discontinued in 2005; monthly indices of average compensation and hourly labor cost published; major unemployment surveys could be improved.
  - National accounts: Inventories and inventory prices are erratic and often estimated as residuals; shifting to chain price indexing recommended to reduce base-year distortions and improve treatment of copper price fluctuations.
  - Producer data and price statistics: Capacity utilization data not yet available on a time series basis; CPI has limited geographic coverage and an outdated basket and weight structure; PPI lacks quality adjustments and carries forward missing prices.
  - Fiscal data: Adoption of GFSM 2001 is a major improvement; reconciliation of fiscal balance with changes in government net debt could be improved; timely high-frequency data on tax revenue by type would help analysis; gaps remain in coverage of military debt.
  - Capital account data: Chile provides monthly portfolio investment flows and assets/liabilities; a more detailed breakdown of portfolio flows, including gross and geographical basis, would assist analysis.
- Chile subscribes to the Fund's Special Data Dissemination Standard.

### Macroeconomic outlook and staff projections
- Growth projection:
  - The economy is projected to expand by around 5¾ percent in 2007.
- Risks:
  - Upside risks for domestic demand are balanced by concerns over energy supply and modest downside risks from the global outlook.
- Inflation and exchange rate:
  - Inflation is expected to rise toward the BCC’s 3-percent target.
  - The peso is assessed to be broadly in line with fundamentals.
- Monetary policy:
  - With inflation expectations firmly anchored, monetary policy appropriately supported the recovery through the slowdown in 2006.
  - Given strong output growth, monetary stimulus will likely be withdrawn in the coming months.
  - The BCC’s balance sheet has been strengthened; staff welcomes the government’s commitment to continue to recapitalize the bank.
- Fiscal policy:
  - Fiscal policy remains well anchored by the structural surplus rule.
  - A modest reduction in the surplus target is justified by the improvement in the government’s net debt position.
  - Authorities intend—supported by the rules-based system—to keep public expenditure increases consistent with macroeconomic stability.
  - To cover future pension liabilities, the authorities are committed to maintaining a positive surplus target for the foreseeable future.
- Public spending quality:
  - Ensuring high-quality public spending remains critical.
  - Costs and benefits of new expenditure projects will need careful weighing.
  - Planned steps to improve efficiency of government spending and increase transparency are well placed.
  - Establishing a medium-term expenditure framework would allow annual budget decisions to be tied more closely to strategic objectives.

### Staff recommendations and next steps
- Support reform sequencing that maintains macroeconomic stability while addressing social issues and implementing structural reforms to boost long-term growth.
- Continue gradual liberalization of pension fund investment limits, contingent on financial stability and AFP capacity.
- Ensure public expenditure increases remain consistent with stability; focus on high-quality, transparent spending and a medium-term expenditure framework.
- Improve labor market flexibility and strengthen incentives to participate in the labor market.
- Enhance statistical coverage and quality for labor costs, capacity utilization, prices, and fiscal and capital account breakdowns.
- It is recommended that the next Article IV consultation take place on the regular 12-month cycle.

*Source: IMF staff appraisal and mission findings as presented in the content unit.*

### Box 1. Reforming the Pension System

### Box 1. Reforming the Pension System

### Objectives and motivations
- Address several shortcomings of Chile’s 26-year old pension system:
  - Relatively low coverage ratio, in part because many workers have failed to accumulate the necessary 20 years’ worth of contributions.
  - Many women, in particular, are left without incomes in old age.
  - Investment options have been constrained.
- Reform is a top priority for President Bachelet’s government and was developed by a high-level commission of experts in a broad consultative process.

### Core design features
- Introduction of the Basic Solidarity Pension (BSP), which creates a universal pillar within Chile’s privatized system.
- Key elements:
  - A minimum pension for Chileans over 65 (equal to about one fifth of the average wage).
  - Means-tested subsidies targeted to the poor.
  - Subsidies for initial contributions by women and the young.
  - Gradual enforcement of participation among the self-employed.

