Public Information Notice No. 02/78

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Chile

July 31, 2002

On July 19, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Chile.¹

Background

Chile's economic fundamentals remain sound and have improved through the evolution of the policy regime in recent years. Yet the country is operating in a difficult environment, for several years now coping with a sequence of negative shocks, most recently including the world economic slowdown, a further terms of trade decline, and spillovers from Argentina. Such developments are largely responsible for the substantial slowdown in Chile's growth that has followed the very strong performance of most of the 1990s. Nevertheless, growth has continued, and recent shocks have been absorbed in an orderly fashion. Reflecting the economy's strong fundamentals and the skilled implementation of the new frameworks for macroeconomic policy, Chile was able to maintain favorable access to global finance even during last year's market drought, and the authorities did not need to raise—and in fact have been able to reduce—interest rates.

Real GDP grew by 2.8 percent in 2001, as weakening domestic demand was offset by a strong expansion of net export volumes. With a substantial decline in Chile's terms of trade, however, the external current account deficit widened moderately, to about 2 percent of GDP. International reserves remained at comfortable levels, and the banking system sound. Notwithstanding a substantial depreciation of the Chilean peso in response to external factors, inflation kept within the target band of 2 to 4 percent. The unemployment rate remained elevated in 2001, around 9 percent, compared to 6 percent before the 1998-99 recession.

In 2001, the authorities achieved their new, ongoing target for the structural balance of the central government (the actual balance held steady, with a deficit of about 1 percent of GDP, as a firming of the underlying government accounts was offset by the effects on revenue of lower copper prices and a widening output gap). Early in the year, the central bank began easing monetary policy in response to weakening domestic demand and reduced inflationary pressures. After midyear, this process paused, as pressures arising outside Chile induced substantial currency depreciation and raised concern about the inflation target. Noting exceptional circumstances, the central bank for a time intervened in the foreign exchange market, leaning against the wind but not targeting the exchange rate. Subsequently, the Chilean peso "decoupled" from developments in Argentina, and inflation risks subsided. Thus since early 2002 the authorities have been able to reduce interest rates in response to further signs of weak demand and very low inflation, while the peso has been broadly stable.

For 2002, real GDP is expected to grow by 2.6 percent and inflation to remain inside the target band. The central bank will continue to be ready to adjust the policy interest rate, if needed, in either direction, to keep inflation in 2003 also in the target band. Fiscal policy will remain geared to achieving a structural surplus of 1 percent of GDP for the central government. The external account deficit and other indicators of external vulnerability are envisaged to remain at comfortable levels. These projections assume that domestic demand will strengthen fairly soon, in response to the easing of monetary policy, ending of a cycle of inventory decumulation, and with some push from greater investment expenditures of certain public enterprises, as well as some further improvement in the external environment.

Several policy initiatives were introduced in 2001, in which remaining restrictions on external capital flows were eliminated, measures were introduced to develop domestic capital markets, and tax administration and tax law were changed to reduce tax evasion and tax avoidance. Regarding labor markets, an unemployment insurance scheme was adopted, and a wide-ranging package of labor law changes was approved. The problem of unemployment continued to be addressed mainly through government-supported job programs.

Chile has maintained a very open trade regime and has continued to reduce unilaterally its uniform external tariff rate, now down to 7 percent. In one area, however, a recent WTO panel has viewed critically the price-bands system applied to certain agricultural imports. A free trade agreement with the European Union is expected to be soon ratified by Chile's congress, and the authorities expect negotiations on an agreement with the United States to advance as well.

The Chilean authorities are now developing a range of initiatives to enhance growth prospects over the medium term. These are essentially of a microeconomic nature, and include among others: encouraging the development of venture capital, strengthening the framework for resolution of anti-monopoly cases and other economic disputes, and adjusting the regulation of several sectors.

Executive Board Assessment

Executive Directors commended the authorities for their adherence to a sound and consistent policy framework—based on exchange rate flexibility, inflation targeting, and achievement of a structural fiscal surplus—which in 2001 had helped maintain macroeconomic stability, continued access to capital markets, and moderate growth. This performance, in the face of an adverse external environment, is also a reflection of Chile's political stability, good governance, and credible institutions, which serve to reinforce the economic agenda of the authorities.

