## _cr14218 — Spillover Transmission Channels and Effects

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### Context and recent developments
- Chile confronting a changing external environment after benefiting from a global copper boom and easy international financial conditions.
- Outcomes from the boom included a substantial increase in per capita income, a fall in poverty, and a more modest improvement in income distribution.
- New government (President Michelle Bachelet, assumed office on March 11, 2014 for a four year term) with platform emphasizing tax and education reforms, and commitments to energy, labor, productivity reforms, and prudent fiscal policy.
- Chile’s strengths: freely floating currency, credible monetary policy framework, robust public finances, and track-record of macro-financial stability.

### Current conditions and spillovers
- Spillovers:
  - Spillovers from tapering: mild.
  - Spillovers from a dimmer global copper outlook: severe.
- Financial market and corporate sector indicators:
  - Corporate sector has maintained access to external funding; capital inflows remained buoyant, with recent moderation.
  - Effect on EMBI spreads: modest.
  - Local currency long-term government bond yields declined.
- Exchange rate and activity:
  - Peso depreciated by 17 percent against the dollar since April 2013 (amid monetary easing).
  - Peso depreciated 11 percent in real effective terms.
  - Growth moderation started in 2012 and became more pronounced in 2013 as private investment ground to a halt late in the year.
  - 2014Q1: some recovery in activity and private investment; durable goods consumption contracted.
  - Net exports providing an important offset.
  - Staff estimates a modest negative output gap.
- Monetary policy and credit:
  - Central bank cut the policy rate from 5 to 4 percent by April 2014 (cuts began in October 2013).
  - Cuts transmitted quickly to interbank and lending rates and added to peso depreciation.
  - Credit growth moderated for all types of credit except mortgages; real mortgage credit expanded by 9 percent (y/y) in April.
- Inflation and expectations:
  - Inflation 4.3 percent (y/y) in April, up from 1.7 percent in October 2013.
  - Inflation recorded at 4.7 percent in May, above the upper limit of the target band.
  - Inflation expectations anchored at 3 percent over the two-year policy horizon.
- Fiscal and external:
  - Structural deficit in 2013: 0.8 percent of GDP (staff estimate), roughly unchanged from 2012 net of a one-off capital gains tax windfall (equal to 0.4 percent of GDP).
  - Headline balance shifted to a deficit of 0.6 percent of GDP from a surplus of equal size in 2012.
  - Central government net assets: 6.7 percent of GDP.
  - Current account deficit: 3.4 percent of GDP in 2013 (unadjusted); shrunk to 3.1 percent of GDP in 2014Q1 (annual basis).
  - Gross external financing needs: sizeable at 17 percent of GDP, roughly half non-bank corporate debt.
  - Fund’s EBA estimates indicate the peso is in line with fundamentals.
- Financial stability and corporate sector:
  - Bank capitalization adequate; profitability comfortable; nonperforming loans low and fully provisioned.
  - Domestic deposits main funding source; reliance on foreign financing (excluding capital) low at 8.5 percent of total liabilities.
  - Life insurance: returns on equity above the OECD median; insurers accumulated more capital than required; sector expanding into lower-liquidity, higher-risk investments (e.g., real estate).
  - Corporate indebtedness increased to about 92–93 percent of GDP (sources in text: "about 92 percent of GDP" and "about 93 percent of GDP"); most increase reflects FDI-related debt.
  - Corporate debt composition (share of total non-financial corporate debt): Bank credit 49 percent; Factoring and leasing 6 percent; Bonds 14 percent; Foreign bank credit 13 percent; External bond debt 6 percent; External debt: trade credit 3 percent; External debt: FDI 9 percent.
  - Corporate maturing external debt will remain about 6.5–7.25 percent of GDP a year over next three years.

### Outlook and risks
- Baseline projection:
  - Growth bottoms out in 2014 and gradually recovers; activity gathers strength in 2015, with growth reaching 4¼ percent (staff’s estimate of long-run potential) in 2016.
  - Inflation will decline to 3 percent over the next 12–18 months as temporary effects from the peso depreciation wear off.
- Drivers of recovery:
  - Gradual turnaround in private fixed investment, including mining; strong net exports; support from monetary easing and real depreciation.
- Dominant external risks:
  - Copper prices:
    - Copper represents over half of Chile’s exports, equaling 15 percent of GDP.
    - Previous staff analysis: a 10 percent fall in copper prices reduces Chile’s GDP by 0.8 percent over eight quarters.
    - China consumes about 40 percent of world copper.
  - Global financial volatility:
    - Chile less vulnerable than most EMs but exposed via large internationally integrated financial system, increased corporate leverage, and sizeable gross external financing need; sudden stop risk exists.
- Authorities’ views:
  - Broad agreement with staff on outlook and risks.
  - Disorderly slowdown in China seen as most important external risk, especially if postponing copper-related investment projects.
  - Tapering viewed as no longer an immediate risk; vigilance warranted.
  - Medium-term growth prospects expected to improve with structural reforms.

### Policy implications — broad guidance
- Given structural character of growth slowdown and modest output gap, structural reform rather than demand-side policies should have primary role in strengthening prospects for strong and inclusive growth.
- Continued efforts to reinforce financial stability important.

### Policy mix — monetary, fiscal, and contingency
- Monetary policy:
  - Remain vigilant to inflation outlook.
  - Present accommodative stance consistent with keeping inflation in check and supporting recovery.
  - Recent broad-based spurt in inflation calls for caution; interest rates should be left on hold absent further weakening in domestic demand.
  - Normalize policy as economy reverts toward potential.
- Fiscal policy:
  - Broadly neutral fiscal stance appropriate; consistent with full execution of the 2014 budget (approved with a structural deficit of 1 percent of GDP).
  - Full execution would allow robust increase in expenditure, particularly investment, after under-execution in 2013.
  - Headline deficit will double to 1.2 percent of GDP and central government net assets will decline by about 1 percentage point under full execution.
  - Government’s target of a balanced structural position by 2018 is welcome and should be feasible as activity recovers; consolidation should be calibrated to avoid undue contractionary stance.
  - Strong public finances allow automatic stabilizers to operate fully.
- Contingency measures if risks materialize:
  - Floating exchange rate should be first line of defense, especially for a sharp and lasting fall in copper prices and capital flow reversals.
  - Foreign exchange intervention could help avoid excessive currency volatility, if needed.
  - If domestic demand falters, further monetary easing could be appropriate though policy room has shrunk.
  - Fiscal support—beyond automatic stabilizers—could be considered if large decline in activity.
  - In event of capital flow reversal, authorities should be prepared to contain liquidity pressures (expand repo operations, broaden accepted collateral, set up dollar swap auctions).
- Authorities’ stance:
  - Central bank focuses on inflation; believes pick-up temporary and expects inflation to revert toward 3 percent during 2015.
  - Fiscal policy anchored on balanced structural position by 2018; government considering revisions to 2014 budget to include earthquake and fire outlays; macro assumptions of 2014 budget were too optimistic so somewhat larger headline deficit could be expected in 2014.
  - Government committed to bring structural budget to balanced position by 2018 using receipts from tax reform.

### Fostering strong and inclusive growth (structural agenda)
- Medium-term challenges:
  - Growth:
    - TFP increased 0.4 percent a year (particularly lackluster in the copper sector).
    - Scope for employment expansion constrained by low unemployment and decelerating working-age population (from 1.6 percent in 2013 to 1.1 percent by 2019).
    - Structural reforms required to foster sustained growth.
  - Equity:
    - Inequality declined but remains high relative to region and OECD (Gini coefficient 0.52 in 2011).
    - Low intergenerational mobility largely due to unequal access to quality education.
    - Social public spending risen but still lags regional and OECD averages.
    - Tax-transfer system characterized by low progressivity.
- Policy priorities and expected impact:
  - Tax reform to raise 3 percent of GDP by 2018 to fund education reform (1.5 percent of GDP), other social programs (0.5 percent), and close structural fiscal deficit (1 percent).
  - Education reforms: expand early education, modernize preschool framework, exclude profit-seeking schools from public funding, eliminate copayments, eliminate school-level selection, replace municipal school management with national administration, revamp teacher education, and gradually achieve free access to tertiary education with 4-year target: 70% of the population.
    - Specific legislative timing: Several measures "Sent to Congress on May 20 2014"; others "To be sent during 2014H2" or "To be sent within first 100 days (by June 19, 2014)" as presented.
  - Tax reform key elements:
    - Reform taxation of dividends: include undistributed profits in shareholders’ personal income tax base.
    - Raise corporate income tax rate from 20 to 25 percent and lower top marginal personal income tax from 40 to 35 percent.
    - Measures for SMEs: instant depreciation (large companies eligible for 12 months); unique simplified tax regime; increased tax credit for fixed-asset purchases.
    - Modify real-estate related taxes: VAT on sale of new houses; reduced VAT credit to builders of small houses; capital gains from house sales taxed (except seller-occupied houses).
    - Increase financial transaction (stamp) tax.
    - Green taxes: import tax on highly-polluting diesel vehicles and emission-based tax for industrial activity.
    - Strengthen revenue authority administrative capacity.
  - Expected steady-state yields (in percent of GDP) from tax reform elements:
    - Personal income taxation of undistributed profits /2 0.80
    - Increase in corporate tax rate 0.59
    - Measures to reduce evasion and avoidance 0.52
    - Real-estate related taxes 0.39
    - Diesel vehicles import tax and emission tax 0.17
    - Increase in stamp tax 0.15
    - Alcoholic and/or low nutritial value beverages tax 0.15
    - Other measures 0.25
    - Total 3.02
    - Note: 2/ Includes reduction of max. personal rate (-0.10% of GDP).
  - Energy targets:
    - Reduce marginal electricity costs in SIC by 30 percent by 2017.
    - Reduce bid prices for electricity supply by 25 percent by 2025.
    - Reduce energy use by 20 percent by 2025.
    - Achieve 20 percent share of renewables in the energy matrix by 2025.
  - Infrastructure, labor market, and business climate reforms highlighted to boost investment, female labor participation, and competitiveness.

### Financial sector structure, vulnerabilities, and policy recommendations
- Financial system size and composition:
  - Financial system assets exceed 200 percent of GDP; Total: Share of total 100; Share of GDP 205.4.
  - Banks: Share of total 52.4; Share of GDP 107.7.
  - Pension fund administrators 1/: Share of total 28.9; Share of GDP 59.4.
  - Insurance companies: Share of total 10.0; Share of GDP 20.5 (Life: Share of total 8.9; Share of GDP 18.2).
  - Other fund administrators 1/ 2/: Share of total 8.7; Share of GDP 17.8.
  - Life insurance sector assets equal 20 percent of GDP.
  - Mutual funds: 14 percent of GDP in 2012.
  - Pension funds: almost 60 percent of GDP.
- Banking sector soundness and risks:
  - Mortgage loans ~one-quarter of banks’ loan portfolio.
  - Share of mortgages with LTV ≥80 percent stabilized at 60 percent.
  - Prompt implementation of regulation linking mortgage provisioning to LTV levels recommended; consider hard LTV and debt-to-income limits if needed.
  - Loan-to-deposits ratio high by international comparisons; Basel III NSFR assessment: Chilean banks well-positioned per 2011 FSAP Update.
  - Central bank stress-test scenario (severe): 6 percentage point output drop relative to baseline, 300 basis points rise in interest rates short term and 100 basis points long term, and 20 percent peso depreciation — all banks maintain regulatory capital to risk-weighted assets above 8 percent.
- Non-bank financial sector:
  - Life insurers: sector assets equal 20 percent of GDP; exposures to commercial real estate and domestic corporate bonds (almost one-third of life insurers’ investments) merit monitoring; solvency requirements being strengthened; risk-based supervision law urged.
  - Mutual funds: assets 14 percent of GDP; about half in money market funds (maturity 90 days or less); Ley Unica de Fondos effective May 1, 2014.
  - Pension funds: assets almost 60 percent of GDP; commission appointed to propose parametric changes; plan to create a publicly-managed pension fund to complement six privately-managed funds.
- Corporate debt developments (Annex III):
  - Corporate debt about 93 percent of GDP; increased ~10 percentage points since mid-2011.
  - About 50 percent of corporate debt is local bank credit; local bonds and foreign bank credit each about 13.5 percent.
  - Sectoral shares (selected): Community services 22.2 percent (2012); Trade 18.3 percent (2012); Mining 7.4 percent (2012) with FDI-related debt share rising from 11.1 (2009) to 33.5 (2012).
  - Firm-level concentration: five firms contributed 6.1 percentage points of GDP to aggregate increase in debt (2008–2012); LATAM Airlines Group S.A. contributed 2.10, etc.
  - Corporate profitability (return over assets): 2002-2008: 6.40; 2009-2012: 7.33; 2013: 5.80.
  - Leverage (debt to equity): 2002-2008: 0.63; 2009-2012: 0.67; 2013: 0.71.
  - Liquidity (current assets minus inventories to current liabilities): 2002-2008: 1.10; 2009-2012: 1.09; 2013: 0.94.
- Risks and recommended safeguards:
  - Monitor corporate leverage and real estate developments; strengthen macroprudential policies as needed.
  - Priority to complete pending legislative/regulatory reforms: risk-based insurance supervision; comprehensive credit registry; stronger governance and independence for SVS; legal framework for Financial Stability Council.
  - Revise General Banking Law to incorporate Basel III capital standards and improve bank resolution framework; strengthen SBIF independence.
  - Expand credit registry coverage; improve commercial real estate data.
  - Consider macroprudential measures and regulatory reporting enhancements (standardized bank mortgage provisioning linked to LTV levels; enhanced liquidity regulation and reporting in line with Basel III).

