Public Information Notice No. 98/8

Press Information Notice: IMF Concludes Article IV Consultation with Chile

February 20, 1998

The IMF Executive Board on February 11,1998 concluded the 1997 Article IV consultation¹ with Chile.

Background

Chile’s performance since the beginning of the decade has been remarkably strong. Through a combination of prudent fiscal and credit policies, stringent financial sector supervision, structural reforms, an open trade and investment regime, and efforts to improve social conditions, the country has achieved rapid output growth with a reduction in poverty, declining inflation, and a solid external position. Real GDP growth averaged 6.8 percent from 1990 to 1997, inflation declined from 27.3 percent to 6 percent during the period, official foreign reserves amounted to US$17.4 billion at end-1997 (close to ten months of imports of goods and nonfactor services), and the incidence of poverty fell from nearly two-fifths of the population in 1990 to less than one-fourth in 1996.

Economic management was complicated in recent years by sharp swings in export prices— especially copper. After a surge in 1995, the price of copper declined by over 20 percent in 1996, recovered in early 1997, and fell sharply later in the year, contributing to sharp fluctuations in the trade and fiscal balances. To limit the impact of these movements on demand and output growth, the authorities have periodically adjusted the overnight real interest rate, the central bank’s main instrument of monetary control, while trying to keep the fiscal stimulus to the economy broadly neutral. Lower copper export prices also contributed to a decline in the nonfinancial public sector surplus—from 3.5 percent of GDP in 1995 to about 2 percent in 1996 and the first half of 1997 (the latest data available). However, the cyclically adjusted fiscal stance remained broadly neutral in terms of its stimulus to the economy, as an expansion in the coverage of social programs aimed at alleviating poverty and reducing income disparities, including through increases in minimum pensions and an ambitious education reform, was mostly financed through matching tax increases. Output growth is estimated to have slowed from 7¼ percent in 1996 to 6½ percent in 1997.

The task of disinflation in 1996-97 was complicated by a number of other supply shocks (mostly weather related) that contributed to temporary but significant hikes in food and energy prices. Nonetheless, inflation declined to 6.6 percent at end-1996 and 6 percent at end-1997, in line with the authorities’ targets.

Reflecting the decline in copper export prices, the country’s external current account position shifted from a small surplus in 1995 to a deficit of about 4 percent of GDP in 1996-97. Rising profit remittances, reflecting strong foreign direct investment flows since the early 1990s, also helped widen the deficit. The financing of the current account deficit in recent years has shifted from debt to sizable inflows of direct and, to a lesser extent, long-term portfolio investment. Overall, large capital inflows contributed—up to the last quarter of 1997—to a gradual but steady real effective appreciation of the currency. The authorities have continued to deal with these pressures through a combination of prudential fee-based restrictions on inflows aimed at discouraging short-term foreign borrowing, a progressive liberalization of outflows (the existing prudential regulations apply mainly to foreign investment by financial institutions), and occasional discrete changes in the exchange band (including a revaluation in January 1997). In the aftermath of the crisis in Asia, the peso has come under some pressure, weakening by about 8 percent in nominal terms against the U.S. dollar since mid-October 1997. However, the authorities have averted an overshooting of the exchange rate through a tightening in credit conditions, moderate foreign exchange intervention, and cuts in public expenditure.

There have been important further advances in the area of structural reforms in recent years, with the approval of bills increasing private sector participation in the upgrading of infrastructure, as well as improving governance (particularly in the judicial area) and social equity (including through the above mentioned education reform). The supervisory and regulatory framework for the financial system has been updated and strengthened. Overall, bank performance indicators have improved throughout the 1990s along with a process of modernization (including higher foreign investment in the sector) and continued financial deepening.

Executive Board Assessment

Executive Directors noted that Chile had a long record of prudent and skillful economic management, and that recent policies and structural reforms had delivered a very good economic performance in 1997. The strong output growth, the decline in underlying inflation, and a sizable buildup in foreign reserves had created the conditions for further sustained gains in living standards, and had also served to strengthen policy credibility.

Directors considered that Chile’s sound fundamentals, as well as its favorable debt and debt-service indicators, robust financial system, and ample cushion of foreign reserves had equipped it to deal relatively well with the recent turbulence in world financial markets. In this context, they noted the authorities’ prompt actions to tighten monetary policy when the peso came under pressure. However, Directors cautioned that the country’s vulnerability to the events in Asia, particularly given the importance of its exports to that region, as well as the prospects of a prolonged sluggishness in commodity prices and a possible slowdown in capital flows to emerging markets, required vigilance on the part of the authorities and a readiness to tighten macroeconomic policies, if needed. Some Directors saw scope for a rebalancing of the policy mix, with some strengthening of fiscal policy. However, several other Directors considered that reliance on tight monetary policy was appropriate for the time being, especially given the recent exchange rate depreciation and the relative strength of the banking system, which could well withstand the effects of higher interest rates. They also agreed that continued unrestricted access to industrial country markets was crucial to solidify Chile’s outward-looking orientation.

Directors considered that Chile’s prudential restrictions on external indebtedness in the form of a one-year nonremunerated deposit requirement had played a useful role in reducing the volatility of capital inflows and in lengthening the maturity of external obligations. They noted the prudential character of these regulations, and the fact that they operated alongside a stringent system of financial supervision. Some speakers noted that their usefulness in the Chilean case may reflect importantly the country’s strong fundamentals and progress in restructuring the economy. They also felt that such restrictions tend to lose effectiveness over time.

Directors were encouraged by the authorities’ determination to slow the increase in consumer prices to around 4.5 percent in 1998, building on the central bank’s credibility in successfully lowering inflation since the beginning of the decade. They welcomed the recent steps to tighten credit, cut certain public outlays, and cushion the depreciation of the currency through moderate foreign exchange intervention. In their view, however, the risks to the external outlook heightened the importance of measures to reduce the country’s reliance on foreign savings, including the maintenance of a strong fiscal position over the short and medium term. In this regard, Directors noted the importance of raising private savings, and welcomed the authorities’ decision to examine potential measures to this end, through the imminent publication of the report of the commission that is reviewing ways to bolster private savings.

Directors commended the authorities on the impressive progress made in structural reforms, including the recent measures to significantly strengthen the banking system, undertake reforms in education, and improve the judicial system. Directors endorsed warmly the authorities’ plans to deepen structural reforms with a view to diversifying the economy and reducing the economy’s vulnerability to external shocks, achieving further productivity gains, as well as further improving social conditions. Directors also welcomed government plans to further reform financial sector regulations, especially by introducing consolidated supervision of financial holding groups; upgrade infrastructure with an increased private sector role; improve the quality of education and other basic services; and strengthen the regulatory framework for public utilities. In addition, they welcomed the government’s initiative to seek increased transparency in its own military outlays and those in the rest of the region.