CHILE: Best is not enough
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Emerging Markets

CHILE: Best is not enough

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Chile is struggling to adjust to a sharp change in its terms of trade. Far-reaching measures are needed to keep exports competitive

At first sight the Chilean economy couldn’t be healthier. Last year, it grew by just over 5%, a respectable performance for a country that had suffered a major earthquake, and its forecast 6% expansion this year would be the highest in South America.

Beneath the surface, however, the undercurrents of currency appreciation and rising inflation are tugging away at the steady course traditionally maintained by what many regard as the region’s best-managed economy. Moreover, according to Vittorio Corbo, a former governor of the Chilean central bank, it is – like other Latin American countries – not moving fast enough to adjust to a sharp change in its terms of trade.

Chile has advantages on its side. Its floating exchange rate helps to deter speculative financial inflows, and a decade-old fiscal policy, under which the government saves part of its fiscal revenues from copper, by far its main export, dampens the impact of high commodity prices on public, although not private, spending.

But, as compared to its neighbours, Chile also has important disadvantages. The exports whose competitiveness is being undermined by peso appreciation and rising domestic prices account for a third of the country’s GDP and, with just 17 million inhabitants, it does not, like Brazil, have the cushion of a large domestic market.

The recent hike in international oil prices has aggravated exporters’ difficulties. With few hydrocarbon reserves of its own, Chile imports almost all its oil and supports domestic fuel prices less than many other Latin American countries. Moreover, with a drought forcing the power industry to resort to diesel-fired generation to replace hydroelectric production, higher oil prices could not have come at a worse time.

At the beginning of January, after the exchange rate had dropped to below Ps470/$, down from close to Ps550/$ six months earlier, the central bank announced it intended to increase its international reserves by $12 billion this year. The measure, which opened the autonomous central bank up to the charge of bowing to political pressure – it had previously appeared reluctant to intervene – has had a limited impact, with the exchange rate since running mostly in the range of Ps470/$–Ps480/$.

Critics claim that the costs do not justify the benefits. “Some type of intervention was required, but the reserve programme is too predictable,” says Oscar Landerretche, an economist at the University of Chile. “You need to create uncertainty, so sporadic, surprise interventions would have been better.”

CAPITAL FLOWS

Capital controls were also mooted but have been ruled out by finance minister Felipe Larraín. That is partly because capital inflows, which were a concern earlier in the year, have since dropped, and the exchange rate is now being driven mainly by record copper prices. It is, however, also because of Chile’s unsatisfactory experience of their use in the 1990s.

Then in the form of a reserve requirement on short-term inflows, capital controls affected the composition of the inflows but not its overall amount and were blamed for giving large companies, who found ways to sidestep them, an unfair advantage over smaller players. “The subsequent evaluation was that the costs outweighed the benefits,” says Corbo.

Since mid-2010, the central bank has gradually been reducing monetary stimulus and, after a pause in January out of respect for the exchange rate, raised its benchmark rate by 25 basis points in February and announced a larger-than-expected 50 basis point hike on March 17 to 4.0%. Although headline inflation in the 12 months to February reached only a modest 2.7%, forecasts have been rising, driven by food as well as oil prices, and suggest it could reach a peak of 5% or more in the third quarter, escaping the central bank’s 2–4% medium-term target range.

Further monetary tightening is expected, with consensus local forecasts pointing to a year-end benchmark rate of 5.75% but, according to Corbo, the central bank also needs a helping hand from the government. “The economy is overheating and, if all the adjustment is left to the central bank, there’ll be more currency appreciation than is justified by the economy’s long-term fundamentals,” he says.

Fiscal spending accounts for 25% of GDP, up from 20% a few years ago. The government of Sebastián Piñera, Chile’s president since March 2010, has undertaken to increase spending by only 5.5% this year, down from 7.0% last year, but the demands of earthquake reconstruction will make further reductions difficult, says Landerretche, who was chief political adviser to senator Eduardo Frei, Piñera’s main rival in the 2009 presidential race.

But if, as expected, a strong currency is not just a passing phenomenon, more far-reaching measures will be required to preserve the competitiveness of many of Chile’s exports. “Like many other countries, Chile urgently needs to facilitate competition in non-tradable sectors to keep prices down there,” says Corbo.

One short-term measure might be to reduce labour-market rigidities and boost job creation in the face of incipient wage inflation. Another, clamoured for by exporters and promised by the government, would be to bring down high electricity prices by fast-tracking permits for new investment in the sector.

The sound macroeconomic management that has been Chile’s hallmark for the past 20 years looks set to need a wider range of microeconomic and more polically challenging measures.

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