### Fiscal framework and recommendations
- Fiscal framework context:
  - Fiscal rule since 2001; Fiscal Council created in 2013 (by ministerial decree).
  - Staff suggested refinements to provide more predictability and a stronger fiscal anchor.
- Recommendations:
  - Embed clearer guidance on medium-term objectives (e.g., structural balance or net assets) in the rule itself.
  - Adopt a small structural surplus for “steady state” to preserve government net asset position.
  - Include an explicit escape clause to allow discretionary policy in event of large, clearly defined shocks.
  - Strengthen Fiscal Council autonomy and broaden mandate (e.g., assessing outturns against targets); law in Congress will give Council stronger legal basis.
- Authorities’ views:
  - Appreciated recommendations but did not see revisions as immediate priorities; appropriate medium-run fiscal target needs further public discussion.
  - New government committed to eliminate structural deficit gradually to reach structural balance by 2018; staff recommended adopting a small structural surplus to preserve buffers.

### Debt sustainability (Annex VI) — selected figures preserved
- External debt-to-exports ratio (in percent): 112.5 102.7 104.1 130.0 146.1 151.3 155.1 157.4 158.6 159.7 159.2
- Gross external financing need in percent of GDP: 16.1 11.4 14.1 20.6 21.2 16.8 14.1 13.8 13.2 12.7 12.3
- Gross external financing need (raw string in source): 28253555594439.2841424445
- Public sector indicators (selected):
  - Nominal gross public debt: 7.7 12.0 12.5 13.2 14.0 14.4 14.7 14.8 14.8
  - Net public debt (excludes Pension Reserve Fund): -5.2 -4.6 -3.9 -2.6 -1.3 -0.4 0.1 0.4 0.6
  - Real GDP growth (examples in table): -1.0 5.7 5.8 5.5 4.2 3.2 4.1 4.2 4.2 4.3 4.3
  - Baseline underlying assumptions (2014–2019): Real GDP growth 3.2 4.1 4.2 4.2 4.3 4.3; Inflation 3.8 2.8 2.8 2.9 2.9 3.0; Primary Balance -1.2 -0.8 -0.4 -0.1 0.2 0.2; Effective interest rate 5.3 5.7 6.1 6.3 6.5 6.7
- Scenarios and shock tests include interest rate, growth, current account, real depreciation (e.g., one-time real depreciation of 30 percent occurs in 2015), and combined shocks.

### Investment dynamics (Annex II)
- Transformation of investment patterns:
  - Mining share in GFCF rose from 15 percent in early 2000s to 26 percent in 2012.
  - Mining investment as share of GDP increased from 2.5 percent (average 1976–2007) to 4.7 percent (2008–2012).
  - Mining represents more than 13 percent of Chile’s GDP and more than 50 percent of Chile’s exports.
  - China’s copper demand >40 percent of world consumption.
- 2013 investment collapse:
  - Private GFCF dropped by 12 percent y/y (11.4 percent q/q s.a.) in 2013Q4.
  - CBC data suggest double-digit decline in mining projects both q/q and y/y at end-2013.
- Regression and VAR findings (regression with 41 quarterly observations, 2003–13; R2=0.62):
  - Exchange rate (LC/US): Coefficient -0.54; t-statistic -4.22
  - Copper price: Coefficient 0.09; t-statistic 1.73
  - Real wage: Coefficient -0.83; t-statistic -1.27
  - Bank lending rate: Coefficient 0.07; t-statistic -0.13
  - Expected GDP growth rate: Coefficient 4.63; t-statistic -2.72
  - 10y US Government Bond Yield: Coefficient -0.04; t-statistic -2.37
- Outlook:
  - With mining investment boom ending and copper prices downward, short-term GFCF growth outlook uncertain.
  - 2014Q1: 8-percent depreciation of the peso and slight drop in copper price imply investment growth likely to remain weak short run.
  - Planned investment: mining projects short by about 0.4 percent of GDP in 2014–17 relative to end-2013 plans; energy projects about 0.4 percent higher in medium term; construction expected to scale up.

### Supervision, governance, and unfinished reforms
- Multiple agencies: Central Bank, SBIF, SVS, Superintendence of Pensions; Financial Stability Council chaired by Minister of Finance.
- Laws in Congress: legal framework for Financial Stability Council and strengthen SVS independence — to be implemented once approved.
- Strengthen independence of SBIF recommended.
- Consolidated supervision:
  - Current oversight relies on silo approach; recommend clearer powers for continuous consolidated supervision and prudential regulation at conglomerate level.
- Additional initiatives recommended:
  - Prompt approval of legislation expanding credit registry with comprehensive credit history from banks and nonbanks.
  - Revise General Banking Law to incorporate Basel III, improve bank resolution, and strengthen SBIF independence.
- Ongoing reforms in Congress and under consultation (summary):
  - Legal reforms in Congress: risk-based insurance supervision; comprehensive credit registry; stronger governance and independence for SVS; new legal framework for Financial Stability Council.
  - Regulatory changes under public consultation: standardized bank mortgage provisioning model linked to LTV levels; enhanced liquidity regulation and reporting in line with Basel III.

### Executive Board and staff appraisal (high-level)
- Directors commended sound macroeconomic management and robust recent performance; acknowledged challenges from end of copper price boom and normalization of global monetary conditions.
- Current policy mix broadly appropriate: floating exchange rate as shock absorber; monetary policy accommodative while inflation expectations anchored; fiscal policy broadly neutral with automatic stabilizers operating.
- Structural reform emphasis: improve education, foster female labor participation, upgrade infrastructure, promote energy efficiency, support tax reform objectives while maintaining investment incentives.
- Staff proposes next Article IV consultation on standard 12-month cycle.

*IMF staff report: Chapter 1 — “Spillover Transmission Channels and Effects” (page excerpts).*

### 1. Spillover Transmission Channels and Effects___________________________________________________ 18

### 1. Spillover Transmission Channels and Effects___________________________________________________ 18

### Context
- Chile is confronting a changing external environment after benefiting from a global copper boom and easy international financial conditions.
- Outcomes from the boom included a substantial increase in per capita income, a fall in poverty, and a more modest improvement in income distribution.
- Growth tailwinds are reversing as the Fed has started to normalize policy (“tapering”) and the commodity boom is petering out.
- Chile’s strengths: freely floating currency, credible monetary policy framework, robust public finances, and a track-record of macro-financial stability.
- A new government (President Michelle Bachelet, assumed office on March 11, 2014 for a four year term) has a platform emphasizing tax and education reforms, and commitments to energy, labor, productivity reforms, and prudent fiscal policy.

### Current conditions and recent spillovers
- Spillovers from tapering have been mild; spillovers from a dimmer global copper outlook have been severe.
- Financial market and corporate sector indicators:
  - Corporate sector has maintained access to external funding.
  - Capital inflows remained buoyant, with recent moderation.
  - Effect on EMBI spreads has been modest.
  - Local currency long-term government bond yields declined, reflecting policy credibility and low foreign participation.
- Exchange rate movements:
  - The peso depreciated by 17 percent against the dollar since April 2013 (amid monetary easing).
  - The peso depreciated 11 percent in real effective terms.
- Activity and demand:
  - Growth moderation that started in 2012 became more pronounced in 2013 as private investment ground to a halt late in the year.
  - First quarter of 2014 saw some recovery in activity and private investment, but durable goods consumption contracted.
  - Net exports are providing an important offset.
  - Staff estimates a modest negative output gap.
- Monetary policy and credit:
  - Central bank cut the policy rate from 5 to 4 percent by April 2014 (cuts began in October 2013).
  - Cuts transmitted quickly to interbank and lending rates and added to peso depreciation.
  - Credit growth moderated for all types of credit except mortgages, which remain brisk.
- Inflation:
  - Inflation was 4.3 percent (y/y) in April, up from 1.7 percent in October 2013.
  - The pass-through from peso depreciation to consumer prices was swift.
  - Tradable goods inflation showed the largest spike, but non-tradable and core inflation measures also rose.
  - Inflation expectations remain anchored at 3 percent over the two-year policy horizon.
- Fiscal position:
  - Structural deficit in 2013 was 0.8 percent of GDP (staff estimate), roughly unchanged from 2012 net of a one-off capital gains tax windfall (equal to 0.4 percent of GDP).
  - Fall in copper revenue shifted the headline balance to a deficit of 0.6 percent of GDP from a surplus of equal size in 2012.
  - Central government net assets remained at 6.7 percent of GDP, helped by valuation gains.
- External sector:
  - Current account deficit was 3.4 percent of GDP in 2013 (unadjusted).
  - Current account shrunk to 3.1 percent of GDP in the first quarter of 2014 (annual basis).
  - Foreign direct investment has declined but remains the main source of financing, with a growing debt component.
  - Gross external financing needs remain sizeable at 17 percent of GDP, roughly half of which is non-bank corporate debt.
  - Fund’s EBA estimates indicate the peso is in line with fundamentals.
- Financial stability:
  - Bank capitalization appears adequate; profitability remains comfortable; nonperforming loans are low and fully provisioned.
  - Domestic deposits are the main funding source; reliance on foreign financing (excluding capital) is low at 8.5 percent of total liabilities.
  - Life insurance sector: returns on equity above the OECD median; insurers have accumulated more capital than required and solvency requirements are being strengthened; sector has expanded into lower-liquidity, higher-risk investments (e.g., real estate).
  - Corporate indebtedness increased to about 92 percent of GDP, surpassing pre-crisis levels; most of the increase reflects FDI-related debt.
- Real estate and household balance sheets:
  - Real mortgage credit expanded by 9 percent (y/y) in April.
  - Household indebtedness remained broadly stable at about 55 percent of disposable income.
  - House prices are rising again after some deceleration, with large regional variation.
  - Commercial real estate: spotty data; apparent oversupply of office space poses some risk to life insurers.

### Outlook and risks
- Baseline projection:
  - Growth bottoms out in 2014 and then gradually recovers.
  - Activity gathers strength in 2015, with growth reaching 4¼ percent (staff’s estimate of long-run potential) in 2016.
  - Inflation will decline to 3 percent over the next 12–18 months as temporary effects from the peso depreciation wear off.
- Drivers of the baseline recovery:
  - Continued gradual turnaround in private fixed investment, including mining.
  - Strong net exports.
  - Support from monetary easing, real depreciation, and recovering global economy.
- Dominant risks (Annex IV):
  - Copper prices:
    - Copper represents over half of Chile’s exports, equaling 15 percent of GDP.
    - A further sharp and sustained decline in copper prices would hurt investment and growth and require another round of substantial real depreciation.
    - Previous staff analysis suggested that a 10 percent fall in copper prices reduces Chile’s GDP by 0.8 percent over eight quarters.
    - China consumes about 40 percent of world copper.
  - Global financial volatility:
    - Chile is less vulnerable to capital flow volatility than most other emerging markets due to its macroeconomic framework and deep local capital market.
    - Nonetheless, large internationally integrated financial system, significant real-financial linkages, increased corporate leverage, and sizeable gross external financing need expose Chile to sudden stop risk.
- Authorities’ views:
  - Agreed broadly with staff on the outlook and risks.
  - See a disorderly slowdown in China as the most important external risk, especially if associated with postponement of copper-related investment projects.
  - Tapering is no longer seen as an immediate risk, though vigilance remains warranted.
  - Medium-term growth prospects and potential growth should improve with implementation of structural reforms.