### Incentives and marginal returns
- Authorities expect overall incentives to work and save would not worsen, though tradeoffs are typically unavoidable.
- Marginal return on an additional dollar’s worth of pension saving under the new system:
  - Workers currently receiving the (flat) minimum pension guarantee:
    - Marginal return would increase to 62.5 cents per dollar saved.
  - Workers currently receiving more than the minimum pension guarantee:
    - Would face a marginal return of 62.5 cents per dollar saved (unless their pension income exceeds CLP 200,000 per month).
    - This marginal return is lower than the 100 cents return they receive under the current system.

### Financial and market-structure measures
- Measures aimed at increasing competition among pension funds and raising real returns to pensioners:
  - Liberalizing investment rules for Pension Fund Administrators (AFPs).
  - Boosting competition among AFPs by auctioning the right to serve new entrants.
  - Allowing domestic banks to enter the pension fund market.

### Fiscal cost and financing
- Government estimate of reform cost: around 1 percent of GDP per year.
- Partly funded from returns on a pension fund accumulated with the help of structural government surpluses.

### Implementation timeline
- Congressional debate of the reform is expected to last into 2008.

*Source: Box 1. Reforming the Pension System (excerpt).*

### Annex I. Chile: Analytical Work and Technical Assistance

### Annex I. Chile: Analytical Work and Technical Assistance

### Ongoing Background Work
- Chile's Structural Fiscal Balance Rule: A Model Based Evaluation
  - Uses the IMF's Global Integrated Monetary and Fiscal Model (GIMF) to determine which parameters would minimize inflation and output volatility in a stochastic environment.
  - Compares the use of different fiscal instruments (taxes, transfers, spending).
  - Allows for a more or less countercyclical response to excess tax or copper revenue.

- Application of Contingent Claims Analysis to Chile
  - Produces risk indicators based on equity and debt data for seven major Chilean banks.
  - Extends the CCA model by tying returns on banking-sector assets to macroeconomic variables.
  - Finds that banks are heterogeneous in responsiveness to foreign and exchange-rate shocks and sensitivity to interest-rate changes.
  - Presents scenarios to assess how bank capitalization is affected by various macroeconomic shocks.

- Credit Cyclicality: A Cross-Country Comparison
  - Studies determinants of credit cyclicality and compares Chile with 19 other emerging markets and advanced countries.
  - Uses country-specific and panel VARs to focus on effects of financial frictions and financial development on the degree of pro-cyclicality of credit.

- Trade Performance, Trade Liberalization and Competitiveness
  - Analyzes developments of non-copper exports and imports, focusing on impact of exchange rate movement and trade liberalization.
  - Employs a vector error correction model (VECM) using quarterly data for 1990-2006.
  - Compares trade elasticities for Chile with those of other Latin American countries.

### Recent Technical Assistance
- Risk Management and Contingent Claims Analysis
  - BCC and Fund staff collaborated on contingent claims analysis and identification of domestic and external vulnerabilities.
  - Activities included several missions and a paper in the BCC's Financial Stability Report co-written with Fund staff.

- Assessing the Institutional Aspects of Reserves Management
  - BCC was appointed as the government's fiscal agent in the management of the Economic and Social Stabilization Fund and of the Pensions Reserve Fund in March 2007.
  - An MCM mission assessed the BCC's compliance with Fund management reserves management guidelines in April 2007; results are reported in this report.

### Past Background Work
- Toward Improving the Data and Procedures Used in Current Analysis and Forecasting at the Central Bank of Chile (2006 Selected Issues Paper)
- Deepening Liquidity in Chilean Fixed-Income Markets (2006 Selected Issues Paper)
- Public Sector Debt and Market Development (2006 Selected Issues Paper)
- The Experience of Poverty Reduction in Chile (2006 Selected Issues Paper)
- Assessing the Long-Run Shortfalls of the Chilean Pension System (2005 Selected Issues Paper)
- Competition in the Chilean Banking Sector: A Cross-Country Comparison (2005 Selected Issues Paper)
- Perspectives on Chile's Private External Debt (2005 Selected Issues Paper)
- Experience with Public-Private Partnerships (2005 Selected Issues Paper)

### Supplementary Information (Staff Report for the 2007 Article IV Consultation)
- Paragraph 1
  - The supplement reports on economic and policy developments since the staff report issued on June 25.
  - The thrust of the staff appraisal remains unchanged.

