Public Information Notice No. 05/104

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Chile

August 5, 2005

On July 29, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Chile.¹

Background

Over the past two decades, Chile has adhered to a sound and consistent policy framework. Its policy mix has been based on fiscal prudence, a successful monetary policy based on an inflation targeting framework with a floating exchange rate, free trade, and an open capital account, within a sound financial regulatory and supervisory framework.

Since 2000, the current administration has been adhering closely to the structural surplus rule, a key fiscal innovation. The fiscal rule, which requires a cyclically adjusted central government overall surplus of 1 percent of GDP, has proven to be an effective counter-cyclical tool. During 2000-03, when output growth was below its long-run trend, the actual overall balance of the central government registered deficits of just below 1 percent of GDP a year on average, and in 2004 the balance shifted to a surplus of 2.2 percent of GDP, consistent with the strong economic recovery and high copper prices. The transition to a full-fledged inflation targeting framework has been completed in 2000. The framework has been successful at keeping inflation very close to the mid-point of the target band of 2-4 percent—2.8 percent a year on average during 2000-04, while allowing the peso to float freely.

A strong external environment and an expansionary monetary policy has helped spur Chile's economic growth in 2004 and in early 2005. Robust growth in the global economy, including Asia—which absorbs one-third of Chile's total exports—has helped boost mineral export prices, particularly copper, Chile's main export commodity. Chile has also benefited from low world interest rates. Reflecting these developments, real GDP grew by 6.1 percent in 2004, the strongest rate of growth in 7 years. Despite steady employment growth, the unemployment rate is still relatively high, at about 8 percent, as strong economic growth has encouraged more workers to return to the labor market.

In the context of a still weak economic recovery and downward pressure on domestic prices, the monetary authorities eased their policy stance in late 2003 and in early 2004. Later in the year, when it was clear the economic recovery was well under way, and the forecast inflation has returned above the center of the target range, the central bank initiated a tightening cycle toward a neutral stance. It has raised its policy rate on seven occasions since September 2004, by a total of 175 basis points to 3.5 percent in mid-July 2005.

External conditions faced by the Chilean economy remain broadly favorable but increases in petroleum prices could lead to a slowdown in global demand and in Chilean exports. The authorities have taken steps to protect the economy from sudden cuts in natural gas imports and to encourage a switch in electricity generation from relatively cheap natural gas to alternative sources.

In the period ahead, the economy is expected to continue its robust growth, and GDP is projected to grow by 5.5-6 percent in 2005. Reflecting a supportive external environment, and a still expansionary monetary policy, strong investment growth is expected to continue in 2005. Domestic consumption would also pick up, boosted by higher incomes, an increase in employment, and strong consumer lending. Consistent with strong growth and high copper prices, the fiscal balance is projected to register a surplus of 2.3 percent of GDP in 2005. The current account surplus is projected to narrow to 0.5 percent of GDP in 2005, reflecting a higher import bill, including on oil and capital good imports.

Executive Board Assessment

Executive Directors commended the Chilean authorities for their consistent and skillful implementation of sound macroeconomic policies, which have helped entrench low inflation and sustain economic growth while contributing to a significant reduction in poverty. Directors observed that Chile's macroeconomic policies, centered on well-established rules and institutions, have been reinforced in recent years by strict adherence to the structural fiscal surplus rule and a highly regarded inflation targeting framework. Supported by increasing trade and financial integration and a robust financial system, these policies have paid considerable dividends, providing counter-cyclical support to the economy, strengthening its resilience to external shocks, and leading to favorable market ratings and sustained economic growth. Chile remains a model reformer and Directors looked forward to its continued leadership role in building a strong political consensus in favor of a robust macroeconomic policy framework in the period ahead.

Directors noted that Chile's short-term outlook appears bright. A favorable global environment, continued strength of mineral prices, the ongoing rebound in private investment, and the pick up in domestic consumption are expected to contribute to strong economic growth in 2005 and 2006. Existing risks to the outlook appear manageable, and Directors commended the authorities for their prompt action to mitigate the impact of disruptions in the supply of gas from the region.

Directors welcomed the authorities' strict adherence to the structural fiscal surplus rule, which calls for a surplus of 1 percent of GDP in the overall balance of the central government. While further entrenching Chile's commitment to a prudent fiscal policy, this rule has also been effective in providing counter-cyclical support to the economy since its adoption in 2000. Directors commended the authorities for restraining spending, despite higher revenues from the surge in copper prices. Going forward, Directors advised continued commitment to fiscal discipline. They welcomed plans to require future budgets to accumulate resources to cover potential future contingent liabilities and to include a measure of the structural fiscal position. Directors called for progress on the introduction of an appropriate and transparent mechanism by the government to cover the annual deficits of the central bank, with a view to working toward its recapitalization while preserving its institutional independence.

Directors supported the thrust of the government's debt management strategy, including the authorities' decision to selectively prepay debt and replenish the Copper Stabilization Fund. They also welcomed the rapid growth of exchange rate hedges, and supported efforts to deepen the domestic financial market, including the development of a market for long-term peso-denominated bonds.

Directors recognized that Chile's inflation targeting framework has gained a high degree of credibility and successfully helped anchor inflation expectations. They considered that the monetary stance in 2004 had been appropriate, with inflation gradually returning to the mid-point of the 2-4 percent target band. Directors also supported the gradual tightening of monetary policy under way, which is consistent with the inflation objective and the closing of the output gap.

Directors observed that the floating exchange rate regime has benefited the economy and allowed it to adjust smoothly to external shocks. They commended the central bank's transparent policy framework, with no intervention in the foreign exchange market. Together with fiscal prudence, this framework has helped support competitiveness, as evidenced by the strong growth in nontraditional exports.

While the Chilean banking sector is robust, Directors saw room for further progress on improving the financial system's efficiency and oversight consistent with the recommendations of the 2004 Financial System Stability Assessment. Early approval of the Capital Markets II draft law would be an important step in this regard. Directors welcomed the strengthening of market risk regulations in the banking sector. They looked forward to further improvements in the supervision of the insurance sector and steps to foster competition among private pension funds. While private pension funds are generally well run, Directors felt that a judicious liberalization of restrictions on the investment of these funds would encourage a risk-based approach in the management of their investments. Directors welcomed the authorities' plan to revise Chile's Anti-Money Laundering and Combatting the Financing of Terrorism (AML/CFT) legislation to enhance the ability of the Financial Intelligence Unit (FIU) to obtain information.

Directors encouraged the authorities to continue to accord a high priority to reforms aimed at promoting sustained growth and further reducing income inequality and high unemployment over the medium term. To sustain the ongoing diversification of exports, they supported efforts to boost research and development and improve further the business environment. They also welcomed reforms to improve pre-school coverage for low income groups, provide education subsidies to low-income households, and enhance funding for tertiary education. Directors stressed that further improvements in labor market flexibility would also be important to expand employment opportunities.

Directors underscored Chile's leadership role in opening markets through comprehensive and sustained trade and financial market liberalization. They welcomed the implementation of recent bilateral trade agreements and encouraged the authorities to continue their efforts in supporting multilateral trade liberalization.