### Policy implications
- Overall guidance:
  - Given the structural character of the growth slowdown and the modest-sized output gap, structural reform rather than demand-side policies should have the primary role in strengthening prospects for strong and inclusive growth.
  - Continued efforts to reinforce financial stability will be important.

- A. Policy mix
  - Monetary policy:
    - Should remain vigilant to the inflation outlook.
    - Present accommodative stance is consistent with keeping inflation in check over the policy horizon and supporting the recovery.
    - Recent broad-based spurt in inflation calls for caution and for interest rates to be left on hold absent a further weakening in domestic demand.
    - Monetary policy normalization should proceed as the economy reverts toward potential.
  - Fiscal policy:
    - A broadly neutral fiscal stance would be appropriate.
    - Consistent with full execution of the 2014 budget (approved with a structural deficit of 1 percent of GDP).
    - Would allow for a robust increase in expenditure, particularly investment, after under-execution in 2013.
    - Headline deficit will double to 1.2 percent of GDP and central government net assets will decline by about 1 percentage point under full execution.
    - Government’s target of a balanced structural position by 2018 is welcome and should be feasible as activity recovers; consolidation should be calibrated to avoid an unduly contractionary stance.
    - Strong public finances allow automatic stabilizers to operate fully.
  - Contingency measures if risks materialize:
    - Floating exchange rate should be the first line of defense, especially in case of a further sharp and lasting fall in copper prices and capital flow reversals.
    - Foreign exchange intervention could help avoid excessive currency volatility, if needed.
    - If domestic demand falters, further monetary easing could be appropriate though policy room has shrunk.
    - Fiscal support—beyond automatic stabilizers—could be considered if there is a large decline in activity.
    - In event of a capital flow reversal, authorities should be prepared to contain liquidity pressures, including through expanding repo operations, broadening accepted collateral, and setting up dollar swap auctions.
  - Authorities’ stance:
    - Central bank will continue to focus on inflation; believes the pick-up is temporary and expects inflation to revert toward 3 percent during 2015.
    - Fiscal policy anchored on target of a structural balanced position by 2018.
    - Government considering revisions to the 2014 budget to include additional outlays related to earthquake and fires; macro assumptions of the 2014 budget were too optimistic so a somewhat larger headline deficit could be expected in 2014.
    - Government committed to bringing the structural budget to a balanced position by 2018 using receipts from tax reform.

- B. Fostering strong and inclusive growth
  - Medium-term challenges:
    - Growth:
      - Rapid growth over the past decade was led by investment and employment expansion; total factor productivity (TFP) increased 0.4 percent a year (particularly lackluster in the copper sector).
      - Shifting tailwinds raise doubts about mining as a future driver of growth.
      - Scope for employment expansion constrained by low unemployment and a decelerating working-age population (from 1.6 percent in 2013 to 1.1 percent by 2019).
      - Floating exchange rate and flexible labor market will facilitate adjustment, but structural reforms are required to foster sustained growth.
    - Equity:
      - Inequality has declined but remains high compared with the region and OECD countries.
      - Low intergenerational social mobility largely caused by unequal access to quality education.
      - Social public spending has risen significantly but still lags regional and OECD averages.
      - Chilean tax-transfer system is characterized by low progressivity and has been less effective in reducing poverty and income inequality compared with OECD experience.

*IMF staff report: Chapter 1 — “Spillover Transmission Channels and Effects” (page excerpts).*

### 19.      The government is launching an ambitious policy agenda that could galvanize strong

### 19.      The government is launching an ambitious policy agenda that could galvanize strong 

### Policy agenda: main areas and priorities
- Education and tax reforms
  - Tax reform: proposed to reduce regressivity and raise 3 percent of GDP by 2018 in revenue to fund education reform, increase outlays on health, and raise public savings.
  - The proposal matches new spending with permanent revenue; mission supported objectives.
- Education (priorities and diagnosis)
  - Chile’s PISA score improved over the past decade and is the highest in the region but still well below OECD averages.
  - Student performance is highly dependent on socio-economic background; improving education would help growth and equity.
  - Chile’s public spending on education is low by international standards and has limited scope for efficiency gains; improvements would require more resources.
  - Immediate reform priorities (ElementStatus):
    - Early education
      - Expand coverage of childcare — Sent to Congress on May 20 2014
      - Modernize preschool institutional framework and establish Preschool Deputy Ministry — Sent to Congress on May 20 2014
    - Primary and secondary education
      - Exclude from receiving public funding (e.g. vouchers) profit seeking schools — Sent to Congress on May 20 2014
      - Eliminate copayments by increasing public subsidy — Sent to Congress on May 20 2014
      - Eliminate any form of student admission selection at the school level — Sent to Congress on May 20 2014
      - Replace municipal school management with a national administration with local branches — To be sent during 2014H2
      - Revamp teachers' education and training — To be sent during 2014H2
    - Tertiary education
      - Gradually achieve free access to tertiary education. 4-year target: 70% of the population — To be sent during 2014H2
      - Establish Superintendence of Tertiary Education to modernize institutional framework — To be sent within first 100 days (by June 19, 2014)
  - Mission supported the direction and underlined importance of leveling the playing field and raising quality of early-childhood education.
- Tax reform (high-level features and risks)
  - Reform involves several changes to Chile’s integrated tax regime; current system of tax deferral for undistributed earnings (in place since 1984) has become a source of significant tax planning and evasion.
  - Reform expected to be approved in September 2014; tilted toward taxing upper-income brackets, including focus on capital income and closing loopholes, and should reduce regressivity.
  - Uncertainty exists over expected revenue yield and economic impact due to size and complexity; limited international experience for proposed new profit/dividend tax regime.
  - Higher taxation of corporate profits and capital income would likely dampen investment and corporate savings; instant depreciation and higher public savings would provide some offset.
  - Strengthening the tax authority and planned gradual implementation are welcomed to allow fine-tuning.
- Energy
  - Demand for electricity has risen and will continue to rise, but investment in generation has stalled.
  - Government plans to promote energy investment and efficiency, facilitate entry and use of new, clean technologies; mission commended these plans.
- Infrastructure
  - Chile ranks well in international comparisons but with scope for improvement, notably transportation, logistical hubs (including ports), water and telecommunication infrastructure.
  - Frontloading infrastructure investment could boost investment and growth in the near term.
- Labor market
  - Government considering reforms; mission encouraged reforms to promote female labor force participation (training and improved access to daycare).
  - Despite progress, female participation lags OECD and regional averages and is low for lower-income groups.
  - Minimum wage is quite binding; government commitment implies an increase by about 20 percent over three years at the time of a weaker labor market.
  - Mission stressed importance of maintaining labor market flexibility while fostering equity.
- Business climate
  - Chile scores high regionally in World Economic Forum and World Bank Doing Business rankings and compares well with OECD peers.
  - “Business-in-a-day” reform (2013) and Bankruptcy Law (early 2014) improved the business environment.
  - Authorities plan to promote research and development, job training, SME management, and competition to spur innovation, growth, and diversification.

### Expected impact and objectives
- Authorities emphasize reform agenda designed to:
  - Provide a strong boost to medium-term growth.
  - Achieve a fairer distribution of income for social stability.
- Tax reform will provide fiscal resources to be used on education and health and to increase public savings.
- Improving access to high quality education will strengthen long-term growth prospects and address a root cause of inequality.
- Planned agendas for energy reform and productivity, innovation and growth aim to address main concerns of Chilean industry.
- Authorities expect implementation of the reform program to have an important positive impact on medium-term growth prospects and potential output.

### Reinforcing financial stability: structure and exposures
- Financial system size and linkages
  - Financial system assets exceed 200 percent of GDP.
  - Bank credit equals 77 percent of GDP.
  - Chilean banks (and corporations) are net borrowers in world markets; subsidiaries of foreign banks account for a large share of bank assets.
  - Foreign participation is significant in insurance and pension fund sectors; domestic banks have expanded operations abroad.
- Financial System Structure (2012) — assets as share of system total and GDP (in percent)
  - Banks: Share of total 52.4; Share of GDP 107.7
  - Pension fund administrators 1/: Share of total 28.9; Share of GDP 59.4
  - Insurance companies: Share of total 10.0; Share of GDP 20.5
    - Property and casualty: Share of total 1.1; Share of GDP 2.3
    - Life: Share of total 8.9; Share of GDP 18.2
  - Other fund administrators 1/ 2/: Share of total 8.7; Share of GDP 17.8
  - Total: Share of total 100; Share of GDP 205.4
  - 1/ Assets under management. 2/ Includes mutual funds, investment funds, investment funds for foreign capital.
- Non-bank financial institutions (selected observations)
  - Life insurance sector assets equal 20 percent of GDP.
  - Mutual funds doubled size in last 5 years, reaching 14 percent of GDP in 2012.
  - Pension funds have assets of almost 60 percent of GDP and are the largest non-bank financial institutions.

### Banking sector soundness: risks and policy implications
- Real estate exposure
  - Mortgage loans represent about one-quarter of banks’ loan portfolio.
  - Share of mortgages with elevated (80 percent or higher) loan-to-value (LTV) ratios has stabilized at 60 percent.
  - Prompt implementation of regulation linking mortgage credit provisioning to LTV levels is important; further action (hard limits on LTVs and debt-to-income ratios) might need consideration.
  - Mission encouraged authorities to address real estate data gaps, particularly for commercial real estate.
- Bank funding and liquidity
  - Banking system’s loan-to-deposits ratio is high by international comparisons; main reason is heavier reliance on institutional deposits and higher share of loans.
  - Basel III Net Stable Funding Ratio (NSFR) is broader; 2011 FSAP Update found Chilean banks well-positioned to meet the NSFR.
  - Mission welcomed SBIF and Central Bank work to enhance liquidity regulation and reporting, considering recent Basel Committee proposals.
- Corporate exposure
  - Corporate debt has risen as a share of GDP; profits and liquidity ratios worsened from pre-crisis levels, especially in construction and retail trade sectors.
  - Corporate loans represent roughly half of banks’ portfolios.
  - Local and global appetite for Chilean corporate debt remains strong; firms’ currency mismatches appear limited.
  - Central bank stress-tests find banking sector solvent even under extreme scenarios:
    - Test scenario: 6 percentage point output drop relative to baseline and subdued medium-term growth, a 300 basis points rise in interest rates in the short term and 100 basis points in the long term, and 20 percent peso depreciation — all banks maintain regulatory capital to risk-weighted assets above 8 percent.

### Non-bank financial sector: developments and recommendations
- Insurance companies
  - Life insurance sector profitability is healthy; sector assets equal 20 percent of GDP and expected to expand with rising retirees.
  - Longevity risk mitigated by regular review of mortality tables per 2004 FSAP recommendation.
  - Longer average maturity for assets than liabilities exposes life insurers to decreases in interest rates.
  - Growing direct exposure to commercial real estate and exposures to domestic corporate bonds (almost one-third of life insurers’ investments) merit monitoring.
  - Mission encouraged speedy approval of law in Congress to introduce risk-based supervisory system and changes in solvency requirements.
- Fund management industry
  - Mutual funds assets are 14 percent of GDP; primarily in fixed income, about half in money market funds (maturity 90 days or less).
  - 2013 law Ley Unica de Fondos (effective May 1, 2014) unified legal framework, modernized regulation, improved investor protection, enhanced SVS supervisory powers, and set qualification requirements for fund managers.
- Pension funds
  - Privately-administered pension system is large by international standards; assets almost 60 percent of GDP (see above).
  - Government appointed a commission to propose parametric changes to ensure adequate replacement rates given declining returns and rising life expectancy.
  - Government plans to create a publicly-managed pension fund to complement six privately-managed funds; authorities stress the new fund manager would operate under same legal and regulatory framework and focus on enrolling workers not currently covered by private funds (e.g. self-employed, rural).