Directors considered that the authorities' objectives of promoting a recovery of domestic demand and moderate output growth this year are broadly appropriate, particularly in light of the still high level of unemployment and associated output gap. They agreed that regional uncertainties could adversely affect the outturn, but considered that the country continues to be well-placed to adjust to new adverse shocks in an orderly fashion.

Directors supported the authorities' fiscal stance of resisting pressures in favor of a stimulus, and holding steady the central government structural surplus. Adherence to the structural target would safeguard the public finances over time, while permitting the operation of automatic stabilizers.

Directors welcomed the authorities' efforts to enhance fiscal transparency through their planned participation in a fiscal Report on the Observance of Standards and Codes (ROSC). Directors considered that a capitalization of the central bank would also add to fiscal transparency, and some Directors recommended a more comprehensive definition of the fiscal balance—incorporating the rest of the general government.

Directors noted that the inflation-targeting framework combined with the floating exchange rate regime continues to serve Chile well. With inflation subdued, and in light of the output gap, they supported the recent lowering of the policy interest rate. At the same time, Directors observed that it would be essential for the authorities to adjust the monetary policy stance should inflationary pressures emerge. Directors welcomed the steps being taken to further enhance monetary instruments, and a few suggested a cautious approach in the possible use of foreign exchange swaps recently introduced for liquidity management purposes. Directors considered that the central bank's actions had been consistent with its announced policy of intervening in the foreign exchange market only in exceptional circumstances—as a key plank of the authorities' framework—and stressed the importance of continuing to adhere to this strategy in the difficult and uncertain external environment.

Directors noted that banking system indicators appear sound, as reflected by prudential and earnings ratios, as well as stress tests recently conducted by the staff. A few Directors suggested that there was scope for increased bank competition aimed at lowering interest spreads, particularly on small business loans. They welcomed the progress being made in the area of consolidated supervision of financial conglomerates, as well as the efforts to strengthen anti-money laundering legislation, and the authorities' request for a Financial Sector Assessment Program in the coming months. Some Directors considered that strengthening the supervisory framework further would also require providing staff of the bank supervisory agency with proper legal protection.

Directors were of the view that Chile's medium-term outlook remains favorable, noting that the slowing of growth in recent years is related in part to temporary factors. However, some Directors cautioned that global and regional factors, and the still weak domestic demand and business confidence could continue to complicate the recovery. Directors welcomed the government's initiative to work closely with the private sector on the pro-growth agenda, and observed that growth should be boosted over the medium term by the range of proposals which the authorities are developing. These proposals aim to foster a deeper venture capital market for small and innovative firms, strengthen the framework for resolving anti-monopoly and other economic disputes, and improve regulation. Directors encouraged the authorities to press ahead with these reforms. A few Directors also recommended consideration of bringing private capital into state-owned companies.

Directors noted that a faster rate of growth would help tackle the still high rate of unemployment. They recognized the temporary need for measures such as government-supported job programs, but also noted that the persistence of high unemployment suggests that labor markets are not sufficiently flexible, or operating adequately. In this connection, Directors suggested that greater attention be placed on education and job training for low-skilled workers, and on other ways of enhancing labor market flexibility more generally. Several Directors expressed concern over the extent of the cumulative increase in the minimum wage, as well as over the possible higher labor costs implied by the recent labor reform package. Some Directors considered that wage and labor market developments, while creating rigidities in the economy, were adequate in the context of the country's social and economic objectives.

Directors commended Chile for its open trade regime and for continuing to reduce unilaterally the country's uniform external tariff, and welcomed the recent trade agreement with the European Union as part of initiatives to diversify the economy. Some Directors recommended that the authorities reevaluate the longstanding practice of using tariffs to hold domestic prices of certain agricultural goods within bands, and it was also suggested that efforts to phase them out would be assisted by the elimination of distortions in the agricultural policies of some industrial countries.

Directors recognized that the data received by the staff are timely and broadly adequate for surveillance purposes, recalling the positive overall assessment in last year's ROSC data module, and noting that since then the authorities have made progress in several areas. They urged the authorities to persevere in these efforts, and in particular to widen the coverage of fiscal and external statistics in the context of the forthcoming ROSC on fiscal transparency.