## _cr16376

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### Executive summary — context and overarching assessment
- Chile’s fundamentals and policy framework remain strong, but prospects are shaped by lower dynamism in key trading partners, permanently lower copper prices, slower trend growth, and mounting social demands for inclusive growth.
- Important reforms are underway to lift growth and reduce inequality, but they generate transition costs; staff recommendations aim to balance trade-offs between growth, stability, and social objectives.

### Near-term outlook and key macro projections
- Growth:
  - GDP growth: expected to rise from 1.7 percent to 2 percent in 2017.
  - Since 2014, growth averaged 2 percent; GDP decelerated to 1.6 percent (saar) in H1 2016.
  - Private consumption slowed to 1.8 percent y/y in 2Q2016.
  - Business investment remains low; signs of turnaround: improved mining exports and trade balance; uptick in real incomes from rapid disinflation.
- Inflation and exchange rate:
  - Inflation decelerated from 4 percent in July to 3.1 percent in September.
  - With the output gap widening, inflation projected at 2.7 percent in 2017.
- Labor market:
  - Unemployment expected to peak at almost 8 percent by mid-2017.
- Fiscal:
  - Fiscal stimulus delivered ½ percent of potential GDP per year during 2013–16.
  - Starting 2017 the structural deficit set to narrow at the yearly pace of ¼ percent.
- Monetary policy:
  - Policy rate unchanged at 3½ percent since the beginning of the year; monetary policy appropriately accommodative.
  - Staff estimate of the real neutral rate: between ½−1½ percent.

### Medium-term and structural challenges
- Trend growth:
  - Trend GDP growth declined to 2.8 percent (from 4.8 percent in 2011).
  - IMF staff projects trend growth of 3¼ percent in 2021 in the non-mining sector and 2¾ percent for the economy as a whole.
  - Potential growth deteriorated from 5 percent in 2011 to 2½ percent in 2015–16 (IMF estimates).
- Drivers of slowdown:
  - Scaling back of investment, flagging productivity, and slowing labor supply reflect infrastructure bottlenecks, low human capital, and demographics.
  - Mining sector: accounts for 10 percent of total potential GDP; slowdown due to declining ore grade quality and slower capital accumulation amid low copper prices.
- Inclusion and social needs:
  - Old-age poverty at 18 percent of population (compared to 12 percent OECD average).
  - Closing Chile’s infrastructure gap would require a doubling of infrastructure investment to about 5 percent of GDP in the coming years (Ministry of Public Works).

### Fiscal position, projections, and policy recommendations
- Current and projected fiscal metrics:
  - Headline deficit expected to widen to 3.1 percent of GDP in 2016.
  - Permissible expenditure growth under the fiscal rule down: USD 2.56/lb copper price and 3 percent trend growth (down from USD 2.98/lb and 3.6 percent in 2016 budget).
  - Government financial assets about 21 percent of GDP in 2016, of which more than 50 percent are highly liquid.
  - Debt projections:
    - Debt projected to reach 25 percent of GDP next year.
    - Debt projected to reach 30 percent of GDP by 2021.
- Public Sector Debt Sustainability (baseline indicators, percent of GDP unless noted):
  - Nominal gross public debt: 2016: 17.5; 2017: 20.8; 2018: 25.0; 2019: 27.2; 2020: 28.7; 2021: 29.4; 2021 (continued): 29.9.
  - Net public debt (excludes Pension Reserve Fund): 2016: 0.2; 2017: 3.6; 2018: 6.8; 2019: 9.5; 2020: 11.5; 2021: 12.8; 2021 (continued): 14.0.
  - Primary Balance (baseline projections): 2016: -2.8; 2017: -2.9; 2018: -2.3; 2019: -1.7; 2020: -1.1; 2021: -0.8.
- Fiscal policy recommendations:
  - Continue fiscal consolidation gradually over 2017—18, justified by positive net worth, low financing costs, and focus on human capital and infrastructure.
  - Any new spending commitments should be part of a budget balance-neutral package.
  - Identify and eliminate inefficiencies in public spending; evaluate expenditure programs for effectiveness and improve targeting, including linking free access to tertiary education to means-testing.
  - Consider giving the Advisory Fiscal Council financial independence and broadening its mandate.

### Pension reform: issues, government proposal, and simulated impacts
- System weaknesses:
  - Contribution rate set at 10 percent; retirement ages 60 for women and 65 for men.
  - Solidarity pillar covers 60 percent of the poor at a fiscal cost of 0.7 percent of GDP per year.
  - Average pension below the minimum wage; replacement rates very low relative to the OECD average of 63 percent.
- Government proposed contours:
  - Gradually increase contribution rates by 5 percentage points over 10 years.
  - Allocate additional revenue between individual accounts and solidarity-related payments (shares to be determined).
  - Reduce pension fund administration costs.
- Staff recommendations:
  - Preserve current system principles but strengthen delivery; raise contribution rates toward 15 percent to raise replacement rates close to OECD averages; consider gradual increase in retirement age.
  - Make contributions of self-employed mandatory; strengthen solidarity pillar while mitigating growth costs.
  - Comprehensive assessment of economic effects and growth costs is necessary.
- IMF GIMF simulations (three-region OLG model):
  - Mixed-option 1 (50/50 allocation to solidarity and future transfers):
    - Real GDP: declines by slightly more than 0.5 percent by 2021.
  - Mixed-option 2 (solidarity financed by consumption tax):
    - Real GDP: about 0.2 percent lower than baseline by 2021.
  - Full option (higher contributions only to individual accounts):
    - Real GDP: 0.7 percent lower than baseline by 2021.

### Monetary policy guidance
- Target band: 2−4 percent inflation.
- Staff: central bank should cut rates if disinflation pressures become broad based and persistent, and if the growth slowdown intensifies.
- Decision to ease now versus wait should weigh benefits of safeguarding against declines in inflation expectations versus costs of reacting to temporary factors.
- Authorities concur: monetary policy more accommodative in response to slowdown; policy should remain data dependent.

### Financial sector resilience, vulnerabilities, and recommended reforms
- Current assessment:
  - Financial sector balance sheets healthy; non-performing loans around 2 percent of total loans.
  - Household debt historically high at 60 percent of GDP (household debt as share of gross disposable income around 60 percent end-2015).
  - Non-financial corporate debt around 150 percent of GDP as of 2016Q1 (excluding ‘other accounts payable’); foreign-currency debt of NFCs substantial at 55 percent in 2016Q1.
  - Life insurance companies and pension funds—assets exceeding 90 percent of GDP in 2015—pressured by low-yield environment.
- Stress tests and scenarios:
  - Corporate stress tests (BuDA, BuDA forecasts):
    - Baseline: PDs of Chilean NFCs remain at current levels; median PD implies implicit Moody’s rating of Ba.
    - Pessimistic: median PDs within one year double relative to baseline.
    - Regional downturn: effects similar magnitude to pessimistic scenario; some firms’ PDs approach 30 basis points.
    - Banking provisions: doubling of PDs requires doubling of total loan loss provisions for commercial credit; required increase in provisions would amount to 1 percent of assets, or 80 percent of annual profits.
  - Macro-financial amplification examples:
    - 1 ppt. lower growth in China -> GDP impact: -0.4 (through copper exports).
    - Faster U.S. monetary normalization: 100 basis points increase in EMBIG yield/Central Bank raises policy rates -> GDP impact: -0.4.
    - 1 ppt. lower growth in Brazil -> GDP impact: -0.06.
    - 3 ppt. lower growth in Argentina -> GDP impact: -0.05.
    - 10 basis points increase in the (12-month ahead) probability of default of Chilean non-financial corporates -> GDP impact: -1.
  - An increase in Chile’s EMBI spread by 100 basis points would cause growth to drop by roughly 0.3 percentage points within less than one year.
- Recommended actions:
  - Adopt key Basel III regulations and risk-based supervision of insurers swiftly.
  - Increase minimum total solvency requirement to 10.5 percent of RWA over six years; mandate capital surcharge of up to 3.5 percent RWA for domestically systemically important banks (proposed GBL).
  - Enhance coordination and information sharing among financial sector supervisors; ensure Financial Markets Commission (FMC) operational independence and appointments in line with Basel Core Principles.
  - Consider a voluntary stewardship code to improve corporate governance.
  - Banco Estado: staff recommends a capital injection of $US1.4 billion and governance upgrades.

### Financial Conditions Index and financial cycles (Annex I)
- FCI construction:
  - Based on 42 variables; sample January 1996–June 2016.
  - FCI normalized around 0 (1996–2006); values above zero indicate “loose” conditions and below zero “tight” conditions.
  - TVP-FAVAR primary model; PCA-FAVAR and KF-FAVAR produce similar FCI.
- Key findings:
  - FCI turning points coincide with known financial events.
  - Since the end of the commodity super-cycle, financial conditions tightened due to increase in Chile’s EMBIG spread, higher FX volatility, higher likelihood of nonfinancial corporate defaults, and lower consumer and commercial credit.
  - In 2016, financial conditions shifted from slightly tight to neutral.

### Macro-financial linkages and balance-sheet snapshot (Annex II)
- Balance-sheet highlights:
  - Households: real new house prices increased 70 percent since 2007Q1.
  - NFCs: Debt/GDP around 150 percent as of 2016Q1; foreign-currency debt share increased from 40 percent of GDP in 2012Q1 to about 55 percent in 2016Q1.
  - Banks: loan-to-deposit ratio around 110 percent.
  - Government debt about 20 percent of GDP, predominantly long-term; debt ratio doubled since late 2010.
- Inter-sectoral contagion thresholds (network contagion analysis):
  - 10 percent default by insurance and pension companies → banking capital reduced by about 28 percent.
  - 10 percent default by NFCs → banking capital reduced by about 53 percent.
  - 10 percent default by households → banking capital reduced by about 35 percent.
  - Combined shocks:
    - 15 percent default by households and NFCs → banking sector insolvent.
    - 20 percent default by NFCs alone → banking sector insolvent.
    - 30 percent default by households alone → banking sector insolvent.