### Supervision, governance, and unfinished reforms
- Multiple agencies provide oversight: Central Bank (regulator), SBIF, SVS, Superintendence of Pensions (supervisors); Financial Stability Council chaired by Minister of Finance facilitates coordination and data sharing.
- Laws in Congress: two laws to provide legal framework to Financial Stability Council and strengthen SVS independence; should be implemented promptly once approved.
- Strengthening independence of banking supervisor (SBIF) is important.
- Conglomerates and consolidated supervision
  - Most financial institutions are part of conglomerates; current oversight relies on silo approach with built-in firewalls.
  - Authorities have advanced risk identification, tightened related-party exposure limits for banks, and improved coordination and information exchange.
  - Financial Stability Council law, when approved, will remove data sharing constraints among supervisors.
  - A more comprehensive approach (as suggested by 2011 FSAP) would require clear allocation of powers for continuous consolidated supervision, prudential regulation at conglomerate level, and corrective actions.
- Additional initiatives recommended
  - Prompt congressional approval of legislation expanding the credit registry with comprehensive credit history from banks and nonbanks.
  - Revise the General Banking Law (unfinished) to incorporate Basel III capital standards, improve legal framework for bank resolution, and strengthen SBIF independence.

### Financial sector reforms in progress (summary)
- Legal reforms currently in Congress:
  - Risk-based insurance supervision
  - Comprehensive credit registry
  - Stronger governance and independence for the Securities and Insurance Superintendence (SVS)
  - New legal framework for the Financial Stability Council, improving coordination and data sharing
- Regulatory changes under public consultation:
  - Standardized bank mortgage credit provisioning model linked to LTV levels
  - Enhanced liquidity regulation and reporting, in line with Basel III

*Source: IMF staff report content provided in the supplied PDF content unit.*

### 28.      The authorities explained that they are committed to push ahead with financial sector

### _cr14218 - 28.      The authorities explained that they are committed to push ahead with financial sector

### Financial sector reforms
- Authorities committed to prompt approval of legislative initiatives already in Congress.
- Other reforms to be pushed forward:
  - Revising the General Banking Law to complete the adoption of Basel bank capital standards.
  - Strengthening SBIF’s independence.
  - Modernizing the banking resolution framework.
- Timing of these reforms requires careful consideration given the broader policy agenda.
- Shorter-run action: the Central Bank has put in consultation a new proposed regulation for the sound management of banks’ liquidity risk.

### Enhancing the fiscal framework
- General assessment:
  - Chile has a fiscal rule since 2001 and a Fiscal Council created in 2013 (by ministerial decree).
  - There is scope to refine the fiscal framework, though no urgent need for changes.
  - Mission suggested consideration of modifications to provide more predictability and a stronger anchor for fiscal policy.
- The rule/target (recommendations):
  - Embed clearer guidance on medium-term objectives (e.g., structural balance or net assets) in the rule itself.
  - Historical note: when the rule was created the authorities set a structural surplus target of 1 percent of GDP.
  - Recommendation: a small structural surplus for “steady state” would help preserve the government net asset position.
  - Recommendation: an explicit escape clause to allow discretionary policy in the event of large, clearly defined shocks.
- The Fiscal Council (recommendations):
  - A law now in Congress will give the Council a stronger legal basis (expected approval soon).
  - Consider strengthening the Council’s autonomy and broadening its mandate (e.g., to include assessing outturns against targets).
- Authorities’ view:
  - Appreciated recommendations but did not see revisions to the fiscal framework or the Council’s mandate as immediate priorities.
  - Noted that the appropriate medium-run fiscal target will need further consideration and public discussion.

### STAFF APPRAISAL — macroeconomic outlook and policy stance
- Macroeconomic environment:
  - Chile confronting a challenging macroeconomic environment.
  - Activity has slowed markedly, reflecting adjustment toward trend after a period of rapid growth.
  - Signs of a budding recovery exist but are subject to considerable uncertainty and risk.
  - Growth prospects affected by waning/reversing tailwinds as global monetary policy normalizes and the copper price boom peters out.
  - Chile faces the headwind of a slowing working-age population.
- Structural reforms:
  - Strengthening prospects for strong and inclusive growth requires comprehensive structural reforms to rekindle productivity, spur investment, and boost human capital.
  - No single bottleneck; a broad reform effort is needed.
- Assessment of government reform agenda:
  - Tax reform is expected to reduce regressivity, close loopholes, raise permanent revenue to fund education reform and additional health spending, and raise public savings.
  - Tax reform may dampen investment and corporate savings, but other reforms (education, female labor force participation, labor market flexibility, infrastructure, innovation) could boost medium- and long-run growth.
  - Greater clarity on details, timetables, and priorities—followed by rigorous implementation—is critical.
- Current policy mix:
  - Freely floating exchange rate is acting as a shock absorber.
  - Monetary policy can remain accommodative so long as inflation expectations remain anchored.
  - Fiscal policy should remain broadly neutral with full operation of automatic stabilizers.
  - Authorities’ commitment to achieve a balanced structural fiscal position by 2018 is appropriate; the path should be calibrated to avoid excessive drag on the recovery.
- Fiscal framework enhancements:
  - Clearer guidance on medium-term fiscal objectives would provide a stronger anchor.
  - A small structural surplus target over the cycle would help preserve strong fiscal buffers.
  - An escape clause for discretionary policy in the event of shocks could enhance clarity and preserve flexibility.
  - Putting the Fiscal Council on a more solid legal basis is important; strengthened autonomy and a broader mandate would improve effectiveness.
- Financial oversight:
  - Chile has made significant progress since the 2011 FSAP, but important parts remain unfinished.
  - Important initiatives in Congress to complete:
    - Risk-based insurance supervision.
    - A comprehensive credit registry.
    - Stronger governance and independence of the Securities and Insurance Supervisor.
    - A new legal framework for the Financial Stability Council.
  - Follow-up needed to align capital standards with Basel III and provide greater independence to the Supervisor of Banks and Financial Institutions.
  - Monitor corporate sector financial health and leverage, and developments in the real-estate sector.
  - Ongoing strengthening of supervision of financial conglomerates is important; consider a more consolidated approach to oversight of conglomerates.
- Consultation scheduling:
  - Staff proposes to hold the next Article IV consultation on the standard 12-month cycle.

### Box 1 — Spillover Transmission Channels and Effects (summary)
- Chile is highly open: trade and financial openness indicators are the highest in the region and Chile is highly dependent on commodities exports.
- Key transmission channels: interest rates and commodity prices.
- Baseline medium-term impacts summarized (effects on GDP growth in percent):
  - 1 ppt increase in the U.S. federal funds rate: -0.61 (Chile), -0.42 (Regional Average).
  - 1 ppt increase in the 10-year U.S. Treasury bond yield: -0.64 (Chile), -0.13 (Regional Average).
  - 1 ppt increase in U.S. growth: 1.73 (Chile), 2.89 (Regional Average).
  - 1 ppt increase in the EMBI yield: -0.9 (Chile), -2.41 (Regional Average).
  - 1 standard deviation negative shock to Argentina's GDP: -0.04 (Chile).
  - Stable net commodity price index in 2014-19: -0.8 (Chile), -0.9 (Regional Average).
- Openness scores (In percent of GDP):
  - Trade Openness (exports+imports): 69.54 (Chile), 46.0 (Regional Average 1/).
  - Trade Exposure to US (exports): 11.11 (Chile), 11.3 (Regional Average 1/).
  - Financial Openness (international assets + liabilities): 226.5 (Chile), 131.4 (Regional Average 1/).
  - Exposure to Capital Flows (st. dev. of nonofficial flows): 3.0 (Chile), 3.0 (Regional Average 1/).
  - Commodity Concentration (net commodity exports): 14.4 (Chile), 9.1 (Regional Average 1/).
- Notes:
  - Source: Spring 2014 World Economic Outlook; Regional Economic Outlook Western Hemisphere.
  - 1/ Average includes Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela (commodity-price average differs as noted).
  - Effects reported are in percent of GDP growth; timing and averaging conventions as in original table.

### Box 2 — Tax Reform (summary of objectives, measures, and yields)
- Objectives of the tax reform proposal:
  - (i) Raise 3 percent of GDP in revenue to finance an increase in spending on education (1.5 percent of GDP) and other social program (0.5 percent), and close the structural fiscal deficit (1 percent).
  - (ii) Make the tax system more progressive.
  - (iii) Streamline savings and investment incentives and reduce tax avoidance and evasion.
  - Implementation over four years.
- Key elements:
  - Reform taxation of dividends: include undistributed profits in the shareholders’ personal income tax base; addresses FUT ledger complexity and tax planning/evasion.
  - Raise the flat corporate income tax rate from 20 to 25 percent and lower the top marginal personal income tax from 40 to 35 percent.
  - Measures to foster investment for SMEs: instant depreciation of investment (large companies eligible for 12 months); establish a unique simplified tax regime with greater coverage; increased tax credit for fixed-asset purchases.
  - Modify real-estate related taxes and strengthen some excise and green taxes:
    - VAT charged on the sale of new houses; existing VAT credit to builders of small houses will be reduced; capital gains from house sales taxed (except seller-occupied houses).
    - Financial transaction (stamp) tax increased.
    - Green taxes: import tax on highly-polluting diesel vehicles and an emission-based tax for industrial activity.
  - Strengthen revenue authority administrative capacity: revamp international tax norms and auditing practices, improve access to information, and strengthen equipment and staffing.
- Estimated steady-state yields (in percent of GDP):
  - Personal income taxation of undistributed profits /2 0.80
  - Increase in corporate tax rate 0.59
  - Measures to reduce evasion and avoidance 0.52
  - Real-estate related taxes 0.39
  - Diesel vehicles import tax and emission tax 0.17
  - Increase in stamp tax 0.15
  - Alcoholic and/or low nutritial value beverages tax 0.15
  - Other measures 0.25
  - Total 3.02
- Source: Ministry of Finance (Dipres).
- Note: 1/ Steady state level. 2/ Includes reduction of max. personal rate (-0.10% of GDP).

### Energy Reform Agenda — Targets by Numbers
- Reduce marginal electricity costs in SIC by 30 percent by 2017.
- Reduce bid prices for electricity supply by 25 percent by 2025.
- Reduce energy use by 20 percent by 2025.
- Achieve 20 percent share of renewables in the energy matrix by 2025.
- Source: National authorities.

*IMF staff report content from the provided PDF chapter/section.*

### Box 3. Electricity Sector in Chile

### Box 3. Electricity Sector in Chile

### Overview and system structure
- Chile imports about three-quarters of its energy needs, including for electricity generation.
- The Central Interconnected System (SIC) and Northern Interconnected System (SING) represent 75 and 24 percent of installed generation capacity, respectively.
- SIC is mostly hydropower and serves the central part of the country with over 90 percent of the population.
- SING is mostly thermal power, based on coal, natural gas and oil, and it serves the northern parts where the mining industry is located.
- Demand for electricity has been rising steadily, but several generation projects have been delayed due to environmental and administrative reasons.

### Prices and regional/sectoral variation
- Average electricity prices in Chile are not very different from the rest of the world.
- There can be large price differences across sectors and regions in Chile, but the averages are broadly in line (in levels or trend) with regional and OECD averages.

### Policy agenda and priorities (May 2014)
- The government’s energy agenda, launched in May 2014, seeks to:
  - promote investment and competition;
  - build consensus with local communities.
- The agenda focuses on:
  - facilitating new entrants;
  - promoting clean technologies;
  - improving energy efficiency;
  - improving the interconnection of the SIC and SING grids.

*Source: Box 3, "Electricity Sector in Chile," from the IMF staff report.*

### Annex I. Past Fund Advice

### Annex I. Past Fund Advice

### Fiscal Policy
- Recommendation: Withdrawal of the fiscal stimulus injected in 2009 and continuing gradual fiscal consolidation with the aim of a positive structural fiscal balance over the medium term.
- Traction:
  - The authorities gradually withdrew the fiscal stimulus injected in 2009 between 2011 and 2012, and adopted a tighter fiscal stance than implied by the 2013 budget.
  - Medium-term objective: achieve a balanced structural position by 2018 from the current structural deficit target of 1 percent of GDP.

