When left-leaning president Michelle Bachelet returned to power in March 2014, one of her first moves was to propose big tax rises to fund education reform. It seemed an obvious — and popular — move. Education protests in Chile have grabbed international attention since August 2011 when communist activist Camila Vallejo — turned senator aged just 25 — gained global fame as leader of the student protests.
However, in August, a poll by the Centre of Public Studies (CEP) suggested that health was more of a worry to the population than education. “This was something of a punch to the government as that was not what it believed,” says Paulina Yazigi Salamanca, Chile economist at Latin American investment bank Credicorp in Santiago.
The surprise poll result does little to weaken the impression that the government may have been a little quick on the trigger with its reform programme. Economists generally agree that changes in education are necessary not only for social equality but also to improve the productivity of the economy in the long term. Yet the way the government set out tax rises scared the business community just when a wave of external factors was hitting Chile’s economy — one of the most open in the world.
GDP growth had already dropped sharply drop in the last quarter of 2013 and has remained below expectations so far in 2014, coming in at 2.4% in the first quarter and just 1.9% in the second. As a result, the central bank has reduced its growth forecast for this year from 4% to just 2%.
Luis Óscar Herrera, head economist for the Andean region at BTG Pactual in Santiago, highlights a tumbling copper price, falling terms of trade, lower mining investment and US tapering concerns as negative effects on Chile. “As a commodities exporter, Chile is exiting a very favourable decade and now there has to be a rebalance away from internal demand to other sectors of the economy.”
Economists are unanimous in their opinion that internal and external factors have played their part in the slowdown. “Within Chile we have seen a drastic fall in confidence levels that was much more abrupt than in other countries facing similar dynamics,” says Herrera. “Indeed, investment has fallen further than the deterioration of fundamentals should justify. This is because there has been a lot of uncertainty about reforms that has driven pessimism.”
TAXING TIMES
When Bank of America research analysts visited Chile in April, shortly after Bachelet announced the planned reforms, they said local consensus was that the proposals were “ill-timed and convoluted”. After the government released a video explaining the reforms, the opposition party deputy said it had a “high level of hostility”.
Juan Pablo Swett, president of Chile’s Entrepreneurs Association, replied with a video of his own, in which he claimed that “if the tax reform is approved as is, it will liquidate us. It makes taking a business forward impossible.”
These “heated moments”, as Benjamin Sierra, financial markets economist at Scotiabank in Santiago, describes them, show that the form of negotiating was “not of the standard” that Chileans are used to. “The reforms were carried out in a clumsy manner that undermined basic confidence,” says Sierra. “More than just the content of the discussion, it became a question of how we talk to each other. Had the government not had majorities in both chambers, there would have been more of a political discussion around the reforms.
“Both the government and private sector made quite hard line statements.”
The tax and education reforms required a more profound study than was carried out, believes Sierra.
On September 11, the tax bill passed its third and final stage in Congress — but only after an opposition consensus had been able to amend the bill heavily during the second stage.
“The negotiations led to one big change: the elimination of a 10% withholding tax on the distribution of corporate profits — which should be less harmful for investment and not damage corporate savings to the same extent.
There is also more choice for companies, as they can now choose between either paying a corporate tax rate of 25% plus another 10% in income taxes for shareholders, or paying 27% and income taxes, but with the right to discount some earnings that are reinvested.”
Nevertheless, the content of the reform remains “punitive” for businesses, says Herrera. “The bottom line is that corporate taxes are going up from 20% to 27%, which will reduce incentives to invest and to finance this from retained earnings,” he says. However, he also admits that at least now that the tax reform is approved companies can more accurately plan for the future.
“There is still pessimism in the business community,” says Yazigi at Credicorp, “but I feel the central bank and finance ministry are trying to get closer to the private sector in order to lift confidence. That will be very important for private investment, which is the most volatile variable within the GDP account.”
LOOKING FOR A LIFT
Nevertheless, after such a tumultuous year few, if any, expect an investment-led recovery in the short term. Rather, external factors may start to work in Chile’s favour again.