### Financing options for the proposed pension reform (Annex III)
- Reform design modeled in GIMF with OLG agents; key simulation results:
  - Mixed-option 1 (50/50 labor-tax-funded): Real GDP declines by slightly more than 0.5 percent by 2021.
  - Mixed-option 2 (solidarity financed by consumption tax): Real GDP about 0.2 percent lower than baseline by 2021.
  - Full option (contributions only to individual accounts): Real GDP 0.7 percent lower than baseline by 2021.
- Policy implications:
  - Differentiated funding recommended to balance adequacy for low-income old households and growth costs.
  - Consumption tax financing less distortionary than labor tax financing in model simulations.

### Data reporting and authorities’ stance (1996 / December 7, 2016 statements)
- Data reporting:
  - Chile in process to gain adherence to SDSS plus; data ROSC published September 17, 2007.
  - CBC reports core and 7 of 28 encouraged financial soundness indicators monthly.
- Authorities’ macro policy pillars:
  - Structural fiscal rule (incorporating long-term copper price and business cycle), inflation targeting with flexible exchange rate, well-capitalized regulated financial system, and open trade and financial integration.
  - Authorities implementing gradual fiscal consolidation (~0.25 percentage points per year); estimated structural deficit for 2016 around 1.7 percent of GDP.
  - Central bank: inflation target 3 percent within two-year horizon; annual inflation reached upper limit and decreased to 2.8 percent in October.
- Authorities agree on advancing financial sector legislative agenda (GBL, FMC) and on careful evaluation of pension reform trade-offs.

_International Monetary Fund staff summary based on the provided content unit._

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Context and overarching assessment
- Chile’s fundamentals and policy framework remain strong, but prospects are shaped by lower dynamism in key trading partners, permanently lower copper prices, slower trend growth, and mounting social demands for inclusive growth.
- Important reforms are underway to lift growth and reduce inequality, but they generate transition costs. Staff’s recommendations aim to balance trade-offs between growth, stability, and social objectives while assessing the macroeconomic policy mix during this transition.

### Key findings and policy recommendations
- Near-term growth prospects:
  - Conditions are in place for a modest recovery next year: growth is expected to rise from 1.7 percent to 2 percent next year.
  - A faster recovery is hampered by weak domestic demand and slow improvement in confidence, dampened by uncertainty related to the labor reform and costs associated with a new corporate income tax perceived as complex.
- Trend growth:
  - Trend GDP growth has declined substantially to 2.8 percent (from 4.8 percent in 2011).
  - The scaling back of investment, flagging productivity, and slowing labor supply reflect infrastructure bottlenecks, low human capital, and demographics.
- Fiscal policy:
  - Fiscal consolidation should commence, but Chile can proceed slowly. The 2017 budget appropriately shifts towards fiscal consolidation.
  - A strong net public-asset position allows Chile to proceed slowly in the near term while growth is weak and pro-growth and equality reforms are implemented.
  - As the economy recovers, stronger fiscal adjustment is needed.
  - Pension reform: to provide adequate old-age income, the planned pension reform should strengthen the private and the public solidarity pillars while mitigating growth costs.
- Monetary policy:
  - Monetary policy is appropriately accommodative.
  - The central bank should lower rates if disinflation becomes broad based and more persistent, and if growth risks intensify.
- Structural reforms:
  - Reforms are setting the stage for stronger growth.
  - The reform agenda could be strengthened by fast-tracking a new infrastructure fund geared to raise private participation, improving programs to strengthen workers’ skills, and facilitating growth of businesses.
- Financial sector resilience:
  - Financial sector balance sheets are healthy, but risks to stability bear close monitoring.
  - Weaker-than-expected growth could strain solvency of highly leveraged firms, less resilient SMEs, and indebted households.
  - Corporate stress tests show that banks’ balance sheets can withstand a significant rise in credit risks.
  - There is considerable scope to enhance resilience: adopt key Basel III regulations and risk-based supervision of insurers swiftly; enhance coordination and information sharing among financial sector supervisors; consider a voluntary stewardship code to improve corporate governance.

### Recent developments (A. Recent Developments)
- Growth performance and composition:
  - Since 2014, growth averaged 2 percent, substantially below rates of 4 percent a few years ago, but above the Latin-American six largest countries average of 0.3 percent during the last 3 years.
  - GDP decelerated to 1.6 percent (saar) in the first half of 2016, mainly due to flagging external demand from the region and a second round of copper price declines in 2015.
  - The contraction in mining contributed more than half to the overall growth slowdown; ex-mining activity remained sluggish owing to soft domestic demand.
  - Private consumption slowed to 1.8 percent y/y in 2Q2016 in line with decelerating wage and employment growth.
  - Business investment remains low owing to uncertain external conditions, diminishing construction activity, and depressed sentiment, though signs of a turnaround have emerged (improved mining exports and trade balance; uptick in real incomes from rapid disinflation).
- Confidence and policy stance:
  - Business confidence is improving but remains depressed; passage of large parts of reform agenda has reduced uncertainty, but legal ambiguities in the new labor law and costs of a complex new business tax weigh on sentiment.
  - The central bank has kept the policy rate unchanged at 3½ percent since the beginning of the year.
  - Fiscal policy delivered stimulus of ½ percent of potential GDP per year during 2013–16; starting 2017 the structural deficit is set to narrow at the yearly pace of ¼ percent.
- Financial conditions:
  - Forward guidance has reduced interest rate expectations; financial conditions have shifted from slightly tight to neutral (relative to 1996–2015 average).

### Outlook, macro-financial linkages, and risks (B. Outlook, Macro-Financial Linkages, and Risks)
- Baseline forecast and drivers:
  - GDP is forecast to grow at 2 percent in 2017, slightly up from 1.7 percent this year.
  - Faster external demand in key trading partners—up by 0.3 ppts. to 3 percent in 2017—and more stable copper prices are projected to lift exports.
  - Spillovers to business investment are slow; business confidence likely to improve only moderately as effects of new labor legislation (effective April 2017) take time to be understood.
  - Private consumption will be held back by slow wage growth and rising unemployment (expected to peak at almost 8 percent by mid-2017).
  - Beyond the near-term, growth is expected to accelerate as ongoing reforms remove growth bottlenecks.
- Inflation and exchange rate:
  - Disinflation is set to continue into 2017. Inflation decelerated from 4 percent in July to 3.1 percent in September.
  - With the output gap widening next year, inflation is projected to decline to 2.7 percent in 2017.
- Financial vulnerabilities and macro-financial amplification:
  - Household debt is historically high at 60 percent of GDP.
  - Among large corporates, foreign currency debt is substantial at 55 percent in 2016Q1, though long maturities and hedges limit currency mismatch risks.
  - Households have significant claims on other financial corporates equal to 88 percent of GDP.
  - A deterioration in external growth or financing conditions could force firms to deleverage, increasing defaults and tightening credit via macro-financial linkages.
  - An increase in Chile’s EMBI spread by 100 basis points would cause growth to drop by roughly 0.3 percentage points within less than one year.
- Stress-test and scenario simulation results (Simulated GDP Impact of Risk Scenarios)
  - 1 ppt. lower growth in China -> GDP impact: -0.4 (through copper exports)
  - Faster pace of U.S. monetary policy normalization: 100 basis points increase in EMBIG yield / Central Bank of Chile raises policy rates -> GDP impact: -0.4
  - 1 ppt. lower growth in Brazil -> GDP impact: -0.06 (non-copper exports)
  - 3 ppt. lower growth in Argentina -> GDP impact: -0.05 (non-copper exports)
  - 10 basis points increase in the (12-month ahead) probability of default of Chilean non-financial corporates (investment, deleveraging channel) -> GDP impact: -1
- Risk assessment:
  - Risks tilted to the downside: unexpected slowdown in China, setbacks in Brazil, sustained global policy uncertainty, faster-than-expected U.S. tightening, drawn-out legal uncertainty from labor reform, larger-than-expected implementation costs of corporate tax reform, pension reform raising contribution rates and dampening medium-term growth, and a sharper cooling in the real estate market.
  - Upside: private sentiment could rebound more rapidly approaching presidential elections if perceived policy uncertainty diminishes.

### Medium-term challenges (C. Medium-Term Challenges)
- Inclusion and social demands:
  - Demand for more inclusive growth is growing amid large skill disparities, duality between formal and informal sectors, transportation bottlenecks, limited retraining programs, and high old-age poverty at 18 percent of population (compared to 12 percent OECD average).
  - Population aging will further raise social demands.
- Long-run growth decline:
  - GDP growth in Chile has more than halved over the past three decades from 6.8 percent on average in 1990–94 to around 2 percent in recent years.
  - Potential growth deteriorated from 5 percent in 2011 to 2½ percent in 2015–16 according to IMF estimates.
  - Approximately half of the decline is due to weaker capital accumulation related to persistent terms-of-trade shock; the other half comes from lower labor and TFP growth (about 20 and 30 percent of the total slowdown, respectively).
- Sectoral drivers of the slowdown:
  - Mining: disinvestment. The slowdown in the capital-intensive mining sector (10 percent of total potential GDP) is explained by flagging productivity due to declining ore grade quality and slower capital accumulation amid low and uncertain copper prices.
  - Non-mining: infrastructure bottlenecks and low average skill levels have constrained TFP; population aging and tapering gains in female labor force participation constrain labor supply growth.
- Policy implications:
  - Structural reforms are necessary to raise long-run growth and inclusion; closing Chile’s infrastructure gap would require a doubling of infrastructure investment to about 5 percent of GDP in the coming years (Ministry of Public Works).

