Public Information Notice No. 01/73

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Chile

July 27, 2001

On July 16, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Chile.¹

Background

Chile's economic performance was very strong during most of the 1990s, but the country suffered a recession in 1998-99. In early 1998, Chile faced a widening external current account deficit—resulting from surging domestic demand and a large drop in copper export prices—which together with turbulence in world financial markets weakened investor confidence and put downward pressure on the currency. In response and to prevent the loss of the nominal anchor, the authorities raised the policy interest rate markedly. The combination of an adverse terms of trade shock, diminished supply of external finance, and contractionary monetary policy led to a sharp fall in domestic demand, and a decline in economic activity. Monetary and fiscal policies were eased starting in late 1998, which together with higher copper prices helped reverse the recessionary trend.

Real GDP grew by 5.4 percent in 2000, despite a slowdown which began in the second half of the year. For 2000, the deficit of the combined public sector fell by 1 percent of GDP, reflecting an improvement in the central government accounts. The external current account deficit widened moderately, and international reserves were stable at comfortable levels. Inflation rose to 4.5 percent by end-2000, reflecting higher oil prices, but subsequently fell to levels within the target band of 2-4 percent that became effective this year. Despite the economic recovery, unemployment was at end-2000 considerably above its pre-recession level.

For 2001, real GDP is expected to grow by 4 percent, assuming some pickup in activity later in the year owing to an easing of monetary policy that begun in August 2000 and intensified in 2001, and an envisaged improvement in external conditions. Inflation is projected at about 3 percent at the year's end, and the external current account deficit at around 2 percent of GDP. The combined public sector deficit is projected to narrow moderately, to about 2 percent of GDP. The authorities are addressing unemployment problems with temporary programs, including a scheme to support rescheduling of small- and medium-sized enterprises' debt.

Chile's economic policy regime has been enhanced in recent years, including by switching to a freely floating exchange rate, strengthening the inflation targeting framework, progressively removing capital account controls, and introducing measures to further develop domestic financial markets. On the side of fiscal policy, the new government has committed itself to a rule-oriented approach, defined in terms of a structural fiscal balance measure for the central government accounts. The target, a surplus of 1 percent of GDP, came into operation in 2001 and will be pursued on an ongoing basis. A new law on tax evasion and tax avoidance is aimed at increasing government revenue by 1 percent of GDP over the medium term.

Chile has maintained a very open trade regime and has continued with the unilateral phased reduction of its uniform external tariff rate, now down to 8 percent. At the same time, the new trade safeguards law has been applied to support a price-stabilization scheme for certain agricultural products which at time has generated import tariffs above Chile's WTO-agreed maximum tariff. The authorities recently intensified trade agreement negotiations with the United States and the European Union. Earlier this year Chile introduced a new system of unemployment insurance. A proposal for a reform of the labor market is currently in congress, but its outcome remains uncertain.

Executive Board Assessment

Executive Directors commended the Chilean authorities for their exemplary and long record of sound economic policies, which in the 1990s resulted in high and sustained economic growth and a gradual decline in inflation, along with an impressive record of poverty reduction. Directors noted that growth had been interrupted by the recession that began in 1998, but that a significant recovery of output has been underway since late 1999. The unemployment rate has, however, declined only slightly.

Directors observed that in 2000, the authorities restrained government expenditure to reverse a previous trend of a weakening of the public accounts, and early in the year firmed up monetary policy to contain inflationary pressures. They considered that the authorities acted appropriately by easing monetary policy starting in the second half of the year, as the slowdown in output growth reduced the inflation risk.

Directors endorsed the authorities' broad macroeconomic policy approach and stance for 2001. Monetary policy, with interest rates now at a historical low, seems under present circumstances appropriate for maintaining inflation within the target band of 2-4 percent. On fiscal policy, the actual balance is expected to hold steady in 2001, consistent with achieving the authorities' target for the structural balance of the central government, while the combined public sector deficit is expected to decline moderately. Directors considered that these policies should provide support to a pick-up of output growth and are likely to result in a small decline in underlying inflation and a moderate external current account deficit for the year. Directors noted that negative external developments, particularly in other emerging markets, could adversely affect the short-term outlook for economic activity. Nevertheless, Chile has not been affected significantly by contagion effects, and the country is well placed to deal with any such adversity.

Directors considered that the monetary and exchange rate policy regime are serving Chile well—including an exchange market that operates without intervention, except in extraordinary circumstances, and an inflation-targeting framework focused on a continuous inflation band. They thought that the floating of the peso provided sufficient flexibility to help the country deal with external shocks while allowing monetary policy to remain focused on achieving the inflation target. A number of Directors expressed some concern about the recent issue of foreign exchange indexed bonds, and recommended that the authorities be cautious in using this type of instrument.

Directors supported the new framework for formulating fiscal policy on the basis of an ongoing target for a structural balance measure. They noted that this approach allowed the authorities to commit to a precise fiscal target without suppressing the operation of automatic stabilizers. Looking ahead, Directors recognized the significance of achieving this target on an ongoing basis as a means to enhance credibility, and stressed that the determination of the copper reference price should be transparent. Some Directors, noting that the framework focuses only on the central government accounts, recommended that the authorities consider in due course adopting a more comprehensive measure of the structural balance, which includes also the central bank losses and the balance of state-owned enterprises. Directors welcomed the recent steps to enhance fiscal transparency, including the authorities' decision to participate in the fiscal transparency ROSC module.

Directors supported the authorities' continued steps to further develop domestic financial markets and to strengthen Chile's financial integration with the rest of the world. They considered that all these measures would contribute to deeper and more efficient capital markets and proper incentives for capital flows in the context of a sound banking system.

On the basis of available indicators, the banking system remains strong. Directors encouraged the authorities to continue to implement strict supervision practices and to advance in the introduction of supervision of financial conglomerates on a consolidated basis. They called for early progress in the capitalization of the central bank, which will add to fiscal transparency and strengthen public confidence in the bank's independence.

Directors commended Chile for its very open trade regime and welcomed the continued unilateral reduction of the country's uniform external tariff.

Directors observed that the high level of unemployment continues to be a problem, and noted the small decline in the unemployment rate so far from its 1999 peak. While agreeing that no easy solution to the unemployment problem is available, many Directors expressed concerns about the effect on incentives that could be generated by recent measures to facilitate rescheduling of debt of small and medium-sized enterprises. Directors considered that the authorities' initiatives to support employment would make a transitory contribution, but that it would be important to accompany them by caution in granting adjustments to the minimum wage and to keep labor markets flexible more generally. They encouraged the authorities to ensure that any new labor market reform measures do not introduce rigidities that would reduce the economy's ability to generate employment. Directors welcomed the new system of unemployment protection, which will enhance social safety net and reduce the distortions generated by severance payments.

Directors considered that the medium-term outlook for the Chilean economy is favorable. Growth will be supported by continued prudent monetary and fiscal policies and by recent structural reforms, including capital account liberalization and import tariff reduction. Directors thought that Chile's comfortable level of international reserves, strong banking system, credible policy framework, and exchange rate flexibility places the country in a good position to cope with changes in the external environment.

Directors noted the positive overall assessment of Chile's data dissemination practices and data quality found in the recent ROSC data module, and that Chile regularly provides the staff with timely data that are broadly adequate for surveillance purposes. They encouraged the authorities to continue improving Chile's statistical base, including by widening the coverage of fiscal and external statistics.