### Monetary Policy
- Recommendation: Normalization of easy monetary policy stance following the global financial crisis to avoid inflationary pressures, and maintaining a neutral stance to support an orderly deceleration in activity towards trend. Cutting the monetary policy rate if (expected) inflation remains low and activity slows down. Letting the floating exchange rate be the first line of defense against external shocks.
- Traction:
  - The central bank accelerated the pace of policy normalization in early 2011 to help bring inflation expectations closer to the target, and maintained a neutral stance in 2012.
  - Amidst a low inflation environment and slowing economy, the central bank has cut the policy rate gradually starting in mid 2013.
  - Authorities see the exchange rate as a key shock absorber and let it adjust broadly without intervention.

### Financial Sector
- Recommendation: See Annex V on 2011 FSAP update.
- Traction: See Annex V on 2011 FSAP update.

### Structural Reforms
- Recommended priorities:
  - i) Establishing a reform agenda for boosting productivity growth
  - ii) Improving labor market efficiency and flexibility, including by streamlining the high minimum wage and severance payments, increasing the flexibility of working hours, raising (female and youth) labor participation, and improving the efficiency of training programs
  - iii) Enhancing energy supply and infrastructure
  - iv) Improving income distribution and access to quality education
- Traction and measures taken:
  - Government initiatives to boost productivity: reducing the cost of doing business, increasing competition (facilitating entry of new firms), making credit more accessible to small and medium enterprises, supporting innovation, strengthening protection of intellectual rights, speeding business incorporation, streamlining bankruptcy procedures, and reducing international trade costs.
  - Recent labor participation and equity measures: extending the length of maternity leave, employment subsidies for low income women and youth, and employment support and training services (albeit not used up extensively).
  - Authorities had difficulty achieving consensus on other measures to increase labor market flexibility and efficiency, and on enhancing generation and transmission of electricity.
  - Education and social protection: established an education quality assurance system, improved access to scholarships and state-guaranteed loans with lower interest rates, and strengthened (conditional) cash transfer programs recently.

---

### Annex II. A Closer Look at Investment

### Transformation of Investment Patterns
- Finding: The global copper boom has triggered a gradual transformation of investment in Chile; investment has become less focused on construction and much more on mining.
- Key statistics:
  - Mining share in GFCF increased from 15 percent in the early 2000s to 26 percent in 2012.
  - As a share of GDP, mining investment increased from 2.5 percent on average in 1976–2007 to 4.7 percent in 2008–2012.
  - Mining represents more than 13 percent of Chile’s GDP and more than 50 percent of Chile’s exports.
  - China’s copper demand represents more than 40 percent of total world copper consumption.

### Correlation with Copper Demand and Recent Collapse
- Finding: GFCF growth has become more tightly linked with copper demand; correlation between private GFCF growth and copper prices strengthened in the last five years (both on q/q and y/y basis).
- 2013 outcome:
  - Investment growth collapsed in 2013, particularly in the fourth quarter.
  - Private GFCF dropped by 12 percent y/y (11.4 percent q/q s.a.) in 2013Q4.
  - CBC data suggest a double digit decline in mining projects both q/q and y/y at end-2013.
  - Additional contributors: one-off base effects in transportation equipment in 2012, changes in statistical treatment of inventories (and GFCF), and tapering construction after post-2010 earthquake reconstruction.
  - An unexplained idiosyncratic domestic effect remains; business community cites uncertainty from the new government’s reform agenda, in particular the tax reform.

### Regression and VAR Analysis: Determinants of Private GFCF
- Regression setup and fit:
  - Dependent variable: quarterly growth of seasonally adjusted private GFCF.
  - Explanatory variables: first lag in the change of the exchange rate and real wages; second lag in the change of copper prices, interest rates, and expected GDP growth rate.
  - Regression with robust standard errors, 41 quarterly observations in 2003-13, and R2=0.62.
  - Note: Due to high correlation of copper price change, exchange rate depreciation, and Chile’s growth expectations with China’s growth, China’s growth was omitted from the regression.
- Regression coefficients and t-statistics (as reported):
  - Exchange rate (LC/US): Coefficient -0.54; t-statistic -4.22
  - Copper price: Coefficient 0.09; t-statistic 1.73
  - Real wage: Coefficient -0.83; t-statistic -1.27
  - Bank lending rate: Coefficient 0.07; t-statistic -0.13
  - Expected GDP growth rate: Coefficient 4.63; t-statistic -2.72
  - 10y US Government Bond Yield: Coefficient -0.04; t-statistic -2.37
  - Statistical significance legend: 1/ ***=1 percent confidence, **=5 percent, *=10 percent (note: table shows significance as ********* in source).
- VAR insights and caveats:
  - The copper price decline and exchange rate depreciation—both largely driven by demand deceleration in China—had a significant negative impact on private investment since mid-2013.
  - Weakening in the 1-year forward GDP growth expectations also appears to have had an effect on investment in the fourth quarter, while interest rates and real wages had a negligible effect.
  - Caveats:
    - Alternative models and specifications are not able to eliminate large residuals in 2012Q3 and 2013Q4; structural VAR projections show significant errors in those quarters.
    - Copper price, exchange rate, and Chile’s growth expectations are very highly correlated and likely jointly affected by external factors such as China’s demand for copper.
    - The VAR model suggests that a 1-percentage point increase in China’s growth leads to an increase in the copper price and appreciation of the Chilean peso by about 3.5 percentage points in 8 quarters and to a 4-percentage point increase in GFCF growth over the same horizon.
    - Some short-term effects appear counterintuitive (e.g., China’s growth having a negative impact on Chile’s investment growth in the short-run; exchange rate depreciation increasing import costs of capital goods in the short run).

### Short-term and Medium-term Outlook
- Short-term outlook:
  - With Chile’s mining investment boom coming to an end, copper prices on a downward trend, and weakening growth expectations, the short-term GFCF growth outlook remains uncertain.
  - Observed in 2014Q1: an 8-percent depreciation of the peso and a slight drop in the copper price imply investment growth is likely to remain weak in the short run.
  - An improvement in the 1-year forward output growth expectations is likely to have tangible effects only after the first half of 2014.
  - Sectoral prospects: CBC data suggest a significant rebound in the second half of 2014 can be expected only in energy projects.
- Medium-term outlook and planned investment:
  - Planned investment projects have been scaled down with deterioration in investment conditions in 2013; energy and mining have been affected the most.
  - Compared to investment plans at end 2013, mining projects will remain short by about 0.4 percent of GDP in 2014–17.
  - Projects in the energy sector have only been postponed and will be about 0.4 percent higher in the medium-term.
  - Construction is expected to be scaled up.
  - While the across-the-board postponement of planned 2014 investment is unlikely to recover fully in 2015–17, the government’s reforms agenda on energy and infrastructure—not reflected in these projections—is likely to be an important impelling force in investment recovery.
  - The exchange rate adjustment will foster export growth eventually, which should help propel investment growth in the medium term, as well.

*Source: Annex I and Annex II text from the provided IMF content unit.*

### Annex III. Recent Developments in Corporate Debt

### Annex III. Recent Developments in Corporate Debt

### Aggregate corporate debt levels and composition
- Corporate debt is currently at about 93 percent of GDP.
- Corporate debt has increased by about 10 percentage points since mid-2011 and has surpassed pre-crisis (2008) levels.
- FDI-related (external) debt accounts for most of this increase; FDI-related debt is mostly in mining and is likely to have a lower rollover risk than other forms of financing (e.g., bonds and bank loans) as it is between related parties.
- Breakdown by instrument (share of total non-financial corporate debt):
  - Bank credit: 49 percent
  - Factoring and leasing: 6 percent
  - Bonds: 14 percent
  - Foreign bank credit: 13 percent
  - External bond debt: 6 percent
  - External debt: trade credit: 3 percent
  - External debt: FDI: 9 percent
- About 50 percent of corporate debt is in the form of local bank credit.
- Local bonds and foreign bank credit together now represent each about 13.5 percent.
- Firms have increased issuance of external bonds to reach 6 percent of total corporate debt.
- Corporate maturing external debt will remain at about 6.5–7.25 percent of GDP a year over the next three years, in line with the 2005–13 average.

### Sectoral distribution and concentration
- Sectoral reliance on external vs. domestic financing:
  - Community services (mainly health and education) and the trade sector—the two sectors with the largest share of aggregate corporate debt—rely relatively less on external debt (20 percent of total debt).
  - Mining relies heavily on external debt, of which about half is in the form of FDI-related debt.
  - Construction and agriculture depend almost exclusively on domestic financing (in particular, bank financing).
- Sectoral shares of total debt (selected entries; percent):
  - Community services: 2009 = 20.3, 2012 = 22.2
  - Trade: 2009 = 15.3, 2012 = 18.3
  - Mining: 2009 = 5.2, 2012 = 7.4 (share of FDI-related debt in total debt: 2009 = 11.1, 2012 = 33.5; share of other external debt in total debt: 2009 = 59.9, 2012 = 34.9)
  - Total/average (selected summary): 2009 = 100, 2012 = 100; (share of FDI-related debt in total debt) 2009 = 3.9, 2012 = 7.6; (share of other external debt in total debt) 2009 = 23.1, 2012 = 20.4.

### Firm-level concentration and notable contributors
- Microeconomic data (Capital IQ database) on 319 Chilean firms reporting in both 2008 and 2012:
  - These firms’ total debt amounted to roughly 60 percent of GDP in 2012 (or about two-thirds of total corporate debt).
  - The increase in the indebtedness of five firms (between 2008 and 2012) equaled six percentage points of GDP.
  - Selected firms and their contribution to the aggregate increase (change in debt, 2008–2012; percentage points of GDP):
    - LATAM Airlines Group S.A. (Industrials): 2.10
    - Cencosud S.A. (Consumer Staples): 1.40
    - Corporación Nacional del Cobre de Chile (Materials): 1.20
    - AntarChile S.A. (Industrials): 1.00
    - Empresas CMPC S.A. (Materials): 0.60
  - Total contribution of these five firms: 6.1 (percentage points of GDP).

### Corporate profitability, leverage, and liquidity indicators
- Aggregate and sectoral trends:
  - In 2013, the food and transportation and telecommunication sectors experienced a marked decline in profitability and liquidity, and an increase in leverage.
  - The construction sector has almost doubled its leverage from the 2002–08 average; its profitability is lower but has remained stable since 2009.
  - The services sector has the highest leverage but is among the most profitable and liquid.
- Selected corporate financial indicators (examples):
  - Profitability (return over assets; in percent) — Total/average:
    - 2002-2008: 6.40
    - 2009-2012: 7.33
    - 2013: 5.80
  - Leverage (ratio of debt to equity) — Total/average:
    - 2002-2008: 0.63
    - 2009-2012: 0.67
    - 2013: 0.71
  - Liquidity (ratio of current assets minus inventories to current liabilities) — Total/average:
    - 2002-2008: 1.10
    - 2009-2012: 1.09
    - 2013: 0.94

### Indicators of vulnerability and stress-test results
- Currency mismatches remain limited, as reported by the central bank.
- Debt service capacity:
  - The median of the net debt to EBITDA ratio is quite high compared with other emerging market economies, but has remained stable.
  - A broader cross-country comparison of debt-to-equity ratios shows Chile roughly in line with its income level.
  - Interest coverage ratios (EBITDA divided by interest expenses) suggest Chilean companies have a relatively good capacity to service debt.
- IMF GFSR stress test (April 2014) scenario:
  - Assumed a 25 percent increase in borrowing costs and a 25 percent decline in earnings.
  - Result: a low increase in Chilean debt-at-risk relative to other emerging economies.
  - Debt-at-risk definition: the share of debts of firms with an interest coverage ratio below two after the shocks.
- Distributional indicators:
  - The share of debts with interest coverage ratio below two (ICR < 2) and ICR < 2 after stress are presented for multiple countries, with Chile included among peers.
  - The share of firms with high currency mismatches (mismatch < -10% or mismatch > 10%) has been tracked over time and remains limited.