*Source: _cr16376 - EXECUTIVE SUMMARY (IMF staff, November 23, 2016).*

### 17.      Projected trend growth is insufficient to narrow the income gap with advanced

### 17.      Projected trend growth is insufficient to narrow the income gap with advanced economies

### Projected trend growth and convergence
- Staff projects trend growth of 3¼ percent in 2021 in the non-mining sector.
- Staff projects trend growth of 2¾ percent for the economy as a whole.
- At 2¾ percent, Chile’s projected trend growth is comparable to estimates in emerging economies with similar per capita income levels but is not much higher than rates in advanced economy commodity exporters (e.g., Australia, Canada) which have substantially higher per capita income levels.
- Conclusion: at currently projected rates, Chile would catch up only very slowly to income levels of comparable developed economies.

### Authorities’ views on trend growth and reform
- Authorities stressed the role of the reform agenda in tackling both inequality and low growth, while being cognizant of short-run trade-offs.
- Authorities saw trend growth as having declined but noted estimates were uncertain and that the recovery in productivity growth could be stronger than staff projects.
- Authorities noted the reform package was aimed at raising skills levels to help with inequality and that old-age poverty needed to be tackled by expanding the social safety net.

### External balance
- Current account deficit narrowed from 3.7 percent of GDP in 2013 to 2 percent in 2015.
- Real effective peso depreciation contributed to adjustment: 10 percent in real effective terms (2013–15).
- Staff projects a current account deficit of 2.2 percent of GDP for the current year.
- Over the medium term, when internal demand recovers, the current account is expected to widen to around 2.5 percent of GDP.
- EBA-based estimates suggest the REER was moderately undervalued in 2016 (between 5 and 10 percent), but IMF EBA model estimates may not capture effects of unusually low business sentiment related to the large-scale reform package.
- If confidence and investment remain structurally weak, Chile’s external position would be stronger than warranted by macro fundamentals.

### Fiscal policy: stance, outlook, and recommendations
- Fiscal stimulus averaged around ½ percent of potential GDP since 2013.
- Headline deficit is expected to widen to 3.1 percent of GDP in 2016 as reform-related expenditures exceeded revenue gains from the 2014 tax reform amid a weak economy.
- The 2017 budget aligns with a consolidation path of about ¼ percent per annum in structural terms (starting from a lower headline fiscal balance).
- Permissible expenditure growth under the fiscal rule has more than halved relative to 2015 (staff estimates), reflecting downgraded long-term copper prices and trend growth: USD 2.56/lb and 3 percent, respectively, down from USD 2.98/lb and 3.6 percent in the 2016 budget.
- Debt projections and assets:
  - Debt is projected to increase rapidly and reach 25 percent of GDP next year.
  - Debt is projected to reach 30 percent of GDP by 2021.
  - Government financial assets are sizeable at about 21 percent of GDP in 2016, of which more than 50 percent are highly liquid.
- Policy recommendations:
  - Continue fiscal consolidation gradually over 2017—18, justified by positive net worth, low financing costs, and focus on human capital and infrastructure.
  - Any new spending commitments should be part of a budget balance-neutral package.
  - Identify and eliminate inefficiencies in public spending to limit scaling back of pro-growth spending.
  - Evaluate expenditure programs for effectiveness and improve targeting, including linking free access to tertiary education to means-testing.
  - Consider giving the Advisory Fiscal Council financial independence and broadening its mandate to assess annual and medium-term fiscal targets.
- Authorities broadly concurred with staff: maintain fiscal credibility, use fiscal space cautiously, pursue a comprehensive expenditure review, and strengthen the Advisory Fiscal Council (legislative constraints noted).

### Pension reform: challenges and recommended measures
- System features and problems:
  - Chile’s pension system, created in 1981, is based on individual savings accounts administered by Administradoras de Fondos de Pensiones and was complemented in 2008 by a publicly-funded solidarity pillar.
  - The system raised national savings, helped develop capital markets, and reduced fiscal risks.
  - The system is not delivering adequate benefits for a large share of retirees: Chile’s average pension is below the minimum wage and estimated replacement rates are very low relative to the OECD average of 63 percent.
  - Main causes: low mandatory contribution rates of 10 percent and short contribution periods due to discontinuous career paths; contributions not adjusted to rising life expectancy and dependency ratios; narrow coverage (e.g., self-employment, informal labor); solidarity pillar does not provide adequate minimum pensions.
- Government’s proposed contours:
  - Gradually increase contribution rates by 5 percentage points over 10 years.
  - Allocate additional revenue between individual accounts and solidarity-related payments (details to be determined).
  - Reduce costs of pension fund administration.
- Staff recommendations and considerations:
  - Preserve the current system but strengthen delivery.
  - For future retirees:
    - Raise contribution rates for individual accounts alongside other measures; an increase of contribution rates to 15 percent would raise replacement rates close to OECD country averages.
    - Gradual increase in the retirement age (currently 65 years for men and 60 for women) would similarly increase replacement rates; given projected rise in life expectancy by 5 years in 2050 such increases are likely necessary regardless.
    - For women, a gradual increase of the retirement age to 65 years should be strongly considered given discontinuous lifetime-employment and contributions.
    - Make contributions of self-employed mandatory to increase coverage.
  - For current retirees:
    - Increase pension and solidarity pillar benefits, but given fiscal constraints any increases need to account for future aging-related commitments.
    - Study growth and equity implications of different financing modalities; IMF simulations suggest a pension reform package funded by a mix of higher contributions and indirect taxes would carry lower growth costs than one funded exclusively by increased contribution rates.
  - A comprehensive assessment of economic effects, growth costs in the near to medium-term, and impacts on current and future pensions is necessary.
- Authorities agreed with key principles but emphasized support for the retired middle class in the short run and careful evaluation of tradeoffs between efficiency, incentives, inequality, and fiscal considerations.

### Monetary policy and inflation
- Recent developments:
  - Central bank policy has become more accommodative this year.
  - Inflation slowed from 4 percent in July to 3.1 percent in September.
  - Policy rate has remained unchanged at 3½ percent.
  - Central bank softened its policy guidance, dropping its tightening bias in August.
- Considerations and guidance:
  - Target band: 2−4 percent.
  - Staff: central bank should cut rates if disinflation pressures become broad based and persistent, and if the growth slowdown intensifies.
  - Decision to ease now versus wait should weigh benefits of safeguarding against declines in inflation expectations versus costs of reacting to temporary factors.
  - Staff agrees with central bank’s recent forward guidance adjustments and data-dependent stance.
- Authorities concurred: monetary policy more accommodative in response to slowdown; policy should remain data dependent.
- Staff estimate of the real neutral rate: between ½−1½ percent.

### Macro policy mix and contingency planning
- Assessment:
  - Current policy mix is broadly adequate.
  - Permanently lower copper revenue and trend growth imply fiscal policy needs to adjust moderately while remaining geared toward growth-enhancing education and infrastructure spending.
  - Monetary authorities should be prepared to ease as needed.
  - Enhanced financial sector supervision and broadly unchanged macro-prudential stance can contain feedback effects from rising credit costs and financial tightening while mitigating pro-cyclicality.
- Downside scenario guidance:
  - Monetary policy should be the first line of defense if external conditions weaken.
  - If a severe slowdown occurs, fiscal tightening should be paused and attainment of a structural balanced budget goal further delayed, while tilting spending to pro-growth infrastructure and education programs.
- Authorities broadly agreed; the central bank emphasized its reaction would depend on the type of downside risk and its impact on the inflation forecast.

### Upgrading growth and securing stability: intersection of challenges
- Key challenges:
  - Subdued trend growth, high inequality, and risks to stability intersect.
  - Infrastructure bottlenecks and demographic trends are slowing investment, productivity growth, and labor force participation.
  - Income inequality is high—the post-tax-and-transfers Gini index is 15 percentage points above the OECD average—driven by large wealth inequality and a substantial skill divide.
  - Financial sector vulnerabilities include high corporate leverage, substantial foreign currency debt and exposure to the region, and a slowdown in the real estate sector.
- Growth reforms:
  - Structural reforms since 2014 are assessed by staff to be growth positive over the medium term.
  - Notable improvements: bottlenecks in the electricity sector have lessened; costs for attending secondary and tertiary education are declining; 50,000 additional childcare facilities have been created.
  - New competition and productivity laws passed in 2016 improve the business environment.
  - Transitory costs, particularly from frontloaded tax increases, are inevitable and should be managed carefully.

*Source: IMF staff calculations and chapter content from the provided PDF.*

### 39.      There is scope to strengthen the effectiveness of the reform agenda:

### 39.      There is scope to strengthen the effectiveness of the reform agenda:

### Infrastructure and public-private partnerships
- Fast-track creation of a new Infrastructure Fund (IF) geared to attract private capital; scope should be narrowed to infrastructure projects suitable for PPPs and adopt additional safeguards to strengthen governance and limit fiscal risks from contingent liabilities.
- Infrastructure Fund: Strategic planning and fostering PPPs — Announced.

### Structural reform status (selected items)
- Tax Reform — Capital Income Tax: Enacted.
- Tax Reform — Excise and Broadening of VAT Base: Passed.
- Labor reform — Abolition of replacement during strikes; Establishment of minimum floors for salary negotiations: Passed.
- Education Reform — End Co-payments, Student Selection and for-profit Institutions: Passed.
- Education Reform — Improve Teaching Quality and Early Education: Passed.
- Education Reform — Universal Tertiary Education: Passed.
- Energy — Ease Permits and Incentivize Renewable Energy: Enacted.
- Productivity reform — Ease financing of productive investments, boost service exports, and cut red tape: Passed.
- Infrastructure Fund — Strategic planning and fostering PPPs: Announced.
- Telecommunication — Reduce digital divide: Announced.
- Competition law — Strengthens sanctioning system: Passed.