The price of Chile’s most important export, copper, has risen after hitting a low in March. As Scotia’s Sierra points out, expectations over Chinese growth have stabilised, with 7% again expected this year.
Chile’s peso has slumped from under Ps500/$1 a year ago to around Ps600/$1 in September 2014, which could help exporters to compete, particularly with the US and China having replaced Europe as the country’s main trading partners.
Indeed, in the long term, the open economy that means Chile suffers extraordinarily from commodity price volatility is also an
advantage. “Away from copper there are promising signs of diversification in agro-industry, finding a different way of taking advantage of the surge in Chinese consumption,” says Herrera. “The Pacific Alliance (including Colombia, Peru and Mexico) and deeper integration that it should bring will also be a positive in the medium to long term.”
Chile’s well respected central bank has responded to the slowdown with 150bp of rate cuts since October 2013. Although inflation has tipped over the 4% mark, an expected continued fall in domestic consumption means few expect that to last long, so at least one more rates cut is predicted by the end of the year to help stimulate the economy.
In addition, Chile’s net creditor status and recent disciplined public spending suggests there is room for increasing fiscal spending and investment, says Sierra. In early September, Bachelet announced $500m of additional public spending for the fourth quarter of the year — with half being reassigned from other parts of the Treasury budget and half coming from increased revenues expected from the tax reform.
Finally, potential for tighter external monetary conditions does not cause too much worry because, as Yazigi says, “that would be a sign that economic conditions are improving elsewhere, which should be of benefit”.
All this points to the possibility that the third quarter could be the low point for GDP growth.
ENERGY EXPECTATIONS
Yet the temporary increase in public spending will be a short term injection of life into the economy. Longer term, in certain areas Chile requires substantial improvement. Energy, in particular, stands out as a drag on the economy. Alongside education, energy is one of “two very clear challenges” in the long term, says Sierra.
“The energy matrix is expensive and will soon be unable to meet demand,” he says. “This is critical.”
Chile is an anomaly in South America as it produces almost no oil or gas of its own, importing 97% of the fossil fuels it uses. According to the World Bank, it imports 70% of its energy. Though liquid natural gas terminals have been built to allow the shipping of gas from abroad, the cost of electricity — which the energy ministry says has doubled in the last seven years — is crippling for the copper mines that drive Chile’s economy.
This has triggered another set of necessary reforms from Bachelet, including a greater role for state oil company Enap, underlining the importance of liquid natural gas, and removing barriers to renewable energy developments.
The reforms are designed to make the investment process less complex, align national and local objectives and make the process more expeditious, according to Herrera. “We can at least say that the government has a concrete goal: to reduce energy costs 25%-30% by the end of its term,” he says.
Yazigi says the reform is around 70% of what the market was expecting. “They make the rules of the game clearer so there can be more investment, which is the main problem,” she says. “Demand will be exceeding supply in five to 10 years. Furthermore, energy in Chile is very expensive, very dependent on contaminating energies — it needs to become more sustainable.”
However, after Bachelet announced the reforms in May, Fitch said they were “short on specifics” and suggested that simultaneous tax increases may negate any energy price saving as power companies would end up passing higher costs to their customers. In the long term, consumer electricity prices will be largely determined by “uncontrollable variables including hydrology and the cost of thermal fuels,” said Fitch.
Chile’s reliance on external variables, therefore, is unlikely to change — and its open economy has made it Latin America’s perennial star pupil. But some diversification would undoubtedly reduce vulnerability and the discussion again comes back to education. “If you look at the best developed commodity exporters like Australia, Canada or New Zealand, they have a very well educated population that provides a natural diversification of the economy,” says Sierra. “That is what Chile needs to aim for with education.”
Amid the furore surrounding tax reforms, Yazigi has noticed that it is still unknown precisely what the government will do about education. “We only know that they have the money,” she says.
Bachelet’s ambition has set the bar high. The tax reform controversy has at least ensured that energy and education changes will come under intense scrutiny.