- Paragraph 2: Growth and external projections
  - Economic developments remain consistent with output growth of around 5¾ percent in 2007.
  - On an annualized basis, the monthly GDP indicator has been growing at above 6 percent so far this year.
  - Strong retail sales and employment data confirm the broad-based nature of the recovery.
  - WEO projections for copper prices have been raised since the staff report was issued, raising the projected current account and fiscal surpluses.

- Paragraph 3: Inflation
  - Inflation surprised on the upside in May and June, with both headline and core inflation now slightly above the 3 percent target.
  - Amid upward pressure from food and energy prices, staff projects inflation to remain around this level for the rest of the year.
  - Medium-term inflation expectations continue to be firmly anchored at the 3 percent level.

- Paragraph 4: Monetary policy
  - The Banco Central de Chile (BCC) lifted its policy rate by 25 basis points to 5¼ percent on July 12.
  - The BCC cited global supply shocks and reduced slack in the economy, and anticipated it would likely be necessary to further reduce monetary stimulus in the coming months.

- Paragraph 5: Fiscal position and assets
  - The 2007 central government surplus is now projected at over 7 percent of GDP, compared with 6 percent of GDP in the staff report.
  - The update reflects higher copper prices and a projected rebound in VAT receipts based on improved collections in recent months.
  - Invested government assets now exceed 10 percent of GDP, more than twice central government debt.

*INTERNATIONAL MONETARY FUND — CHILE: Staff Report for the 2007 Article IV Consultation (Supplementary Information), Prepared by the Western Hemisphere Department, Approved by Markus Rodlauer and Adnan Mazarei, July 13, 2007*

### 6.      In line with its commitment to recapitalize the central bank gradually, the

### _cr07333 - 6.      In line with its commitment to recapitalize the central bank gradually, the

### Central bank recapitalization and fiscal action
- The government transferred $736 million (½ percent of GDP) to the BCC in late June.  
- The first such annual payment was made in December 2006.  
- Authorities announced a reduction of the structural fiscal surplus target from 1 percent to ½ percent of GDP beginning in 2008.  
- Invested government financial assets now exceed 10 percent of GDP, and the central government has become a net creditor.

### Macroeconomic outlook and monetary policy
- GDP growth: The Chilean economy is enjoying a broad-based upswing; GDP growth is expected to reach 5¾ percent in 2007, above the estimated potential growth rate of around 5 percent.  
- Inflation: Inflation has recently increased but remains close to the 3 percent inflation target.  
- Central bank policy rate: The central bank raised its policy rate by 25 basis points to 5¼ percent on July 12, noting it would likely be necessary to further reduce monetary stimulus in the coming months.  
- Exchange rate: Despite a sizeable nominal appreciation against the U.S. dollar, the real effective exchange rate has only moderately appreciated since the onset of the copper boom in 2004.

### Fiscal position and public finances
- Nominal fiscal surplus: The nominal fiscal surplus is expected to be at over 7 percent of GDP in 2007, based on strong corporate tax revenues and a projected rebound in VAT receipts.  
- Government financial position: Reflecting the improvement in its financial position, the government reduced the structural surplus target and continues to build up a pension reserve fund and recapitalize the central bank.  
- Recommendation: Directors noted the rebound in value added tax collections and recommended that revenue performance continue to be monitored closely.

### Structural reforms and financial sector development
- Pension reform: A major pension reform has been submitted to Congress, designed to achieve broader coverage, liberalize investment rules for pension funds, and increase competition in the financial sector.  
- Directors supported the proposed pension reform but emphasized that, in implementing the reform, its overall cost should be kept within the projected amount of one percent of GDP, and that incentives to save remain unimpaired.  
- Capital markets: A second round of capital market reforms was passed into law in May, aimed at further developing domestic markets and integrating the financial sector more closely into global capital markets.  
- Other initiatives: The government launched initiatives to boost education, strengthen job-specific human capital, and promote innovation. Directors encouraged continued reforms to foster competition, enhance labor market flexibility, and further integrate the financial system into global capital markets.

