Chile: Staff Concluding Statement of the 2016 Article IV Mission

IMF News, November 2, 2016

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Chile: Staff Concluding Statement of the 2016 Article IV Mission

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• Published: November 2, 2016

I. Context — key findings

• Chile’s fundamentals and policy framework remain strong, with a credible and effective fiscal and monetary framework, a modern and stable financial system, and a flexible exchange rate.
• External environment and structural change:
  • Demand from key trading partners is less dynamic than in the past; economic rebalancing in China is slowing demand for raw materials, including copper.
  • Incomes are growing less rapidly in the U.S. and Europe; structural problems in Latin America will weigh on external demand and investment despite a better outlook for next year.
  • Structural changes have lowered Chile’s trend growth: medium-term growth is estimated at around 3 percent, down from over 4 percent a few years ago.
  • Population aging is slowing labor supply; infrastructure bottlenecks and workers’ low skills hamper sectoral reallocation, dampen investment, and suppress productivity growth.
• Social pressures:
  • Income inequality remains high despite recent improvements; public demand for adequate pensions and health care is mounting.
  • As the population ages, pressures on pensions and health care will rise over the medium-term, requiring better diagnoses and policy solutions.
• Structural reforms underway:
  • Competition in the energy sector has increased; red tape is being reduced.
  • A fundamental education reform is upgrading human capital.
  • A new corporate income tax to finance reforms is slowing capital formation.
  • Growth implications of the new labor reform are uncertain due to legal ambiguities.
• Recent performance:
  • Since 2014, growth averaged 2 percent, down from rates of 4 percent a few years ago, but well above the Latin-American six largest countries average of 0.3 percent during the last 3 years.

II. Outlook and risks — projections and scenarios

• Near-term projections (Calendar Year, Growth Rate):
  • Real GDP: 2016 — 1.7; 2017 — 2.0; 2018 — 2.7
  • CPI inflation: 2016 — 4.0; 2017 — 2.8; 2018 — 2.9
  • CA balance 1/ (In percent of GDP): 2016 — -2.2; 2017 — -2.4; 2018 — [not specified]
  • Source: IMF staff estimates
  • 1/ In percent of GDP.
• Baseline outlook:
  • GDP is forecast to grow moderately faster at 2 percent in 2017, slightly up from 1.7 percent in 2016. Faster growth in the region and advanced economies should lift exports but domestic demand is set to pick up only gradually.
  • A weak labor market and a slow recovery in sentiment are holding back private consumption and investment.
• Downside risks:
  • External: an unexpected slowdown in China or setbacks from adjustments in Brazil could dampen exports and investment.
  • Domestic: drawn-out resolution of legal uncertainty in the new labor bill could delay recovery in confidence.
  • Pension reform: should a pension reform be approved with increased contribution rates, growth could be damped over the medium-term relative to the baseline, though growth effects would be relatively moderate.
  • Amplification channels: high leverage among households and corporates could amplify the impact of downside risks—accelerated job losses could raise defaults on mortgages and consumer credit; deterioration in external financing could impair highly leveraged firms’ ability to honor debt, tightening credit and shrinking domestic demand.
  • Financial buffers: despite risks, sufficient buffers mean the financial sector would remain safe.
• Upside scenario:
  • If global growth strengthens more than expected and global protectionist sentiment fades, Chile is well placed to take advantage given its open economy.

III. Policy recommendations — macro and structural

• Overall stance:
  • The policy mix remains moderately supportive of activity amid structural shocks and transitions.
  • Monetary policy could become more accommodative should disinflationary pressures broaden.
  • Structural reforms should focus on key growth bottlenecks in skill formation and firm growth.

• A. Fiscal policy — recommendations and rationale
  • Maintain fiscal credibility while addressing skill and infrastructure gaps; gradual adjustment is needed due to permanently lower copper revenue and diminished trend growth.
  • The 2017 budget:
  • Is aligned with the consolidation path announced last year of about ¼ percent per year in structural terms.
  • Aims to maintain pro-growth spending within a tight budget envelope.
  • To limit scaling back of pro-growth spending, identify and eliminate inefficiencies in public spending.
  • Fiscal consolidation:
  • Debt is projected to increase rapidly and reach 25 percent of GDP next year.
  • A gradual adjustment path over 2017−18 is justified because public net worth is still positive, financing costs are low, and expenditures build human capital and infrastructure.
  • As growth recovers, a more ambitious fiscal consolidation path should be adopted.
  • Any new spending commitments should be part of a balance neutral package.
  • To buttress fiscal credibility, the Advisory Fiscal Council could be given financial independence and its mandate broadened to assess annual and medium-term fiscal targets.