### Financial sector exposures and resilience
- Corporate debt represents a large share of the Chilean financial system’s assets:
  - Commercial loans account for roughly 50 percent of banks’ portfolios.
  - Domestic corporate bonds account for 30 percent of life insurance companies’ investments and 10 percent of pensions funds’ investments.
- Central bank stress tests indicate the banking sector remains solvent even under extreme scenarios:
  - All banks maintain capital adequacy ratio above 8 percent in a test involving:
    - a 6 percentage point drop in output relative to baseline and subdued growth over the medium term;
    - a 300 basis points rise in interest rates and 100 basis points in the long term;
    - a 20 percent peso depreciation.

### Risk scenarios and recommended policy responses (from Risk Assessment Matrix)
- Potential external shocks:
  - Sharp slowdown in China's economic growth and a decline in the copper price.
    - Likelihood: Low in the short run; medium over the medium run.
    - Impact: High. China constitutes 25 percent of Chile's total exports of goods and nearly 40 percent of exports of mining products, making Chile vulnerable.
    - Recommended policy response:
      - The floating exchange rate is the first-line of defense.
      - Foreign exchange intervention could help avoid excessive currency volatility, if needed.
      - As long as inflation expectations remain well anchored over the policy horizon, there is room for monetary easing to support demand.
      - In case of more severe output drop, there would be ample room for a robust fiscal response.
  - Surges in global financial market volatility related to revised expectations on the exit from unconventional monetary policy.
    - Likelihood: High.
    - Impact: Medium. Chile's gross external financing requirements have declined since 2013, but remain at 17 percent of GDP, exposing the country to a sudden stop.
    - Recommended policy response:
      - The floating exchange rate remains the first line of defense. Foreign exchange intervention could help avoid excessive currency volatility, if needed.
      - Authorities should be prepared to react as they did at the onset of the global financial crisis and use measures to contain liquidity pressures: expanded repo operations, broadening the range of accepted collateral, and setting up dollar swap auctions.
- Potential domestic shocks:
  - Sharp decline in real estate prices.
    - Likelihood: Low/Medium.
    - Impact: Medium/Low. About 1/3 of banks' loan portfolio contains mortgage and construction company loans, and about 1/4 of life insurance companies' assets is in mortgage-related instruments. A decline in real estate prices could affect the construction and financial sectors and, through a drop in collateral values, trigger a cycle of tighter credit, lower economic activity, financial stress, and real estate prices.
    - Recommended policy response:
      - Priority to strengthen further financial oversight and regulation, including through macroprudential policies, as needed, to help prevent excessive exposure of the financial system.
      - In the event of a sharp correction in real estate prices, authorities should be ready to consider actions (easing off macroprudential and/or monetary policy) to dampen a possible vicious feedback loop between real estate prices, credit, and activity.

*Source: Annex III. Recent Developments in Corporate Debt (IMF Staff).*

### Annex V. 2011 FSAP Update––Status of Main Recommendations

### Annex V. 2011 FSAP Update––Status of Main Recommendations

### Reduce information gaps (consolidated credit registry; standardized residential and commercial property price indices)
- A bill was submitted to Congress in August 2011 to create a public credit bureau to consolidate data provided by financial institutions (banks, retailers, insurance companies, and others); it will include both positive and negative information for individuals and companies and will be managed by the Superintendence of Banking and Financial Institutions (SBIF).
- The Central Bank has started publishing residential housing price data back to 2001.
- The working group on Housing Market of the Financial Stability Council (CEF) has produced data on Loan-to-Value ratios.
- The BCCh intends to publish series on regional housing prices starting June 2014.
- Compiling a commercial property price index remains a working project.

### Develop a strategy to ensure adequate replacement rate for retirees
- The 2008 Pension Reform introduced a new solidarity pillar, measures to reduce the gender gap in old-age income (e.g. division of balance in case of divorce), subsidies for young workers, and gradual mandatory participation of independent workers (2012 was the first year of the phase-in transition).
- Mechanisms for voluntary pension savings with tax incentives were improved and widened; the collective voluntary saving mechanism has not yielded the expected results.
- The Superintendence of Pensions (SP) developed two methodologies to measure and forecast replacement rates:
  - One model uses administrative and survey data at the individual level and has been improved to better fit observed data.
  - A pension risk model used in a public web-based pension simulator that allows users to estimate their pension under different return assumptions; the simulator has been updated to simplify use and improve accuracy, with additional improvements planned for 2014.
- Since its launching, the simulator has averaged 10 thousand visits per month.
- The SP launched a web tool for members to check if employers have paid contributions on behalf of workers.
- Ongoing joint work with the OECD on computing replacement rates.
- The new government appointed a commission of 25 national and international experts to work on proposals to improve replacement rates and other aspects of the pension system; a report by the commission is expected by January 2015.

### Strengthen independence and legal protection of regulatory agencies
- In 2013, the Government submitted a draft law to Congress to improve governance of the Superintendence for Securities and Insurance (SVS) by converting it to a Commission managed by a five-member council.
  - The Chairman remains appointed by the president but can no longer be removed remove at will.
  - Commissioners are submitted by the President to the Senate for approval and are protected from dismissal for political reasons.
  - The draft law proposes improvements to enforcement and transparency (an annual report will be published and regulatory impact assessment will be made prior issuing new regulations) and extends legal defense in the performance of official duties to Commissioners and the Prosecutor.
  - It grants the Commission significant increases in budget and staff.
- The bill has been approved by the lower house and is currently being discussed in the upper house.
- No action has been taken to enhance the independence of other agencies including the banking supervisor (SBIF).

### Strengthen enforcement powers of securities regulators
- The draft law would establish a Securities and Insurance Prosecutor—an autonomous body in charge of investigation and enforcement proceedings.
- Sanctions will be applied by the Commission upon conclusion of the investigation by the Prosecutor.
- The bill enhances the supervisor’s power to request information, access and share confidential information, and introduces plea bargain and whistleblowers as additional investigative tools.

### Complete incorporation of Basel bank capital standards; strengthen legal framework for bank resolution
- A draft bill focused on incorporation of Basel bank capital standard has been elaborated, but amendments to enhance independence of the SBIF and major changes to the legal framework for bank resolution were not included.
- The new administration is deciding how to proceed with this project.
- The SBIF and the Central Bank are working on improvements in liquidity regulation and reporting, taking into consideration recent proposals of the Basel Committee on Banking Supervision.

### Establish legal framework for consolidated oversight of financial conglomerates
- The Committee of Financial Superintendents (CSSF) is developing a methodology for supervision of financial conglomerates, including overall risk assessment and identification of lead supervisors.
- The CSSF has established formal rules for sharing information relevant for supervision and regulation.
- The new Financial Stability Council (CEF) builds on the work of the CSSF and is supported by three working groups: Risk Analysis, Regulation and Legislation, and Financial Conglomerates (the latter is working on identifying key indicators of financial health for conglomerates).
- In 2013 a draft bill was submitted to Congress to grant legal status to the CEF and improve coordination and information exchange between staff of the regulatory agencies for assessing systemic risks and supervision of financial conglomerates.

### Enhance uniformity in business conduct regulation for asset management services and investment advice
- In December 2011, the SVS issued regulation on internal control and risk management for securities intermediaries, setting minimum requirements for control and risk management.
  - Securities intermediaries must have an Internal Audit Unit and an internal risk management system consistent with the complexity of operations.
  - Senior executives will be accountable for implementation of internal control and risk management.
  - A staff’s code of conduct will be required.
- The Ley Unica de Fondos that standardizes regulation in the fund industry was approved in 2013 and became effective on May 2014.
  - Within this framework, the bill allows the SVS to establish minimum knowledge and professional standards for directors, managers, executives and other relevant functions for the fund management company.
  - It allows the establishment of fit and proper requirements for managers of individual portfolios.

### Introduce comparable transparency standards for fixed income securities traded outside exchanges
- The SVS is reviewing the topic and assessing the necessity of amending the law.
- Short/medium term goals include standardizing information contained in the CSDs, CCPs, and Stock Exchanges’ trade repositories to facilitate access to OTC trades done, cleared or settled through those entities.

### Adopt comprehensive approach to custodial, clearing, and settlement infrastructure
- The SVS is working on draft rules to improve corporate governance and risk management standards of CSDs, CCPs, and Stock Exchanges.
- IOSCO PFMIs will be taken into account during the rulemaking process.

### Further enhance the AML/CFT framework
- In April 2011, the Financial Analysis Unit (UAF), SVS, SBIF, and the SP issued regulations against corruption of senior government officials, establishing criteria to define Politically Exposed Persons (PEP) and procedures for financial intermediaries to determine the source and destination of funds of such persons.
- All entities supervised by the UAF are required to register all transactions of PEP and inform of any suspicious operations.
- Progress has been made on GAFISUD recommendation to require foreign subsidiaries to inform about activities carried out in countries not in compliance with the set standards.
- In 2013, the UAF initiated 315 punitive procedures for non-compliance with anti-money laundering regulations.
- In January 2013, Circular #49 came into force, consolidating supervised entities’ main obligations related to AML/CFT, particularly regarding record keeping, information and reporting, and prevention system functions and implementation.
- In March 2013 the ministers of Interior and Finance jointly launched the “National strategy against money laundering,” a task force involving more than 20 public institutions; a document produced suggested a total of fifty measures to address identified challenges.
- During 2013 the Congress continued second reading of a draft law to adapt current legal regulation on prevention and sanction of crimes of money laundering and terrorism financing to international standards established by FATF-GAFI.

### Consider introduction of a premium-based limited deposit insurance system
- There have been no changes to date.

### Examine options to establish a framework for dealing with a systemic crisis and with potential failure of a financial conglomerate
- The Finance Ministry, Central Bank, and the SBIF conducted a joint crisis exercise in 2011, coordinated by Crisis Management Analytics.
- Progress in enhancing supervision of conglomerates noted; a draft bill will be submitted to Congress to provide the CEF a legal framework and to strengthen supervisors’ capacity to request information on conglomerates.
- Further information mechanisms developed by financial regulators:
  - The SBIF signed MoUs for information sharing with supervisory authorities in Panama and Colombia; MoUs with Brazil and Peru are under review, as well as amendments to the MoU signed with the U.S. and Spain.
  - The SVS signed a MoU with the Peruvian Securities Market Superintendence and the Financial Superintendence in Colombia in the context of an integration project of stock exchanges of Peru, Colombia, and Chile.

*Annex V. 2011 FSAP Update––Status of Main Recommendations (_cr14218).*

### Annex VI. Debt Sustainability Analysis

### Annex VI. Debt Sustainability Analysis

### External Debt Sustainability — Bound Tests and Projections
- Figure A6.1 presents external debt sustainability bound tests with individual shocks described as "permanent one-half standard deviation shocks."
- Scenario labels shown in figures: "Baseline", "Historical", "Interest rate shock", "CA shock", "Combined shock", "Real depreciation shock", "Growth shock", and "Gross financing need under baseline (right scale)".
- Specific scenario note: "Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance."
- Specific scenario note: "One-time real depreciation of 30 percent occurs in 2015."
- Baseline: External debt41.8 38.9 39.2 44.1 47.2 52.4 51.7 50.8 49.9 49.0 47.6 -4.6
- Change in external debt6.3 -2.9 0.4 4.9 3.0 5.2 -0.7 -0.9 -0.9 -0.9 -1.4
- Identified external debt-creating flows (4+8+9) -3.7 -12.5 -5.8 0.8 -1.3 -1.5 -2.1 -1.9 -1.9 -1.6 -1.5
- Current account deficit, excluding interest payments -2.9 -2.5 0.4 2.3 2.3 1.8 1.6 1.8 1.7 1.8 1.8
- Deficit in balance of goods and services -66.6 -69.3 -72.2 -67.8 -64.9 -69.2 -66.7 -64.7 -63.1 -61.5 -59.9
- Exports 37.2 37.8 37.7 34.0 32.3 34.6 33.4 32.3 31.5 30.7 29.9
- Imports -29.4 -31.5 -34.5 -33.9 -32.6 -34.5 -33.4 -32.4 -31.6 -30.9 -30.0
- Net non-debt creating capital inflows (negative) -3.2 -2.2 -1.8 -0.3 -3.0 -3.0 -2.8 -2.6 -2.4 -2.3 -2.1
- Automatic debt dynamics 1/ 2.4 -7.8 -4.4 -1.2 -0.6 -0.3 -0.9 -1.1 -1.1 -1.1 -1.2
  - Contribution from nominal interest rate 0.9 0.9 0.9 1.1 1.1 1.2 1.2 1.0 0.9 0.8 0.8
  - Contribution from real GDP growth 0.4 -1.9 -1.9 -2.0 -1.8 -1.6 -2.0 -2.0 -2.0 -2.0 -1.9
  - Contribution from price and exchange rate changes 2/ 1.2 -6.8 -3.3 -0.3 0.1 ..................
- Residual, incl. change in gross foreign assets (2-3) 3/ 10.0 9.6 6.2 4.1 4.3 6.7 1.4 1.0 1.0 0.7 0.1
- External debt-to-exports ratio (in percent) 112.5 102.7 104.1 130.0 146.1 151.3 155.1 157.4 158.6 159.7 159.2
- Gross external financing need (in billons of US dollars) 4/28253555594439.2841424445
- Gross external financing need in percent of GDP 16.1 11.4 14.1 20.6 21.2 16.8 14.1 13.8 13.2 12.7 12.3
- Scenario with key variables at their historical averages 5/ 52.4 44.5 37.1 30.3 23.9 17.7 -5.2