### Labor market and skills
- Labor force participation has risen in the past, but its growth rate is slowing owing to population aging.
- Labor productivity is substantially below the average in OECD countries.
- Recommendation: More targeted professional and vocational training to raise effective (skill-weighted) labor supply; foster linkages between industries and education institutions; enhance incentives for on-the-job training especially at SMEs and apprenticeship programs.
- Legal uncertainties related to the new labor bill need to be addressed before it comes into force next year; ambiguities include definition of minimum services during strikes, extending benefits to non-participating workers, and status of negotiating groups following a Constitutional Court ruling.

### Productive firms, innovation, and R&D
- Further strengthen ability of productive firms to grow; help SMEs expand via programs to improve business management skills and record keeping.
- Chile’s R&D spending: At 0.4 percent of GDP, Chile has one of the lowest R&D spending rates in the OECD (2 percent of GDP on average).
- Government initiatives to boost innovation: seed money to start ups (“Start-up Chile”), SME-specific credit lines (CORFO), loan guarantees for innovative investments (“Cobertura pro-inversión”), and a registry of firms’ mobile assets.
- Recommendation: Tailor regulatory requirements for accessing capital markets to different firm sizes to help medium-sized firms tap domestic capital.

### Selected innovation indicators (percentile rank; higher means better score)
- Innovation capacity: Chile 57; OECD 82; Other LA6 48.
- Quality of scientific research institutions: Chile 68; OECD 85; Other LA6 48.
- Company spending on R&D: Chile 61; OECD 79; Other LA6 50.
- Source: World Economic Forum (WEF), Global Competitiveness Rankings. LA6 includes Brazil, Chile, Colombia, Mexico, Peru and Uruguay.

### Financial and corporate sector stability: current assessment
- Financial sector balance sheets are healthy but risks to financial stability bear close monitoring.
- Non-performing loans remained low at about 2 percent of total loans.
- Life insurance companies and pension funds—assets exceeding 90 percent of GDP in 2015—are pressured by the low-yield environment and shifting toward higher yield but potentially riskier or less liquid assets.
- Recent central bank stress tests find average banks’ CAR would decline by 2 percentage points from a 13 percent of risk-weighted assets at end 2015 (BCCh’s stress tests assume a decline in GDP growth to -5 percent in the trough quarter, recovering to 1.3 percent in 2017; under the stress scenario, all banks would meet the current minimum capital adequacy ratio of 8 percent).
- Staff’s stress test based on accelerated corporate defaults finds a similar decline.

### Proposed General Banking Law (GBL) and supervisory reforms
- The proposed new GBL aims to:
  - Align definition of regulatory capital with international standards.
  - Increase minimum total solvency requirement to 10.5 percent from 8 percent of RWA over six years.
  - Mandate a capital surcharge of up to 3.5 percent of RWA for systemically important domestic banks.
  - Provide new resolution and financial stabilization tools to the regulator, including early intervention, asset separation (good bank/bad bank), and allowing for certain degrees of bail-in while maintaining current creditor preference and the existing central bank guarantee on current accounts and deposits.
- Current government guarantee under the General Banking Act (GBA): natural persons’ term deposits in local and foreign currency are guaranteed at 90 percent of its value with a cap of $4,000; demand deposits are 100 percent guaranteed.
- Draft law would improve governance of the supervisory agency (SBIF); details of governance reform are yet to be finalized and could lead to integration under the proposed Financial Markets Commission (FMC).

### Financial Markets Commission (FMC)
- Creation of the FMC is an opportunity to upgrade governance of financial supervisors; guarantee operational independence and selection/appointment processes in line with Basel Core Principles and international best practices.
- FMC is expected to eventually incorporate SBIF and SP and currently includes the insurance and capital markets supervisor (SVS).
- Implementation of the FMC should not delay adoption of other reforms (Basel III and risk-based supervision of insurers) and should broaden supervision to shadow banking activities (e.g., factoring companies and cajas de compensación).

### Corporate governance and investor protection
- Chilean companies are relatively opaque, ownership of large conglomerates is concentrated, and compliance with best practices in corporate governance is low.
- Recommendation: Institutional investors, such as pension fund administrators, could favor investments in companies with high governance standards and minority shareholder protection; consider a voluntary governance/stewardship code.

### Specific vulnerabilities and recommended actions
- Banco Estado: staff recommends a capital injection to address an estimated capital shortfall of $US1.4 billion, upgrade corporate governance, review operational risks, and increase efficiency.
- Priority reforms: adopt Basel III capital requirements and risk-based supervision of the insurance sector; improve coordination and information sharing among supervisors and the central bank.
- Continue strengthening financial sector regulation and supervision given vulnerabilities from leverage and inter-sectoral balance sheet linkages (non-financial corporate debt stands at about 105 percent of GDP; 55 percent of non-financial corporate debt is in foreign currency).

### Macro outlook and policy guidance (staff appraisal)
- Chile faces a challenging macroeconomic outlook: slower trading partner growth and a decline in trend growth; high income inequality and an ageing population heighten social needs.
- Since 2014, growth averaged 2 percent (below past rates of 4 percent but above the Latin-American six largest countries average).
- Policy stance:
  - Freely floating exchange rate supports rebalancing.
  - Monetary policy is appropriately accommodative; if disinflationary pressures broaden and persist, interest rates should be lowered.
  - Fiscal policy should shift toward consolidation given a sizable structural deficit, but proceed slowly in the near term given a strong public net-asset position.
  - Strengthen the role of the Advisory Fiscal Council to buttress policy credibility.
- Pension reform: preserve current system principles while expanding the public solidarity pillar, raising contribution rates for the contributory pillar, and adjust mandatory retirement age in line with rising life-expectancy.
- Structural reforms adopted since 2014 are setting the stage for stronger growth; closing the infrastructure gap could be facilitated by the Infrastructure Fund; improve workers’ skills; resolve legal uncertainties in the labor bill; cut red tape and improve SME access to capital.

_International Monetary Fund staff summary based on the provided content unit._

### Box 1. Spillovers from China’s Economic Rebalancing

### Box 1. Spillovers from China’s Economic Rebalancing

### Key findings on commodity prices and industrial production shocks
- Slower and less investment-driven growth in China is putting downward pressure on commodity prices.
- Evidence from a structural VAR and regression analyses find that shocks to China’s industrial production have large effects on commodity prices.
- Particularly, the impact on copper prices is large, given China’s dominant global role as a copper importer (Kolerus, N’Diaye and Saborowski, 2016).

### Impact on Chile’s exports
- Given Chile’s strong trade linkages, China’s rebalancing has a sizable impact on exports growth.
- Using a multi-country panel VAR, staff estimates that a 1 percentage point decline in China’s final demand lowers average export growth by around 0.5 percentage points over the course of a year (Blagrave and Vesperoni, 2016).
- The estimated impact on Chile’s exports is smaller than that for Australia, but larger than for most Latin American economies.

*Source: IMF staff calculations; Kolerus, N'Diaye, and Saborowski 2016; Blagrave and Vesperoni, 2016.*

### Box 4. Policies to Enhance Corporate Governance (concluded)

### Box 4. Policies to Enhance Corporate Governance (concluded)

### Stewardship codes for institutional investors
- Context: In Chile, institutional investors are important minority shareholders.
- Objective: The introduction of a voluntary stewardship codes could be a powerful tool to promote good corporate governance among investee companies.
- Goal: To ensure that institutional investors are effectively engaged in the promotion of long-term success of the companies they own.
- Design features:
  - Typically voluntary.
  - Use a “principle-based” approach to increase disclosure and encourage monitoring by institutional investors, including asset managers, insurance companies, and pension funds.
- International precedents:
  - The first country to adopt a stewardship was the United Kingdom, in 2010.
  - In Japan, a similar Code was adopted in 2014 and led to a broad-based uptake among institutional investors, investment managers, and pension and insurance funds.

### Governance codes for non-financial corporates
- Purpose: Incentivized governance codes could also be used to enhance transparency in Chile’s non-financial sector.
- Rationale: Governance codes for listed non-financial corporates have been successful in strengthening corporate transparency and accountability in the UK.
- Evidence of uptake: As of 2014, over 90 percent of firms in the FTSE 350 index are compliant with the governance code.
- Possible incentive mechanism for Chile: Adoption in Chile could be incentivized by linking its subscription to the inclusion of a listed company in key equity market indices.

*Source: Box 4. Policies to Enhance Corporate Governance (concluded).*

### Annex I. Characterizing Chilean Financial Cycles:

### Annex I. Characterizing Chilean Financial Cycles: A Financial Conditions Index for Chile

### Definition and purpose
- Financial conditions are defined as the ease of access to funding and refer to conditions emanating from within the financial sector, separate from monetary policy and exchange rate movements.
- Financial conditions affect economic conditions through three channels: credit, leverage, and risk.
- When households and corporations cannot easily obtain credit or equity financing, consumption and investment may be negatively affected. Changes in financial conditions exacerbate business cycle fluctuations through the balance sheets of borrowers.

### Measurement and data
- The Financial Conditions Index (FCI) for Chile is based on information from 42 variables that capture credit conditions, leverage levels, quality of collateral, and intensity of perceived risks.
- The sample used for the estimation of the FCI starts in January 1996 and ends in June 2016.
- The FCI is normalized around 0 over the observation period (1996–2006); values above zero indicate “loose” and below zero “tight” conditions.
- The constructed FCI is purged of cyclical influence by controlling for the contemporaneous and lagged correlation with GDP; the policy interest rate is included as a separate variable in the VAR framework so fluctuations in the FCI do not capture the direct effect of monetary policy decisions.