• B. Pension reform — evaluation and options
  • Current system strengths:
  • Fully-funded defined-contribution system has raised national savings, aided capital markets development, and reduced fiscal risks.
  • Governance and supervision are sound.
  • Shortcomings:
  • The system is not delivering adequate benefits for a large share of retirees (Bravo Commission, 2015).
  • Low pension contribution periods and rates; contributions not adjusted to rising life expectancy; coverage of workers is too narrow; the solidarity pillar does not provide adequate minimum pensions.
  • Reform recommendations:
  • Preserve the current system but strengthen delivery.
  • For future retirees:
  • Raise contribution rates for individual accounts; rates need to be increased materially above 10 percent to ensure adequate pensions.
  • Given life expectancy is projected to rise by about 5 years by 2050, gradually increase the mandatory retirement age, especially for women.
  • Make contributions of the self-employed mandatory to cover a larger share of workers.
  • For current retirees:
  • Raise minimum pension and solidarity pillar benefits, taking future aging-related commitments into account given fiscal constraints.
  • Study growth and equity implications of different financing modalities carefully.
  • IMF analysis suggests 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.
  • Overall: assess economic effects of any reform carefully alongside impacts on current and future pensions.

• C. Monetary policy — stance and guidance
  • Current stance:
  • Since the beginning of the year, the policy rate has remained unchanged at 3½ percent.
  • The central bank has softened its policy guidance and dropped its tightening bias in August.
  • Inflation developments:
  • Inflation declined from 4 percent in July to 3.1 percent in September after remaining above the 2−4 percent target band for an extended period.
  • A stronger peso contributed to disinflation; risk of disinflation spreading to the non-tradable sector has risen with the slowdown in activity.
  • Recommendation:
  • The central bank should cut rates if disinflation becomes broad based and more persistent, and growth risks deepen.
  • The decision whether to ease now or wait should weigh benefits of safeguarding inflation expectations against costs of reacting to temporary factors.
  • Staff agrees with the central bank’s recent adjustments to forward guidance, its decision to keep rates on hold for now, and remaining data dependent.

• D. Structural reform agenda — priorities and measures
  • Reforms since 2014 are setting the stage for stronger growth: electricity bottlenecks have lessened, costs for attending secondary and tertiary education are declining, and 50.000 additional childcare facilities have opened.
  • Transitional costs are inevitable and should be managed carefully.
  • Suggested priorities:
  • Fast-track creation of a new Infrastructure Fund (IF) geared to attract private capital:
  • Narrow scope of IF to infrastructure projects suitable for PPPs.
  • Adopt additional safeguards to strengthen governance provisions and limit fiscal risks from contingent liabilities.
  • Enhance workers’ skills and address legal uncertainties in the new labor bill:
  • Chile’s labor productivity is substantially below the OECD average.
  • Expand targeted professional and vocational training, foster linkages between industries and education institutions, and create incentives for on-the-job training and apprenticeship programs.
  • Address legal ambiguities in the new labor law swiftly to avoid drawn-out implementation costs.
  • Strengthen ability of productive firms to grow:
  • New competition and productivity laws are easing financing of productive investments, supporting service exports, and cutting red tape.
  • Expand programs to improve business management skills and record keeping for SMEs.
  • Tailor regulatory requirements for accessing capital markets to different firm sizes to help medium-sized firms tap domestic capital.

• E. Financial stability and financial sector policies
  • Financial sector conditions:
  • Banks’ earnings slowed in 2016 due to low economic activity, but non-performing loans remain low and capital buffers are well above current legal requirements.
  • Life insurance companies and pension funds face pressure from the low-yield environment and have shifted towards higher yield but potentially riskier or less liquid assets.
  • Risks:
  • Weaker-than-expected growth could strain solvency of highly leveraged firms and less resilient SMEs, with potential amplification via inter-sectoral balance sheet linkages.
  • Regulatory framework risks falling further behind international standards:
  • Adoption of key regulations on bank solvency and insurance supervision should not be delayed.
  • Revision of the General Banking Law to implement Basel III capital requirements for Chilean banks during the current administration is at risk.
  • The law to implement risk-based supervision for Chile’s insurance sector has been with Congress since 2011.
  • Adoption of both reforms would improve supervision efficiency, enhance credibility, and strengthen resilience against shocks.
  • Institutional coordination and scope:
  • Improve coordination and information sharing among financial sector supervisors and the central bank.
  • The proposed creation of the Financial Markets Commission is an important step toward integrated supervision; its implementation should not delay adoption of Basel III or risk-based insurance supervision and should broaden supervision to shadow banking activities (for instance, factoring companies and cajas de compensacion).
  • Corporate governance and investor protection:
  • Chilean companies tend to be relatively opaque and compliance with best practices in corporate governance is low.
  • Institutional investors, such as pension fund administrators, can encourage improvements by preferring investments in companies with high governance standards and protection of minority shareholder interests.
  • Consider creating a new governance code (Stewardship Code) on a voluntary basis and a targeted stock market index for companies with high governance standards, similar to a recently created sustainability index at the Chilean stock market.

The mission is grateful to the authorities and other counterparts for excellent discussions and their hospitality.

IMF Staff Concluding Statement of the 2016 Article IV Mission — Chile

References

• People's Republic of China and the IMF
• Chile and the IMF
• Mission Concluding Statements
• PRESS CENTER
• https://www.imf.org/en/home