Key macroeconomic assumptions underlying baseline (explicit entries preserved):
- Real GDP growth (in percent) -1.0 5.7 5.8 5.5 4.2 3.2 4.1 4.2 4.2 4.3 4.3
- GDP deflator in US dollars (change in percent) -3.2 19.4 9.2 0.7 -0.2 -7.9 2.0 2.4 2.5 2.9 3.0
- Nominal external interest rate (in percent) 2.4 2.6 2.5 3.0 2.5 2.5 2.3 2.0 1.9 1.8 1.7
- Growth of exports (US dollar terms, in percent) -15.0 28.6 14.9 -4.4 -1.0 1.8 2.3 3.3 4.3 4.5 4.7
- Growth of imports (US dollar terms, in percent) -28.1 35.2 26.5 4.2 0.1 0.7 2.7 3.7 4.2 4.6 4.3
- Current account balance, excluding interest payments 2.9 2.5 -0.4 -2.3 -2.3 -1.8 -1.6 -1.8 -1.7 -1.8 -1.8
- Net non-debt creating capital inflows 3.2 2.2 1.8 0.3 3.0 3.0 2.8 2.6 2.4 2.3 2.1

Notes and definitions included in the analysis:
- 1/ and 3/ explain formulas for automatic debt dynamics and residuals.
- 4/ Defined as current account deficit, plus amortization on medium-and long-term debt, plus short-term debt at end of previous period.
- 5/ Key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.
- 6/ Debt-stabilizing non-interest current account: "Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection."

### Public Sector Debt Sustainability (DSA) — Baseline Scenario and Composition
- Table A6.2 and Table A6.3 provide public-sector debt projections, identified debt-creating flows, and alternative scenarios (Historical, Constant Primary Balance, Contingent Liability Shock).
- Sovereign spreads and market indicators (selected entries exactly as presented):
  - Nominal gross public debt 7.7 12.0 12.5 13.2 14.0 14.4 14.7 14.8 14.8
  - Bond Spread (bp) 3/143
  - Public gross financing needs -0.5 0.9 2.1 2.3 2.3 1.2 1.6 0.9 1.2 5
  - Y CDS (bp)73
  - Net public debt (excludes Pension Reserve Fund) -5.2 -4.6 -3.9 -2.6 -1.3 -0.4 0.1 0.4 0.6
  - Real GDP growth (in percent) 4.6 5.5 4.2 3.2 4.1 4.2 4.2 4.2 4.3
  - Inflation (GDP deflator, in percent) 6.0 1.3 1.7 3.8 2.8 2.8 2.9 2.9 3.0
  - Nominal GDP growth (in percent) 10.9 6.8 5.9 7.0 7.0 7.2 7.3 7.2 7.4
  - Ratings (Foreign / Local): Moody's Aa3 / Aa3; S&Ps AA- / AA+; Fitch A+ / AA-
- Cumulative change in gross public sector debt  -0.4 0.8 0.5 0.8 0.7 0.4 0.3 0.1 0.0 2.3
- Identified debt-creating flows -0.9 0.6 1.0 1.2 1.3 1.0 0.9 0.7 0.7 5.7
  - Primary deficit -2.5 -0.7 0.5 1.2 0.8 0.4 0.1 -0.2 -0.2 2.2
  - Primary (noninterest) revenue and grants 21.9 21.7 20.5 20.4 20.8 21.1 21.7 22.3 22.3 128.6
  - Primary (noninterest) expenditure 19.4 21.1 21.0 21.6 21.6 21.5 21.8 22.2 22.1 130.7
- Automatic debt dynamics 5/ -0.5 -0.3 0.1 -0.2 -0.2 -0.1 -0.1 -0.1 -0.1 -0.8
  - Interest rate/growth differential 6/ -0.2 -0.1 -0.1 -0.2 -0.2 -0.1 -0.1 -0.1 -0.1 -0.8
    - Of which: real interest rate 0.2 0.5 0.4 0.2 0.3 0.4 0.4 0.5 0.5 2.3
    - Of which: real GDP growth -0.4 -0.6 -0.5 -0.4 -0.5 -0.6 -0.6 -0.6 -0.6 -3.2
  - Exchange rate depreciation 7/ -0.4 -0.2 0.2 .....................
- Other identified debt-creating flows 2.2 1.6 0.4 0.2 0.7 0.7 1.0 1.0 1.0 4.4
  - Deposits/asset accumulation (negative) 2.2 1.6 0.4 0.2 0.7 0.7 1.0 1.0 1.0 4.4
  - Contingent liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
- Residual, including asset changes 8/ 0.5 0.2 -0.5 -0.4 -0.5 -0.6 -0.6 -0.6 -0.6 -3.4
- Table A6.3: Composition of Public Debt and Alternative Scenarios — underlying assumptions (selected sets preserved):
  - Baseline underlying assumptions (2014–2019): Real GDP growth 3.2 4.1 4.2 4.2 4.3 4.3; Inflation 3.8 2.8 2.8 2.9 2.9 3.0; Primary Balance -1.2 -0.8 -0.4 -0.1 0.2 0.2; Effective interest rate 5.3 5.7 6.1 6.3 6.5 6.7
  - Historical scenario underlying assumptions (2014–2019): Real GDP growth 3.2 4.7 4.7 4.7 4.7 4.7; Inflation 3.8 2.8 2.8 2.9 2.9 3.0; Primary Balance -1.2 2.3 2.3 2.3 2.3 2.3; Effective interest rate 5.3 5.7 6.3 6.6 7.1 7.7
  - Constant Primary Balance scenario: Primary Balance -1.2 across 2014–2019 with other assumptions matching baseline.
  - Contingent Liability Shock scenario includes Primary Balance series -1.2 -8.7 -0.4 -0.1 0.2 0.2 and elevated effective interest rate path 5.3 7.9 6.9 6.9 7.0 7.1

### Scenarios, Shocks, and Alternative Paths
- Interest rate shock: illustrated in Figure A6.1 as an upward-bound test; identified as permanent one-half standard deviation shock in chart notes.
- Growth shock: documented in figure annotations; growth shock (in percent per year) with baseline, scenario, historical values listed: Baseline: 1.9 2.2 2.9; Scenario: 4.2 3.1 4.7; Historical: -1.7 -3.3 1.5 (preserved exactly as displayed in figure area).
- Current account shock (CA shock) and combined shocks are explicitly presented in the figure panels with baseline and scenario averages shown (e.g., CA shock 55 Baseline 48; Combined shock 53 Baseline 48).
- Real depreciation shock: "30 % depreciation" panel noted with baseline 48 and scenario value in figure text (e.g., "30 % depreciation 70 Baseline 48").
- Historical scenarios: "For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead."

### Key Statistics and Indicators (preserved as in tables/figures)
- External debt-to-exports ratio (in percent): 112.5 102.7 104.1 130.0 146.1 151.3 155.1 157.4 158.6 159.7 159.2
- Gross external financing need (in billons of US dollars) raw string as presented: 28253555594439.2841424445
- Gross external financing need (in percent of GDP): 16.1 11.4 14.1 20.6 21.2 16.8 14.1 13.8 13.2 12.7 12.3
- Public debt indicators (selected): Nominal gross public debt 7.7 12.0 12.5 13.2 14.0 14.4 14.7 14.8 14.8; Net public debt (excludes Pension Reserve Fund) -5.2 -4.6 -3.9 -2.6 -1.3 -0.4 0.1 0.4 0.6

*Source: Annex VI. Debt Sustainability Analysis, staff calculations as presented in the IMF staff report (As of May 19, 2014).*

### 7. RAS Planning Water Infrastructure

### 7. RAS Planning Water Infrastructure

### Macroeconomic context and outlook
- Chile confronting a challenging macroeconomic environment after several years of strong performance.
- Investment has weakened and growth slowed markedly in part due to a weaker copper price outlook; the economy is performing slightly below potential.
- The depreciation of the peso has fed into higher inflation, but medium-term expectations remain anchored around the Central Bank’s target.
- The current account deficit narrowed rapidly to 3.1 percent of GDP in the first quarter of 2014; gross external financing needs remain high at 17 percent of GDP.
- Labor market has softened though remains relatively tight.
- Growth projections:
  - Growth will reach 3.2 percent in 2014 and recover to its potential level by 2016.
- Key risks to the outlook:
  - Further declines in copper prices.
  - Global financial volatility.
  - Potential further weakening in investment and consumption of durable goods.

### Monetary and fiscal policy stance
- Monetary policy:
  - Central Bank reduced the policy rate from 5 to 4 percent between October 2013 and April 2014.
  - Monetary easing transmitted to interbank and lending rates and contributed to peso depreciation.
  - Credit growth moderated for all types except mortgage credit, which remains brisk.
- Fiscal policy:
  - Fiscal policy described as broadly neutral, with full operation of automatic stabilizers.
  - 2013 structural deficit was 0.8 percent of GDP (staff estimate).
  - Fall in copper revenue shifted the headline balance to a deficit of 0.6 percent of GDP from a surplus of equal size in 2012.
  - Central government net assets remained at 6.7 percent of GDP.
  - Authorities committed to move toward a balanced structural fiscal position by 2018 while minimizing drag on the recovery.

### Structural reform agenda and policy priorities
- Government policy agenda aims to bolster long-term growth and reduce inequality through reforms in:
  - Taxation: aim to create a more progressive tax structure and raise 3 percent of GDP in revenue to fund greater spending on education and health, while raising public savings.
  - Education: focus on early childhood education, equal access, improving quality and accountability.
  - Energy: promote investment and efficiency and facilitate use of clean technologies.
  - Competitiveness: improving infrastructure, promoting research and development and job training, and new services for small and medium-enterprises.
- Financial sector reforms:
  - Legislation sent to congress to establish risk-based insurance supervision and a comprehensive credit registry, and to strengthen legal framework of the Securities and Insurance Supervisor and the Financial Stability Council.
  - Commission appointed to propose parametric changes to the private pension system to ensure adequate replacement rates.

### Executive Board assessment
- Directors commended sound macroeconomic management and robust recent performance.
- Acknowledged challenges from end of copper price boom and normalization of global monetary conditions, but noted Chile’s strong fundamentals and policy frameworks, including a floating exchange rate.
- Directors’ policy views:
  - Current macroeconomic policy mix broadly appropriate.
  - With inflation expectations well anchored and some remaining slack, monetary policy can remain accommodative, but vigilance needed given recent inflation developments.
  - Broadly neutral fiscal stance supported, with full operation of automatic stabilizers.
  - Support for authorities’ commitment to move toward balanced structural fiscal position by 2018.
- Structural reform emphasis:
  - Improve education, foster female labor force participation, upgrade key infrastructure, and promote energy efficiency.
  - Support tax reform objectives: increase progressivity and generate permanent revenue for social spending while maintaining incentives for private investment.
- Fiscal framework and institutions:
  - Commended fiscal prudence anchored in a credible fiscal rule.
  - Welcomed plan to strengthen legal framework for the Fiscal Council; consideration could be given to increasing its autonomy and broadening its mandate in the medium term.
  - Consideration of setting a small structural surplus target over the cycle to preserve buffers.
- Financial sector oversight:
  - Recognized progress in enhancing oversight and resilience.
  - Encouraged completing Financial Sector Assessment Program recommendations, aligning capital standards with Basel III, and strengthening independence of the Supervisor of Banks and Financial Institutions.
  - Noted need for consolidated oversight of financial conglomerates and monitoring of corporate leverage, the real estate sector, and insurers’ exposure to commercial real estate.