### Methodology and models
- The FCI combines information from 42 financial variables into a single indicator using the Koop and Korobilis (2014) approach, which merges Primiceri’s (2005) time-varying parameter vector-autoregression (TVP-VAR) with factor analysis for large data sets (Doz, Giannone, and Reichlin, 2011).
- The unobservable factor f in the empirical model is the FCI; coefficients λy and λf are factor loadings tracking the effect of macroeconomic and financial conditions on each financial variable.
- General and special cases:
  - TVP-FAVAR (time-varying parameter factor-augmented VAR) — the primary model used.
  - PCA-FAVAR — principal components-based FAVAR (Stock and Watson, 2002; Bernanke, Boivin, and Eliasz, 2005).
  - KF-FAVAR — Kalman-filter based FAVAR (Doz, Giannone, and Reichlin, 2011).
- Because of close tracking among the three models, TVP-FAVAR can be approximated by PCA-FAVAR, but TVP-FAVAR allows the measured effect of financial conditions on economic activity to change over time.

### Interpreting the FCI and variable dimensions
- Variables included in the FCI cover three main dimensions:
  - Risk: several interest rate spreads and asset price volatilities.
  - Collateral values and leverage: measures of gross external debt, bank leverage, housing and stock prices, short-term versus long-term mutual fund assets, and pension fund assets.
  - Credit: commercial, consumption, and mortgage loans and various measures of credit quality.
- Widening spreads, declining collateral/credit volumes, and decreasing leverage denote a tightening in financial conditions.
- EMBIG is measured as EMBI Global spread in percentage points.
- FX rate is measured as dollars per one thousand Chilean Pesos.

### Characterizing Chile’s financial cycles — key findings
- The FCI produced by TVP-FAVAR, PCA-FAVAR, and KF-FAVAR are similar; turning points coincide with well-known financial and economic events.
- The FCI shows a significant tightening during the Asian financial crisis, although financial conditions throughout that episode and the early 2000s were only slightly tighter than average.
- Financial conditions were relatively easy between 2004 and the Global Financial Crisis (2008–09), and proved sensitive to the European sovereign debt crisis (2011–12).
- Since the end of the commodity super-cycle, financial conditions have tightened due to:
  - an increase in Chile’s EMBIG spread,
  - higher exchange rate volatility,
  - a rise in the likelihood of nonfinancial corporate defaults,
  - lower than average consumer and commercial credit by Chilean banks.
- In 2016, financial conditions shifted from loose to neutral.

### Contributions to FCI changes since 2013
- The contribution of each factor to the TVP-FAVAR FCI—credit, leverage, and risk—has changed over time.
- In 2013–14, credit variables tended to improve financial conditions, whereas risk and leverage had the opposite effect.
- Since 2015, credit, leverage, and risk have moved together: overall widening spreads, declining collateral/credit volumes, and decreasing leverage led to some tightening in financial conditions, with the reverse occurring in 2016.
- Note: In every year since 2013, except in the first six months of 2016, the change in financial conditions was lower than what warranted by cyclical macroeconomic conditions. The difference between the measured change in the FCI and the total contribution of credit, leverage, and risk reflects the change in the FCI associated with financial variables excluding the change in macroeconomic variables (Y).

### Variables included in Chile’s Financial Conditions Index (select details)
- The 42 variables are mapped to dimensions and transformations. Examples include:
  - Credit dimension (transformations shown): 1-Year EDF Banks (75th percentile) (LV); 1-Year EDF Corporates (75th percentile) (LV); ELMI+ LC (DLN); Growth in Trade Loans (DP12); Loans commercial (DP12); Commercial Loans / Bank Assets (DL12); Loans consumers (DP12); Consumer Loans / Bank Assets (DL12); Loans housing (DP12); Loans housing / Total bank assets (DL12); Nonperforming loans to bank credit ratio (LV); Total bank assets (LVMA); Total loans to PS (DP12); Trade Loans / Bank Assets (DL12).
  - Leverage dimension: Domestic bond issuance (LVMA); Domestic equity issuance (LVMA); Financials Datastream Return Index (DLN); Financials to Stock Total Market (LVMA); Gross external debt of OFI (DP12); Gross external debt, banks (percent of GDP) (DP12); Gross external debt, direct foreign investment (percent of GDP) (DP12); Gross external debt, general government (percent of GDP) (DP12); Gross external debt, Non-financial firms (percent of GDP) (DP12); Housing prices (DLN); Leverage, capital to assets ratio (LV); LT External Debt (percent of GDP) (DP12); MMMF/Bond Fund Assets (LVMA); Pension Fund Assets (percent of GDP) (DLN); Short Term External Debt (percent of GDP) (DP12); Stock market IGPA (DLN).
  - Risk dimension: Central Bank rate-US T-Bill Spread (LV); CDS Sovereign 2YR (LV); EMBIG (LV); FX Volatility (LV); Interbank-MPR spread (LV); Interest rates commercial loans (spread to monetary policy rate) (LV); Interest rates consumer loans (spread to monetary policy rate) (LV); Interest rates housing loans 3 years or more (spread to monetary policy rate) (LV); Interest rates trade loans (spread to US 3-Month T-bill rate) (LV); Net Loan Spread, 30 to 89 days (DLV); Net Loan Spread, 90 days to 1 year (DLV); Volatility of IGPA (LV).
- Transformations used in the variable list: DL = first difference; DLN = first log-difference; DP12 = 12-month difference; LV = level; LVMA = ratio of level to 12-month moving average.

*Source: Annex I. Characterizing Chilean Financial Cycles: A Financial Conditions Index for Chile (IMF staff calculations; sample January 1996–June 2016).*

### Annex II. A Snapshot of Macro-Financial Linkages

### Annex II. A Snapshot of Macro-Financial Linkages

### A. Balance Sheet Health Checkup
- Overall assessment: balance sheets in key sectors appear on a solid footing, but recent deterioration raises concern about funding stability.
- Households:
  - Real new house prices increased 70 percent since 2007Q1.
  - Household debt as a share of gross disposable income remained around 60 percent as of end-2015.
  - Household debt is low relative to advanced OECD countries but comparable to many emerging market economies.
- Nonfinancial corporates (NFCs):
  - Debt/GDP ratio around 150 percent of GDP as of 2016Q1 (calculations exclude ‘other accounts payable’).
  - Peso depreciation of 50 percent since its peak in 2011 contributed to the rise in the ratio.
  - Among large listed NFCs (2013–2015), the 20 most indebted firms supplemented internally generated funds with substantial debt issuance and cash drawdowns to finance investment and dividends.
  - Mitigating factors:
    - Maturity structure shows little rollover risk in coming years.
    - Vast majority of debt is long-term at fixed interest rates.
    - Chilean firms’ interest-coverage ratios compare favorably to those in other economies (particularly EMs).
- Foreign-currency debt of NFCs:
  - Only 17 percent issued locally.
  - Of externally issued foreign-currency debt: nearly 50 percent is FDI, 30 percent is bonds, and about 20 percent is loans.
  - Majority of foreign-currency borrowing is at fixed interest rates, long term, or related to U.S. dollar domestic bank loans to the agricultural sector (natural hedges).
  - Increase from 40 percent of GDP in 2012Q1 to about 55 percent in 2016Q1 dominated by FDI (about 2/3 of the increase) and external bond issuance (about 1/3).
  - NFC dollar assets minus dollar liabilities and net derivative positions about 2½ percent of total assets as of 2015Q3 (a deterioration of around 4 percentage points since 2012Q1).
- Banks and other financial corporations:
  - Loan-to-deposit ratio around 110 percent.
  - Chilean banks rely heavily on institutional deposits (mutual funds are the biggest institutional depositor).
  - Banks hold a large share of their portfolio in loans.
  - Non-bank financial corporations (pension funds and insurers) have stable debt-to-asset ratios around 1.2.
- Government:
  - Government debt about 20 percent of GDP, predominantly long-term.
  - Debt ratio has doubled since late 2010.

### B. Corporate Stress Tests
- Methodology:
  - Uses a corporate default database and the Bottom-up Default Analysis (BuDA) tool.
  - BuDA forecasts the empirical distribution of probability of default (PD) as a function of macroeconomic conditions, firm-specific balance sheet information, and market-based factors.
  - Calibrated with default and exit data and firm-level financial information for a large sample of EM firms; projects PDs based on firms’ balance sheets.
- Scenarios:
  - Baseline: matches Chile desk projections on real GDP growth, unemployment, and inflation.
  - Pessimistic: real GDP falls by 5 percent over five quarters starting in 2016Q4, then growth slowly returns to trend.
  - Regional downturn: economic activity in Argentina, Brazil, Colombia, Mexico, and Peru falls by 5 percent in the last quarter of 2016 and then slowly returns to trend; Chile’s real GDP growth suffers assuming an elasticity relative to regional GDP growth of 0.3; regional equity markets (excluding Chile) fall 47 percent and then recover gradually.
  - All simulations based on firm data as of end-2015.
- Results:
  - Baseline: PDs of Chilean NFCs remain at current levels; median PD implies an implicit Moody’s rating of Ba.
  - Pessimistic:
    - Median PDs within one year are doubled relative to baseline and are close to levels reached during the great financial crisis (GFC).
    - Cyclical consumer goods sector experiences the largest increases in expected default rates; utilities (including energy and communications) are most stable.
    - Increase in PDs (in basis points) for financial firms is somewhat smaller than for nonfinancial firms.
  - Regional downturn:
    - Effects are of similar magnitude to the pessimistic scenario and affect all Chilean firms, not just those heavily exposed to the region.
    - Among Chilean firms with large exposures to Latin America, a small number display PDs by end-2016 close to 30 basis points (which would trigger a credit downgrade), far in excess of average GFC levels.
- Banking provisions impact:
  - Assuming a doubling of PDs requires a doubling of total loan loss provisions for commercial credit by banks.
  - The required increase in provisions would amount to 1 percent of assets, or 80 percent of annual profits.