### Executive Board assessment and policy recommendations
- Directors commended Chile’s strong institutions and sound macroeconomic policies, noting increased resilience to external shocks, low inflation and public debt, sustained high economic growth, and rising living standards over the past two decades.  
- Directors supported maintaining the current rules-based macroeconomic framework while addressing social issues and implementing structural reforms to boost long-term growth.  
- Monetary policy: Directors endorsed the withdrawal of monetary stimulus in view of the rebound in activity and risks from higher global food and energy prices; they endorsed the floating exchange rate policy and agreed that the value of the currency is broadly in line with economic fundamentals.  
- Fiscal policy: Directors welcomed the modest reduction in the surplus target beginning in 2008 as appropriate given the improved fiscal position, and viewed it as providing room for additional social spending. They also welcomed the commitment to build a pension reserve fund and recapitalize the central bank.  
- Public spending: Noting the success of Chile’s performance-based budgeting system, Directors considered plans to further strengthen the quality of government spending and increase transparency as well placed, and encouraged moving toward adopting a medium-term expenditure framework.

### Key statistics and indicators (selected figures cited in the text)
- Government transfer to BCC: $736 million (½ percent of GDP).  
- Timing of transfers: first annual payment in December 2006; additional transfer in late June (2007).  
- Expected GDP growth (2007): 5¾ percent.  
- Estimated potential growth rate: around 5 percent.  
- Central bank policy rate (July 12): 5¼ percent (raised by 25 basis points).  
- Inflation target benchmark: 3 percent (inflation remains close to this level).  
- Nominal fiscal surplus (2007 expected): over 7 percent of GDP.  
- Invested government financial assets: now exceed 10 percent of GDP.  
- Structural fiscal surplus target change: from 1 percent to ½ percent of GDP beginning in 2008.  
- Projected cost ceiling for pension reform: one percent of GDP.

*Public Information Notice (PIN) No. 07/82, July 19, 2007*

### 1.      This year, Chile’s Article IV Consultation was conducted under the streamlining

### _cr07333 - 1.      This year, Chile’s Article IV Consultation was conducted under the streamlining

### Outlook and Risks
- Growth and recent performance
  - After growing 4 percent in 2006, output growth resumed during the first half of 2007 at a faster pace than previously envisaged.
  - Central Bank of Chile (CBCh) central scenario projects GDP growth for 2007 between 5 and 6 percent, with a balance of risks with an upward bias.
  - New plants in the natural resources sector (pulp and mining) during 2007 will further expand Chile’s productive capacity.
- Demand and supply drivers
  - Private consumption is a key driver of domestic demand and is expected to continue, supported by increasing household income and credit expansion.
  - Investment rebound evidenced by acceleration of imported capital goods, increasing public investment, upward revisions of private investment intentions for 2008 and 2009, improved business confidence, strong firm cash flows, and favorable financial conditions.
  - Non-copper export volume expanded above 10 percent during the first semester of 2007.
  - Real effective exchange rate has remained approximately equal to its 15-year average despite positive terms of trade shocks.
- Risks to the growth outlook
  - Risks are tilted to the upside; growth in the upper part of the CBCh range, and even above 6 percent, cannot be ruled out.
  - Downside external risks: unanticipated change in global liquidity conditions, further increases in the price of oil and other food products, continued limitations in natural gas from Argentina, and other energy sector restrictions.
  - Upside risks: consumption expansion above recent dynamic pace, tighter excess capacity.
- Inflation dynamics and outlook
  - Throughout much of 2006 CPI inflation was on the upper limit of the 3 ± 1 percent target; core inflation measures and other indicators were close to 3 percent.
  - Last quarter of 2006: CPI and core inflation decreased below the 3 percent level.
  - January 2007: Central Bank decreased policy rate by 25 basis points to 5 percent after six months of policy rate stability.
  - First five months of 2007: demand and supply shocks changed inflation outlook; specific food items (grains and milk) and some increases in oil and gasoline prices have increased inflation marginally above the 3 percent target sooner than expected.
  - Inflation expectations remain well anchored at 3 percent (survey data and indexed bond forward inflation compensation).
  - Labor costs remain well contained as indicated by unit labor costs.
  - Inflation upside risks: faster-than-anticipated closure of output gap, continuation of supply shocks to food, oil and gasoline, second-round effects, increases in electricity prices.
  - Inflation downside risks: exchange rate appreciation and faster resolution of observed supply shocks.
  - Authorities’ stance: if inflation forecast exceeds the 3 percent target over a 24 month period, the CBCh stands ready to act to reduce monetary impulse to fulfill commitment to price stability.