### Key economic indicators and selected statistics (as presented)
- GDP (2012), in billions of pesos: 129,553
- GDP (2012), in billions of U.S. dollars: 266.3
- Quota in millions of SDRs: 856
- Per capita (U.S. dollars): 15,302
- in % of total: 0.36%
- Population (2012), in millions: 17.4
- Poverty rate (2011): 14.4
- Main products and exports: Copper
- Gini coefficient (2011): 0.52
- Key export markets: China, Euro area, U.S.
- Literacy rate (2011): 98.9

- Selected annual growth and levels (2009–2015, annual percentage change or percent of GDP as labelled):
  - Real GDP: -1.0 (2009), 5.7 (2010), 5.8 (2011), 5.5 (2012), 4.2 (2013), 3.2 (2014), 4.1 (2015)
  - Total domestic demand: -5.6, 13.6, 9.2, 7.0, 3.8, 2.7, 4.2
  - Consumption: 0.8, 9.7, 7.8, 5.6, 5.4, 3.8, 4.2
    - Private consumption: -0.8, 10.8, 8.9, 6.0, 5.6, 3.2, 4.1
    - Public consumption: 9.2, 4.6, 2.5, 3.7, 4.2, 6.0, 4.3
  - Investment: -23.6, 27.5, 14.4, 10.9, -0.8, -0.6, 4.3
    - Fixed investment: -12.1, 12.2, 14.4, 12.2, 0.4, 1.8, 4.6
    - Private fixed: -17.6, 17.8, 15.2, 13.1, 0.7, 0.7, 4.5
    - Public fixed: 37.7, -18.4, 8.4, 4.0, -2.7, 11.8, 5.2
  - Net exports (contribution to growth): 4.5, -7.7, -4.1, -1.7, 0.6, 1.3, -0.6
  - Exports: -4.5, 2.3, 5.5, 1.1, 4.3, 3.7, 3.2
  - Imports: -16.2, 25.9, 15.6, 5.0, 2.2, 0.1, 4.2
  - Unemployment rate (annual average): 10.8, 8.2, 7.1, 6.4, 5.9, 6.4, 6.4
  - Consumer prices end of period: -1.5, 3.0, 4.4, 1.5, 3.0, 4.4, 3.0
  - Consumer prices average: 1.5, 1.4, 3.3, 3.0, 1.8, 4.5, 3.3
  - Central government revenue (% of GDP): 19.1, 21.6, 22.6, 22.2, 20.9, 20.9, 21.4
  - Central government expenditure (% of GDP): 23.4, 22.0, 21.3, 21.6, 21.5, 22.2, 22.3
  - Central government fiscal balance (% of GDP): -4.4, -0.5, 1.3, 0.6, -0.6, -1.3, -0.9
  - Structural fiscal balance (% of GDP): -4.7, -2.7, -1.1, -0.4, -0.8, -1.1, -0.7
  - Nonmining structural primary fiscal balance (% of non-mining GDP): -7.4, -5.7, -3.3, -2.9, -3.0, -3.4, -2.7
  - Fiscal impulse: 4.9, -1.7, -2.4, -0.4, 0.1, 0.4, -0.7
  - Public sector net debt: -6.5, -2.2, -4.9, -1.7, -2.8, -2.4, -0.9
  - Public sector gross debt: 27.5, 25.9, 34.8, 34.5, 34.3, 34.3, 34.2
  - Central government gross debt: 5.8, 8.6, 11.1, 12.0, 12.5, 13.2, 14.0
  - Share of FX-denominated central government debt (percent): 22.8, 17.3, 17.2, 16.1, 13.4, 12.0, 10.4
  - Broad money (percentage change): -5.3, 9.3, 18.5, 7.6, 14.9, ...... 
  - Credit to the private sector (percentage change): -1.4, 7.1, 16.9, 12.1, 9.7, ...... 
  - 3-month central bank bill rate (%): 1.8, 1.7, 4.9, 5.1, 5.0, ...... 
  - Current account (percent of GDP): 2.0, 1.6, -1.2, -3.4, -3.4, -3.1, -2.8
  - Current account (in billions of U.S. dollars): 3.5, 3.6, -3.1, -9.1, -9.5, -8.1, -7.7
  - Foreign direct investment inflows: 7.5, 7.2, 9.3, 10.7, 7.3, 7.7, 7.2 (in percent of GDP)
  - Gross international reserves (in billions of U.S. dollars): 25.4, 27.9, 42.0, 41.6, 41.1, 41.1, 41.1
  - Reserves in months of next year's imports of goods and services: 4.5, 3.9, 5.6, 5.5, 5.4, 5.3, 5.1
  - Gross external debt: 41.8, 38.9, 39.2, 44.1, 47.2, 52.4, 51.7
    - Public: 7.7, 7.9, 8.2, 9.5, 9.2, 9.5, 9.4
    - Private: 34.1, 30.9, 31.1, 34.7, 38.0, 42.8, 42.3
  - Real effective exchange rate (real appreciation +): -2.2, 5.9, 0.9, 3.7, -1.2, ...... 
  - Terms of trade: 4.3, 22.0, 1.6, -6.1, -2.5, -3.0, 0.7

### Authorities’ statement (high-level)
- Chile’s macroeconomic policy framework based on three pillars:
  - Structural fiscal rule accounting for long-term copper price and business cycle.
  - Inflation-targeting framework by an independent central bank.
  - Well capitalized and adequately regulated financial system.
- Recent developments noted by authorities:
  - Deceleration since early 2013; Central Bank revised 2014 output growth forecast from a range between 3.0 and 4.0 percent to a range between 2.5 and 3.5 percent.
  - Nominal exchange rate depreciated approximately 20 percent since May 2013, aiding competitiveness and export performance.
  - Current account expected to shrink to 2.5 percent of GDP in 2014.
- Monetary policy actions:
  - Central Bank cut policy rate 4 times since October 2013 with cumulative cut of 100 basis points from 5 percent to 4 percent.
  - Monetary policy rate kept at 4 percent since March 2014 to provide stimulus to domestic demand.

*Source: IMF Press Release No. 14/357 and IMF staff Country Report content (June–July 2014).*

### 4.7 percent in May, above the upper limit of the target band. The authorities expect this pass-

### _cr14218 - 4.7 percent in May, above the upper limit of the target band. The authorities expect this pass-

### Inflation and monetary policy
- Inflation recorded at 4.7 percent in May, above the upper limit of the target band.
- Authorities expect this pass-through to be transitory and for inflation to converge to the 3 percent target within the two-year policy horizon.
- Private inflation expectations have remained firmly anchored in the 3 percent target.
- Monetary authorities will evaluate further monetary easing should domestic and external conditions imply a deviation from the objective of maintaining price stability.
- Current assessment: cyclical downturn expected to reduce inflationary pressures, but monetary conditions are already supportive and recent price dynamics have been higher than expected.
- Policy approach: proceed with caution, weigh risks, and prioritize fulfilling the mandate of price stability.

### Fiscal policy
- New administration took office in March 2014 and will continue to implement prudent fiscal policy in line with the structural fiscal rule.
- Structural budget balance for FY 2013 was -0.7 percent.
- Budget law considers a structural deficit of -1 percent in FY 2014.
- Government announced intention to eliminate the structural deficit gradually to reach structural balance by the end of their term in 2018.
- Fiscal Responsibility Act of 2006 requires incoming governments to announce structural fiscal targets for the full length of their mandate within the first 90 days of their administration.
- Chile remains a net creditor; assets in sovereign wealth funds have been built back up to pre-crisis levels.
- Staff warning: maintaining structural balance would erode these buffers as a share of GDP; staff recommended adopting a small structural surplus to preserve them.
- Authorities’ view: buffers provide favorable access to debt markets and capacity to respond to large external shocks, but carrying large buffers imposes substantial opportunity costs in terms of forgone social investment.
- Authorities are open to further discussions and cost-benefit analysis to define appropriate structural balance targets.
- Authorities welcome Fund recommendations to strengthen the institutionality of the Fiscal Council, see merit but do not view it as an immediate priority.
- Observation: institutionality of fiscal prudence and transparency in Chile has been continually improved over past decades.

### Financial sector
- Recent cuts to the monetary policy rate have been effectively transmitted to local financial markets.
- Combination of low risk premiums has generated historically low rates on public and private fixed income instruments.
- Favorable financing conditions have not generated excessive growth in household credit; financial sector remains broadly resilient.
- Risks: cyclical economic slowdown combined with loose financing conditions could pose potential risks monitored by the central bank and financial supervisors.
- Corporate sector has increased debt levels taking advantage of favorable conditions; leverage ratios remain contained but increases reduce resilience to large shocks.
- Real estate sector remains dynamic; vacancy rate in commercial real estate has increased in recent quarters.
- Mortgage growth has remained stable; slight moderation in share of mortgages with high LTV ratios and slight tightening of credit conditions for these loans.
- Monetary authorities are vigilant and have undertaken extensive analysis in recent Financial Stability Reports.
- Over the past two years, authorities have made recurrent calls warning market participants not to extrapolate recent real estate price dynamics; these calls have been effective in moderating some incipient trends.
- Authorities welcome staff support for regulatory reforms before Congress:
  - Financial Stability Council law will strengthen institutionality, give broader powers to share information across supervisory agencies, and increase ability to supervise large conglomerates spanning banking, insurance, pension fund administration, and commercial undertakings.

### Reform agenda
- Chile’s economy has performed exceptionally well for several decades, with high average growth rates and declining macroeconomic volatility, enabling improved income status and substantial reductions in the poverty rate.
- Authorities identify two important challenges: boosting productivity growth and lowering excessive inequality.
- Overcoming these challenges requires extensive structural reforms to enhance medium-term growth prospects.
- President Bachelet has proposed reforms in education, taxes, productivity, and energy aimed at delivering inclusive growth; education system identified as a key bottleneck to both productivity and inequality objectives.
- Current public spending on education is low by international standards; fresh resources will be required to improve access and quality.
- Authorities commit to fiscal prudence: all new permanent expenditures will be matched by increases in structural revenues.
- Proposed tax reform aims to raise structural revenue by 3 percent of GDP.
  - Two-thirds of the revenue will be ear-marked for financing the education reform and other social spending.
  - Remaining one-third will be used to increase public savings by eliminating the current structural deficit of 1 percent of GDP by 2018.
  - This will complete gradual withdrawal of the stimulus initially deployed in response to the 2009 crisis.
- Tax reform design objectives:
  - Raise revenue while maintaining adequate incentives for private investment and activity.
  - Make the tax system more progressive.
  - Shift tax burden towards direct taxes because indirect taxes represent more than half of fiscal revenue.
  - Measures include (i) raising the corporate income tax and (ii) closing a benefit that allows firms to defer payment of taxes on undistributed profits (used extensively for tax evasion).
  - Top personal income tax bracket will be lowered to reduce the gap between the Personal Income Tax (PIT) and Corporate Income Tax (CIT) rates and reduce incentive to elude payment via creation of shell companies.
  - Given size of changes, implementation will be gradual over coming years.
- Authorities agree rapid passage of legislation is important to avoid uncertainty but contend the reform must be given sufficient time for legislative debate.
- Main aspects of the proposal have not changed since initial presentation during the Presidential campaign almost one year ago and have been approved by an ample majority in the lower house.
- As part of legislative process, authorities will discuss additional measures to increase corporate savings and investment while maintaining core objectives and main aspects of the reform.
- Fund engagement: welcome Fund’s decision to co-host the High-Level Conference on “Inclusiveness and Growth in Latin America” with the Government of Chile in Santiago later this year as part of the Road to Lima 2015 events; conference will consider longer-term challenges faced by Latin American countries as they reach middle-income status and leverage Fund international experience to help members achieve development goals.

*Source: IMF staff report content unit _cr14218*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14218.pdf_