### C. Inter-Sectoral Balance-Sheet Linkages
- Net positions and exposures:
  - NFCs have a large net liability position vis-à-vis the rest of the world of about 40 percent of GDP.
  - Domestic banks have significant net asset claims on households (predominantly mortgages) and NFCs (about 75 percent of business loans are in pesos).
  - Households hold a large amount of assets in pension and insurance companies (other financial corporates), about 81 percent of GDP.
- Comparative context:
  - NFC external debt is high relative to peers: Mexico and Brazil show NFC net liability positions vis-à-vis the rest of the world of about 22 and 32 percent of GDP, respectively.
  - Linkages between other financial corporates and banks are significant, implying a contagion channel if the banking sector is hit.
- Network contagion analysis (based on Espinosa-Vega and Sole, 2010):
  - A 10 percent default on liabilities of a given sector yields the following approximate reductions in banking sector capital:
    - 10 percent default by insurance and pension companies → banking capital reduced by about 28 percent.
    - 10 percent default by NFCs → banking capital reduced by about 53 percent.
    - 10 percent default by households → banking capital reduced by about 35 percent.
  - Broader results: a 10 percent default by households would reduce other financial corporations’ capital by about 39 percent.
- Cascading failure thresholds and scenarios:
  - A combined 15 percent default by households and NFCs would leave the banking sector insolvent.
  - A 20 percent default by NFCs alone would leave the banking sector insolvent.
  - A 30 percent default by households alone would leave the banking sector insolvent.
  - A scenario with a 25 percent default by both households and NFCs would leave banks—and subsequently other financial corporates—insolvent.
- Overall assessment: although cross-sector exposures are somewhat elevated and complex, contagion risks are modest for fairly large shocks; however, sufficiently large simultaneous defaults can trigger cascading failures through the financial system.

*Source: Annex II. A Snapshot of Macro-Financial Linkages, _cr16376 - Annex II. A Snapshot of Macro-Financial Linkages*

### Annex III. Financing Options of the Proposed Pension Reform

### Annex III. Financing Options of the Proposed Pension Reform

### Context and objectives
- Purpose: assess pension reform options to raise future pension benefits, align pensions with higher life expectancy, and increase support for and coverage of minimum solidarity pensions.
- Broad finding: simulations using a general equilibrium model show the proposed reforms improve low-income pensions with some mild impact on GDP growth.

### Current system
- System design: contributory scheme with individual savings accounts administered by Administradoras de Fondos de Pensiones (AFPs); created in 1981.
- Contribution rate: set at 10 percent of annual income.
- Retirement ages: minimum retirement age is 60 for women and 65 for men.
- Solidarity pillar: publicly-funded; currently covers 60 percent of the poor at a fiscal cost of 0.7 percent of GDP per year.
- Transition fiscal cost: projected to decrease from 1.4 percent of GDP currently to below 1 percent in 10 years.

### Main issues identified
- Shortcomings (Comisión Bravo, 2015): very low replacement rates; benefits and eligibility vary significantly by gender; high administrative costs (though declining recently).
- Fiscal pressure: authorities estimate spending from the solidarity pillar would need to increase by an additional 0.2 percent of GDP per year over the next decade to maintain current benefits.
- Commission proposal: increase individual contributions to raise adequacy of future pensions.

### Government reform proposal (announced August)
- Core measures:
  - Gradually increase contribution rates by 5 percentage points over a 10-year time span.
  - Allocate the additional revenue in yet-to-be-determined shares to individual accounts and for solidarity or pay-as-you-go (PAYG) related payments (which improve pensions of current retirees).
  - Reduce pension fund administration costs (specific measures not yet defined).
- Retirement age: government is not planning to change the retirement age at the moment.

### Model used for analysis
- Model: IMF Global Integrated Monetary and Fiscal (GIMF) model, three-region open-economy (Chile, Asia, rest of world).
- Household structure: life-cycle overlapping generations (OLG) agents (Blanchard Yaari, 1985) and liquidity-constrained households treated as retirees for analysis purposes.
- Purpose: positive macroeconomic assessment of reform impacts over the near to medium run.

### Reform simulation design (baseline and scenarios)
- Baseline: projection with an increase in old-age workers and pressure for higher fiscal funding of the solidarity pension; under no-policy action an increasing share of lower-income elderlies will not be covered by solidarity pensions.
- Reform modeling:
  1. Increase in (employer-side) contributions modeled as a gradual increase in labor tax by 5 percentage points, over 10 years.
  2. Fraction of additional resources: assume 50 percent rebated back to retirees through solidarity pensions.
  3. Remaining 50 percent allocated to an asset (or reduction of government debt) and used for gradually rising transfers after 10 model-years (benchmark “mixed-option”).
- Alternative funding explored: financing solidarity pillar with a consumption tax instead of a labor tax.
- Full option: higher contributions channeled only to individual accounts (no additional solidarity/PAYG support for current retirees).

### Mixed-option 1 (benchmark: higher contribution rates allocated 50/50 between solidarity transfers and future transfers)
- Macroeconomic impacts (deviations from baseline):
  - Real GDP: declines by slightly more than 0.5 percent by 2021 (about 0.1 percentage points less growth per year in the first 5–6 years).
  - Drivers: higher labor taxes → lower employment, lower aggregate consumption (fall of OLG/highly contributing agents’ consumption), and lower investment.
  - Liquidity-constrained agents: better off than baseline due to targeted transfers (pensions) raising their consumption.
  - Exports: lower as higher labor cost dampens competitiveness, leading to an appreciation of the real effective exchange rate (REER).
- Sensitivity: if labor supply elasticity (Frisch) is doubled in calibration, GDP is about 0.8 percent lower than baseline by 2021 (about 0.2 percentage points lower annual growth in the next 5 years).

### Mixed-option 2 (alternative funding mix: solidarity pillar financed by consumption tax)
- Funding change: solidarity pillar financed by a consumption tax (global base) instead of labor tax while providing the same funding to the solidarity pillar.
- Macroeconomic impacts:
  - Real GDP: about 0.2 percent lower than baseline by 2021 (impact on GDP more muted than labor-tax-funded reform).
  - Rationale: consumption tax is less distortionary than labor tax → reduces labor cost wedge, so labor supply and investment are less penalized.
  - Competitiveness: less impaired; exports decline less than under labor-tax funding.
  - Consumption of liquidity-constrained: similar to authorities’ reform case because transfers still support their consumption.
- Caveat: because the model treats uncovered retirees as liquidity-constrained who also receive higher labor income under consumption-tax scenario, the model implies somewhat higher consumption than would occur in reality (real-world second-round effects weaker).

### Full option (higher contributions channeled only to individual accounts)
- Funding allocation: revenue from higher contributions used only to finance better pensions in the future via the defined-contributions system.
- Macroeconomic impacts:
  - Aggregate consumption: lower over the near to medium run relative to mixed option because higher taxes and less labor income are not compensated by higher pensions for current retirees.
  - Aggregate savings and interest rates: higher, further discouraging domestic investment (model includes a financial accelerator a la Bernanke, Gertler and Gilchrist (1999)).
  - Inflation and REER: lower domestic inflation in the short run relative to mixed option, improving REER and strengthening exports.
  - Real GDP: 0.7 percent lower than baseline by 2021, equivalent to about 0.2 percentage points lower growth in the next 5 years.

### Trade-offs and policy implications
- Differentiation in funding desirable: trade-off between increasing capital accumulation in individual accounts and supporting low-income old households through solidarity pillar argues for differentiated funding.
- Tax choice matters:
  - Financing via labor tax: larger near-term negative impact on GDP, labor supply, investment, and competitiveness; benefits liquidity-constrained retirees via transfers.
  - Financing via consumption tax: less distortionary macroeconomic impact, smaller GDP loss by 2021 (about 0.2 percent vs. slightly more than 0.5 percent under labor tax), less adverse competitiveness impact.
  - Channeling funds solely to individual accounts: largest short- to medium-run drag on GDP (0.7 percent by 2021) and consumption of contributors, but supports higher savings and stronger exports through improved REER.
- Distributional outcome: liquidity-constrained/retiree-like agents gain most when part of additional resources are rebated via solidarity transfers.

### Chile: Overall assessment (selected external and macro indicators)
- Net international investment position (NIIP): expected to remain stable at around –20 percent of GDP in 2016.
- Gross external debt: projected at 65 percent of GDP in 2016.
- Current account (2016): projected at -2.2 percent of GDP (improved from 3.7 percent in 2013).
  - Contributing factors: peso depreciation (14 percent in real effective terms), contraction in investment-related capital imports, import substitution for intermediate inputs.
- Cyclically adjusted current account (2016): -0.6 percent of GDP; above the EBA norm of -3.1 percent (40 percent of distance owes to policy gaps; 60 percent unexplained by EBA regression after correcting for commodity and output cycles).
- Real exchange rate (2016): peso appreciated in 2016 — 8 percent against the dollar, 6 percent in real effective terms.
  - EBA estimates: moderate undervaluation of the peso in 2016 (between 5 and 10 percent); adjusting for low business sentiment related to reforms, peso assessed broadly in line with medium-term fundamentals.
- Capital and financial accounts: CA deficit mostly financed by relatively stable FDI net inflows (mining); Chile resilient to taper tantrum; corporate sector retained access to external funding.
- FX intervention and reserves:
  - Regime: free floating exchange rate; central bank generally does not intervene.
  - Recent interventions: two programs in 2008 and 2011 (both aimed at weakening the peso via USD purchases).
  - Reserves: 6 months of reserves, estimated adequate by standard metrics.