### Fiscal Policy
- 2006 fiscal outcomes and framework
  - Central government overall surplus of 7.7 percent of GDP in 2006 due to the structural budget surplus rule (established 2001) and high copper prices.
  - 2006 fiscal flows: 23.1 percent real increase in revenues and 6.9 percent real increase in public expenditure.
  - Government became a net creditor if recognition bond liabilities (9.5 percent of GDP in December 2006) are excluded.
  - 2007 central government expected surplus of 7.1 percent of GDP.
  - 2007 public expenditure expected to increase by 9 percent in real terms, prioritizing social spending in health, education and social housing.
- Fiscal Responsibility Law (FRL) and sovereign asset management
  - FRL (2006) created two funds; CBCh acts as Fiscal Agent:
    - Economic and Social Stabilization Fund (ESSF): initial deposit USD 6 billion; assets under management USD 7.2 billion at end-April 2007.
    - Pension Reserve Fund (PRF): initial deposit USD 600 million; assets under management USD 617 million at end-April 2007.
  - Financial Advisory Council: six-member panel of independent economists to advise Minister of Finance on investment guidelines and fund matters.
  - FRL allowed government to recapitalize the CBCh by up to 0.5 percent of GDP for 5 years; first payment USD 600 million made in 2006, second payment USD 735 million made recently.
- Change in structural surplus target
  - May 21 presidential announcement reduced fiscal rule structural surplus target from 1 percent to 0.5 percent of GDP.
  - Rationale: review of conditions underlying 1 percent target (CBCh structural deficit, contingent liabilities from state guarantee of minimum and basic pensions, vulnerabilities from currency mismatches of government assets and liabilities).
  - Justification: past 6 years’ 1 percent surplus target provided anchor to fiscal policy, reduced cost of accessing international capital markets, secular fall in long-term interest rates; fall in public debt and increased asset accumulation reduced external vulnerability; CBCh structural deficit reduced.
  - Adjustment maintains rules-based fiscal framework; reduction to 0.5 percent from 2008 onwards.

### Monetary and Exchange Rate Policy
- Inflation targeting framework refinement (January)
  - Previous target: range between 2 and 4 percent.
  - New framework: year-on-year CPI inflation rate of 3 percent with tolerance range of ± 1 percent.
  - Policy horizon changed from “12 to 24 months horizon” to “around two-years time.”
  - Rationale: stronger midpoint anchor and alignment with practice emphasizing two-year horizon.
- Monetary stance and outlook
  - Shift from easing bias early in the year (25 bp cut in January) to a restrictive bias as inflation outlook evolved.
  - Remaining monetary stimulus will probably be withdrawn in the near future; decisions contingent on incoming data and two-year inflation horizon.
- Exchange rate regime and external shock absorption
  - Floating exchange rate creates greater scope for monetary policy and provides a buffer against external shocks.
  - Authorities concur with staff that exchange rate is broadly in line with fundamentals; no evidence of misalignment of the Chilean peso (CLP).
  - Fiscal policy played a key role in saving windfall copper revenues abroad, helping avoid loss of competitiveness and preventing Dutch disease amid large positive terms of trade shock.

### Human capital
- Reallocation from structural surplus target change
  - Change from 1 percent to 0.5 percent of GDP increases available government resources by approximately USD 740 million on a permanent basis.
  - Government emphasis on social spending: USD 650 million will be spent on education with specific measures:
    - Education voucher for children at mainly state-funded schools to rise by 15 percent, coupled with increased school accountability for resource use.
    - Preferential education subsidy targeting most vulnerable children to increase.
    - Family library program for four hundred thousand low-income families to be established.
    - Expansion of existing scholarship programs for students of technical careers.
    - Funds to improve educational and financial capabilities of municipal schools to be allocated.

### Labor markets
- Pension reform
  - High-level technical commission established; government submitted Reform to the Pension System bill to Congress in December 2006.
  - Main elements: establish a basic solidarity pillar including Basic Solidarity Pension (BSP) and Solidarity Pension Contribution (SPC), resolve gender inequalities, incentives to incorporate independent workers, increase competition by allowing new players into the system.
  - Government goal: start paying basic solidarity pensions by mid 2008.
  - Legislative timetable: agreement to accelerate Congressional discussion; pension reform bill to be discussed in the Senate as early as August (after Lower House), to become law by early 2008.
- Minimum wage adjustment
  - Increase in minimum wage of 6.7 percent.
  - Forward-looking clause: if actual growth (4th quarter of 2006 to 3rd quarter of 2007) exceeds 5.8 percent in real terms, the minimum wage increases by an additional 0.7 percent.
  - Government views the forward-looking clause as linking wage increases to economic performance.

### Financial Sector
- Capital Markets II reform (June 2007 law) — three broad areas
  - Promoting access to venture capital and funding for SMEs
    - Tax exemptions on capital gains from venture capital investments.
    - Promote participation of public sector and bank subsidiaries in venture capital funds.
    - Simplify legal framework for setting up venture capital funds and companies.
    - Redesign collateral establishment system.
    - Extend existing tax benefit on trading of newly listed stocks for a further eight years.
  - Strengthening financial market security
    - Simplify review process for banks, insurance companies and AFPs license applications; centralize in corresponding Superintendency.
    - Improve legal protection of financial supervisors.
    - Set higher custody requirements on securities to enhance transaction security.
    - Establish professional requirements for traders at stockbrokers.
    - Provide for dematerialized issuance of securities.
  - Promoting development and deepening of financial markets
    - Changes in definition of sight and time deposits and reserve requirements to be based on effective net worth (rather than basic capital) in line with Basel II guidelines to develop the money market.
    - Authorization of derivatives netting in case of bankruptcy.
    - Increases in investment limits for insurance companies.
    - Modernization of the off-shore stock market.
    - Collective action clauses for bond issuance.
    - New tax benefit for mutual fund investors to promote saving, competition and portfolio reallocation.

### Other Issues
- Chile Invests Plan (March 2007)
  - Package to boost investment, facilitate entrepreneurship, globalize domestic financial markets, enhance trade integration, improve government effectiveness, foster innovation and human capital, and address expanding energy needs.
  - Measures include a new accelerated depreciation tax benefit (under legislative review), identification and elimination of investment process bottlenecks, and increased focus on execution and quality of public investment.
  - Entrepreneurship facilitation: indirect long-term financing products for SMEs via banking system, creation of a fund to guarantee SME investments, and standardized balance sheet reporting for SMEs automatically prepared using tax information.
  - Financial market integration: a derivatives law with comprehensive tax framework to be submitted to Congress; measures to facilitate use of the Chilean peso as an international currency by connecting to global settlement and custody systems and reducing administrative burdens on foreign investors.

### Conclusion
- Rules-based policy framework outcomes
  - Framework for monetary and fiscal policy instrumental in sustaining growth and improving living standards, particularly for low and middle-income Chileans.
  - Recent figures: population in poverty fell by 5 percentage points in the last 3 years, from 18.7 to 13.7 percent.
  - Income distribution: largest improvement since 1990 indicated by a fall in the Gini coefficient.
  - Recognition: invitation extended to Chile in May to open discussions for membership of the OECD.

*IMF staff report text: Chile Article IV Consultation (streamlined procedures).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07333.pdf_