*Source: Annex III. Financing Options of the Proposed Pension Reform, IMF staff analysis.*

### Annex V. Public Sector Debt Sustainability Analysis

### Annex V. Public Sector Debt Sustainability Analysis

### Baseline Scenario — Key Indicators (in percent of GDP; unless otherwise indicated)
- As of November 03, 2016
- Nominal gross public debt:
  - 2014: 7.9
  - 2015: 15.1
  - 2016: 17.5
  - 2017: 20.8
  - 2018: 25.0
  - 2019: 27.2
  - 2020: 28.7
  - 2021: 29.4
  - 2021 (continued): 29.9
- Public gross financing needs:
  - 2014: -0.5
  - 2015: 3.2
  - 2016: 3.8
  - 2017: 3.6
  - 2018: 4.5
  - 2019: 3.8
  - 2020: 3.1
  - 2021: 3.2
  - 2021 (continued): 3.7
- Net public debt (excludes Pension Reserve Fund):
  - 2014: -7.5
  - 2015: -1.2
  - 2016: 0.2
  - 2017: 3.6
  - 2018: 6.8
  - 2019: 9.5
  - 2020: 11.5
  - 2021: 12.8
  - 2021 (continued): 14.0
- Real GDP growth (in percent):
  - 2014: 4.5
  - 2015: 1.8
  - 2016: 2.3
  - 2017: 1.7
  - 2018: 2.0
  - 2019: 2.7
  - 2020: 3.0
  - 2021: 3.1
  - 2021 (continued): 3.2
- Inflation (GDP deflator, in percent):
  - 2014: 4.9
  - 2015: 5.6
  - 2016: 4.3
  - 2017: 3.3
  - 2018: 1.7
  - 2019: 2.8
  - 2020: 3.0
  - 2021: 3.0
  - 2021 (continued): 3.1
- Nominal GDP growth (in percent):
  - 2014: 9.6
  - 2015: 7.5
  - 2016: 6.7
  - 2017: 5.0
  - 2018: 3.7
  - 2019: 5.5
  - 2020: 6.1
  - 2021: 6.2
  - 2021 (continued): 6.5
- Effective interest rate (in percent):
  - 2014: 9.2
  - 2015: 5.2
  - 2016: 4.7
  - 2017: 4.6
  - 2018: 4.7
  - 2019: 4.8
  - 2020: 4.9
  - 2021: 4.9
  - 2021 (continued): 5.0
- Sovereign spreads:
  - Bond Spread (bp) 3/185
  - 5Y CDS (bp): 94
- Ratings (2016):
  - Moody's: Aa3 / Aa3
  - S&Ps: AA- / AA+
  - Fitch: A+ / AA-

### Contribution to Change in Gross Public Sector Debt (percent of GDP)
- Cumulative change in gross public sector debt:
  - 2014: 0.3
  - 2015: 2.3
  - 2016: 2.4
  - 2017: 3.3
  - 2018: 4.2
  - 2019: 2.2
  - 2020: 1.5
  - 2021: 0.7
  - 2021 (continued): 0.5
  - Cumulative (2014–2021): 12.4
- Identified debt-creating flows:
  - 2014: -0.3
  - 2015: 1.6
  - 2016: 1.8
  - 2017: 3.8
  - 2018: 4.5
  - 2019: 2.6
  - 2020: 1.8
  - 2021: 1.0
  - 2021 (continued): 0.9
  - Cumulative (2014–2021): 14.7
- Primary deficit:
  - 2014: -2.2
  - 2015: 1.5
  - 2016: 1.9
  - 2017: 2.8
  - 2018: 2.9
  - 2019: 2.3
  - 2020: 1.7
  - 2021: 1.1
  - 2021 (continued): 0.8
  - Cumulative (2014–2021): 11.7
- Primary (noninterest) revenue and grants (percent of GDP):
  - 2014: 22.1
  - 2015: 20.3
  - 2016: 20.9
  - 2017: 20.6
  - 2018: 20.8
  - 2019: 21.9
  - 2020: 22.2
  - 2021: 22.2
  - 2021 (continued): 22.5
  - Cumulative (2014–2021): 130.3
- Primary (noninterest) expenditure (percent of GDP):
  - 2014: 19.9
  - 2015: 21.8
  - 2016: 22.8
  - 2017: 23.4
  - 2018: 23.8
  - 2019: 24.2
  - 2020: 23.9
  - 2021: 23.3
  - 2021 (continued): 23.3
  - Cumulative (2014–2021): 141.9

### Automatic Debt Dynamics and Components
- Automatic debt dynamics (derived formula in footnote 5):
  - 2014: -0.1
  - 2015: 0.0
  - 2016: 0.1
  - 2017: -0.1
  - 2018: 0.0
  - 2019: -0.3
  - 2020: -0.5
  - 2021: -0.7
  - 2021 (continued): -0.5
  - Cumulative (2014–2021): -2.1
- Interest rate/growth differential (footnote 6):
  - 2014: -0.1
  - 2015: -0.3
  - 2016: -0.3
  - 2017: -0.1
  - 2018: 0.0
  - 2019: -0.3
  - 2020: -0.5
  - 2021: -0.7
  - 2021 (continued): -0.5
  - Cumulative (2014–2021): -2.1
- Contribution of real interest rate:
  - 2014: 0.2
  - 2015: -0.1
  - 2016: 0.0
  - 2017: 0.2
  - 2018: 0.4
  - 2019: 0.3
  - 2020: 0.3
  - 2021: 0.2
  - 2021 (continued): 0.4
  - Cumulative (2014–2021): 1.8
- Contribution of real GDP growth:
  - 2014: -0.3
  - 2015: -0.2
  - 2016: -0.3
  - 2017: -0.3
  - 2018: -0.4
  - 2019: -0.6
  - 2020: -0.8
  - 2021: -0.8
  - 2021 (continued): -0.9
  - Cumulative (2014–2021): -3.8
- Exchange rate depreciation contribution (footnote 7):
  - 2014: -0.1
  - 2015: 0.3
  - 2016: 0.4
  - 2017–2021: .....................
- Other identified debt-creating flows:
  - 2014: 2.1
  - 2015: 0.2
  - 2016: -0.2
  - 2017: 1.1
  - 2018: 1.5
  - 2019: 0.6
  - 2020: 0.6
  - 2021: 0.6
  - 2021 (continued): 0.6
  - Cumulative (2014–2021): 5.1
- Deposits/asset accumulation (negative) (component of other flows):
  - 2014: 2.1
  - 2015: 0.2
  - 2016: -0.2
  - 2017: 1.1
  - 2018: 1.5
  - 2019: 0.6
  - 2020: 0.6
  - 2021: 0.6
  - 2021 (continued): 0.6
  - Cumulative (2014–2021): 5.1
- Contingent liabilities:
  - 2014–2021: 0.0 (each year)
- Residual, including asset changes:
  - 2014: 0.5
  - 2015: 0.6
  - 2016: 0.6
  - 2017: -0.5
  - 2018: -0.3
  - 2019: -0.4
  - 2020: -0.4
  - 2021: -0.3
  - 2021 (continued): -0.4
  - Cumulative (2014–2021): -2.3

### Projections and Scenarios (Figure 1 summary)
- Baseline projections (selected indicators):
  - Real GDP growth:
    - 2016: 1.7
    - 2017: 2.0
    - 2018: 2.7
    - 2019: 3.0
    - 2020: 3.1
    - 2021: 3.2
  - Inflation:
    - 2016: 3.3
    - 2017: 1.7
    - 2018: 2.8
    - 2019: 3.0
    - 2020: 3.0
    - 2021: 3.1
  - Primary Balance:
    - 2016: -2.8
    - 2017: -2.9
    - 2018: -2.3
    - 2019: -1.7
    - 2020: -1.1
    - 2021: -0.8
  - Effective interest rate:
    - 2016: 4.6
    - 2017: 4.7
    - 2018: 4.8
    - 2019: 4.9
    - 2020: 4.9
    - 2021: 5.0
- Historical scenario (alternative):
  - Real GDP growth:
    - 2016: 1.7
    - 2017–2021: 3.8 (each year)
  - Primary Balance:
    - 2016: -2.8
    - 2017–2021: 1.2 (each year)
  - Effective interest rate:
    - 2016: 4.6
    - 2017: 4.3
    - 2018: 4.4
    - 2019: 4.6
    - 2020: 4.9
    - 2021: 4.9
- Constant Primary Balance scenario:
  - Primary Balance:
    - 2016–2021: -2.8 (each year)
- Contingent Liability Shock scenario (selected impacts):
  - Real GDP growth:
    - 2016: 1.7
    - 2017: -0.3
    - 2018: 0.4
    - 2019: 3.0
    - 2020: 3.1
    - 2021: 3.2
  - Inflation:
    - 2016: 3.3
    - 2017: 1.1
    - 2018: 2.2
    - 2019–2021: 3.0, 3.0, 3.1
  - Primary Balance:
    - 2016: -2.8
    - 2017: -11.5
    - 2018: -2.3
    - 2019: -1.7
    - 2020: -1.1
    - 2021: -0.8
  - Effective interest rate:
    - 2016: 4.6
    - 2017: 5.2
    - 2018: 5.1
    - 2019: 5.1
    - 2020: 5.3
    - 2021: 4.9

### Composition of Public Debt and Financing Needs (figures described)
- Net debt (in percent of GDP) projection shows a rise from negative values in 2014–2016 toward positive values through 2021 (chart scale -5 to 45).
- Gross Nominal Public Debt (in percent of GDP) projected to increase through 2021 (chart scale -2 to 16).
- Public Gross Financing Needs (in percent of GDP) shown historically and projected through 2021 (chart scale 0 to 35).
- By maturity: share of medium and long-term versus short-term debt illustrated historically and in projection through 2021 (chart scale 0 to 35).
- By currency: shares of local currency-denominated and foreign currency-denominated debt shown historically and projected through 2021 (chart scale 0 to 35).

### Analytical Notes and Methodology (as provided)
- Public sector is defined as central government.
- Effective interest rate is defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year (footnote 4).
- Automatic debt dynamics derived as [r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ) times previous period debt ratio, with r = effective nominal interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar) (footnote 5).
- Real interest rate contribution derived from numerator in footnote 5 as r - π (1+g); real growth contribution as -g (footnote 6).
- Exchange rate contribution derived from numerator in footnote 5 as ae(1+r) (footnote 7).
- Residual includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period (footnote 8).
- Scenario assumptions: assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year (footnote 9).

*Source: Fund staff calculations.*

### 1996. In coordination with STA, Chile is in the

### _cr16376 - 1996. In coordination with STA, Chile is in the

### Data reporting and quality
- Chile is in the process to gain adherence to SDSS plus.  
- A data ROSC was published September 17, 2007.  
- The CBC uses the standardized report forms (SRFs) to report monthly data for the central bank, other depository corporations (ODCs), other financial corporations (OFCs), and monetary aggregates.  
- Data for the ODCs exclude savings and credit cooperatives and OFCs exclude investment funds, general funds, housing funds, foreign capital investment funds, factoring societies, leasing companies, and financial auxiliaries.  
- The CBC reports all core and 7 of 28 encouraged financial soundness indicators on a monthly basis.

### Common indicators (summary of reporting, frequency, and quality assessments)
- Exchange Rates: Latest observation July 1, 2015; Date Received July 1, 2015; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.  
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Latest observation June 15, 2015; Date Received June 23, 2015; Frequency W; Frequency of Reporting W; Frequency of Publication W.  
- Reserve/Base Money: Latest observation June 15, 2015; Date Received June 23, 2015; Frequency W; Frequency of Reporting W; Frequency of Publication W; Methodological Soundness: O, O, LO, O; Accuracy and Reliability: O, O, O, LO, O.  
- Broad Money: Latest observation May 2015; Date Received June 2015; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- Central Bank Balance Sheet: Latest observation January 2014; Date Received March 2014; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- Consolidated Balance Sheet of the Banking System: Latest observation January 2014; Date Received March 2014; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- Interest Rates: Latest observation July 1, 2015; Date Received July 1, 2015; Frequency D; Frequency of Reporting D; Frequency of Publication D.  
- Consumer Price Index: Latest observation May 2015; Date Received June 8, 2015; Frequency M; Frequency of Reporting M; Frequency of Publication M; Methodological Soundness: LO, LNO, LNO, LO; Accuracy and Reliability: LO, LO, LO, O, LO.  
- General Government Revenues/Expenditures/Budget: Latest observation 2014; Date Received June 30, 2015; Frequency A; Frequency of Reporting A; Frequency of Publication A; Methodological Soundness: O, LO, LNO, LO; Accuracy and Reliability: LO, O, O, LO, O.  
- Central Government Revenues/Expenditures/Budget: Latest observation May 2015; Date Received June 30, 2015; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- Stocks of Central Government and Central Government–Guaranteed Debt: Latest observation Q1 2015; Date Received June 30, 2015; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.  
- External Current Account Balance: Latest observation Q1 2015; Date Received May 18, 2015; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q; Methodological Soundness: O, O, LO, LO; Accuracy and Reliability: O, O, O, O, O.  
- Exports and Imports of Goods: Latest observation June 30, 2015; Date Received June 23, 2014; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- GDP/GNP: Latest observation Q1 2015; Date Received May 18, 2015; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q; Methodological Soundness: O, LO, LO, LO; Accuracy and Reliability: LO, LO, LO, LO, O.  
- Gross External Debt: Latest observation March 2015; Date Received May 7 , 2015; Frequency M; Frequency of Reporting M; Frequency of Publication M.  
- International Investment Position: Latest observation Q1 2015; Date Received May 18, 2015; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.

### World Bank—Fund country-level program (selected entries)
- Investment Loans expected delivery: Chile 2nd Social Inclusion for Shared Prosperity DPL (P158738) — July 2017.  
- Investment Loans expected delivery: Chile - Health Sector Support Project (P161018) — July 2017.  
- Technical Assistance: Technical Assistance for Geothermal Development in Chile — October 2016.  
- Recipient Executed Trust Fund: Sustainable Land Management–GEF (P085621) — September 2014.

### Statement by the IMF Staff Representative (December 7, 2016)
- The statement reports on information available since the staff report; it does not alter the thrust of the staff appraisal.  
- Activity remained soft in October due to a contraction in mining: IMACEC decreased 0.4 percent year-on-year in October of 2016, following a 1.5 percent rise in September. Mining component declined 7.1 percent; non-mining index increased 0.3 percent.  
- Markets expect monetary policy to ease: the November survey of economic expectations showed analysts now expect two policy rate cuts in 2017. Inflation expectations for year-end fell by three tenths to 3 percent in November, while remaining stable at 3 percent at both a one- and two-year horizon (BCCh Economic expectations survey).

### Authorities’ statement (December 7, 2016)
- Chile’s macroeconomic policy framework rests on four pillars: a structural fiscal rule (incorporating long-term price of copper and business cycle), inflation targeting with a flexible exchange rate by an independent central bank, a well-capitalized and regulated financial system, and open trade and financial integration.  
- Authorities remain committed to sound macroeconomic policies and reforms to achieve higher and more inclusive growth, while weighing short-run trade-offs.

### Background and economic outlook
- Recent growth has been moderate and below potential, influenced by the end of the commodity super cycle and subdued global growth.  
- Copper price fall: from US$ 4.0 in 2011 to US$ 2.5 in 2015, and around US$ 2.15 in 2016, which negatively impacted mining investment, national income, and domestic expenditure.  
- Medium-term growth estimates have declined, partly due to deceleration of aggregate productivity, lower labor force expansion from demographic trends, and weakening investment.  
- The policy mix (accommodative monetary policy and fiscal deficits consistent with the fiscal rule) aided cyclical adjustment; a freely floating exchange rate helped early improvement of the current account deficit, which in 2016 is expected to reach around 1.6 percent of GDP (3.7 percent in 2013).  
- Evidence shows resource reallocation from mining to non-mining sectors; rebalancing requires time and supportive policy mix.  
- Central bank forecasts: GDP growth in 2016 within a range between 1.5 percent and 2.0 percent and between 1.75 and 2.75 percent in 2017.  
- Main downside risks: China’s growth sustainability and implications for commodity prices and financial markets; protectionism. Upside: absence of macroeconomic imbalances and sound fundamentals.

### Monetary policy
- Central Bank of Chile operates inflation-targeting with a flexible exchange rate; inflation target is 3 percent within a two-year horizon.  
- Annual inflation returned to the upper limit of the target band (3 plus/minus 1 percent) last July and decreased thereafter, reaching 2.8 percent in October.  
- Prior inflation overshoot was driven by significant peso depreciation, which receded during 2016.  
- The transitory nature of the exchange rate shock, absence of second-round effects, and well-anchored medium-term expectations allowed accommodative monetary policy.  
- Any future changes in the monetary policy rate will depend on domestic and external macroeconomic conditions’ implications for inflation.

### Fiscal policy
- Authorities implementing gradual fiscal consolidation to reach a structural balanced budget over the medium term, while allowing automatic stabilizers to operate.  
- Structural deficit being reduced by approximately 0.25 percentage points per year; in 2016 it is estimated to reach 1.7 percent of GDP.  
- In January, the long-term price of copper used for the structural budget was reduced by almost 14 percent, increasing the estimated structural deficit for 2016 above the pre-announced objective.  
- Authorities implemented an extraordinary expenditure reduction equivalent to 0.25 percent of GDP, mostly on current expenditures.  
- Congress approved the 2017 fiscal budget consistent with the consolidation plan; it considers an expansion of expenditures equivalent to 2.7 percent. Education, healthcare, and citizen security are main priorities; pro-growth public investment remains at historically high levels, around 4 percent of GDP.  
- Fiscal solvency has kept the country’s risk premium among the lowest in emerging markets. Authorities remain vigilant on the medium-term trajectory of public debt and see merit in strengthening the Advisory Fiscal Council, though not an immediate priority.

### Financial sector
- Staff finds financial sector balance sheets healthy but notes vulnerabilities from high corporate leverage, household indebtedness, and strong inter-sectoral linkages. Authorities view real estate sector and SMEs as pockets of vulnerability, not systemic threats.  
- Central bank stress tests: corporate balance sheets mildly sensitive to exchange or interest rate shocks; very large GDP shock needed for substantial stresses.  
- Aggregate household debt ratios continue rising moderately; weaker labor market could hinder repayment capacity.  
- Bank lending aligns with the business cycle; non-performing loans remain low with mild deterioration in commercial loans. Current levels of bank capitalization sufficient to absorb a severe stress scenario.  
- Under a severe stress scenario, all banks remain with a Capital Adequacy Ratio (CAR) above the 8 percent regulatory minimum, but the fraction of banks with CAR above 10 percent has declined in recent years.  
- Authorities agree on advancing the financial sector legislative agenda: new legislation for securities and insurance sectors and creation of a Financial Market Commission (FMC) is at final stage in Congress; next step is initiating a new general banking law (GBL) aligned with Basel III.

### Reform agenda
- Structural reforms since 2014 aim to raise growth: ongoing educational reform to increase human capital, with primary/secondary reforms approved and post-secondary legislation under discussion.  
- Productivity agenda includes improving workers’ skills, expanding firms’ access to financing, innovation, productive diversification, energy, infrastructure, state efficiency, and competition laws.  
- Recent measures: simplifying company procedures, facilitating export services, broadening financing options for financial companies into non-traditional assets including infrastructure projects; a new Antitrust law approved in July.  
- Energy sector: investment bottlenecks lessened and lower energy prices secured through electricity tenders.  
- New labor legislation approved in August to modernize labor relations, to be implemented in April 2017; authorities are engaging companies ahead of collective bargaining.  
- Regarding future pension reform, authorities agree with key principles of staff recommendations, aim to build consensus, and emphasize careful evaluation of growth implications while addressing retired middle class alleviation.

*Source: _cr16376 - 1996. In coordination with STA, Chile is in the*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16376.pdf_