In a dry season
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Emerging Markets

In a dry season

Despite its fiscal virtue, Chilean growth is slipping in the face of an energy shortage, and exporters complain that the strong peso is undermining their competitiveness

In the 1990s, Chileans grew accustomed to what seemed like effortless 7% annual growth. Today, they see anything less – like the 4.2% that, according to consensus local forecasts, will be their lot this year – as failure. And it is all the more galling in their eyes because, instead of heading the Latin American growth stakes, Chile is now lagging behind neighbours like Peru.

This is not the result of any lack of fiscal homework. In that field, Chile has been one of the region’s star students, particularly since 2000 when it introduced a countercyclical structural-surplus fiscal policy. Today, helped by proceeds from record prices for copper, the country’s main export, the government not only runs a budget surplus that, in 2007, reached 8.7% of GDP but has also turned the country into a net creditor.

A recent report by the Organization for Economic Cooperation and Development (OECD) – of which Chile is poised to become the first South American member – praised its “exemplary macroeconomic management” and, indeed, on any checklist of protection against an international financial downturn, Chile gets high marks. “If you run down a list of the factors that made countries vulnerable from the Great Depression through to the Asian, Russian and Brazilian crises, none of them is present in Chile today,” points out finance minister Andres Velasco in an exclusive interview with Emerging Markets.

As well as its fiscal surplus, Chile has been running a substantial surplus in the current account of its balance of payments (although the central bank is forecasting a small deficit this year), and its closely-regulated financial system is well capitalized. In addition, private-sector foreign borrowing, at $50.5 billion – or just under 30% of GDP – is both very manageable and predominantly long term.

The economic downturn in the United States has, of course, hurt some sectors. While sales of wood pulp – a key Chilean export that, like copper, has an important market in Asia – are booming, exports of wood manufactures, which go principally to the US construction market, have tailed off sharply.

Holding up

But, otherwise, most macroeconomic indicators suggest that the economy is holding up pretty well. Last year, investment rose by 12.8% and, according to the central bank, will rise by 8.4% this year, despite higher domestic interest rates. Consumer spending, although slowing, remains strong and, under the 2008 fiscal budget, government spending will rise by 8.9% while still leaving a projected surplus of 4.8% of GDP.

So, with all this ballast, why have private forecasts of GDP growth this year sunk to 4.2%? International turbulence and the rough ride of local share prices are, of course, unnerving for Chilean businesses but, along with the country’s households, they have another worry – the imminent risk of power rationing.

Chile has been short on energy since 2004 when Argentina – currently its only source of the natural gas used to generate power – unilaterally started to restrict exports in a bid to alleviate its own energy crisis. Even as the cuts deepened, Chile scraped through by switching to more expensive oil-based fuels and drawing on its reserves of hydroelectricity.

But now a drought has depleted reservoirs and rivers and, with hydroelectric producers under pressure, president Michelle Bachelet has warned that power rationing – in the form of rolling outages – may be unavoidable. “We’ve done all we could; now it’s up to the weather,” she confessed recently.

As well as dragging down GDP growth, the shortage has pushed up energy prices and, together with an increase in the price of imported foods, particularly grains, has meant a surge in inflation. In 2007, the consumer price index rose by 7.8%, well over the target of 2–4% set by the central bank, which, since July, has gradually raised its reference interest rate from 5.0% to 6.25%.

Dutch disease?

For exporters, even the prospect of power cuts on top of rising energy costs pales in comparison with the appreciation of the peso against the dollar. Warning of Dutch disease, they claim that the strong peso is fatally undermining the international competitiveness of industries like fruit and salmon farming and wine growing, whose development underpinned Chile’s growth in the 1990s.

The government has chipped in with support measures that include an expansion of state guarantees for export credits and a subsidy for the hiring of agricultural labour. However, more radical steps are also being advocated, ranging from direct central bank intervention in the currency market to a reintroduction of the capital controls that Chile used in the mid-1990s to stem a massive influx of short-term capital.

However, despite the widening gap between Chilean and US interest rates, the entry of short-term capital is now negligible, notes Minister Velasco. And it is precisely the floating exchange rate adopted by Chile in 1999 that deters

carry traders.

Chile is, of course, not alone in seeing its currency strengthen on the back of the dollar’s international depreciation and high commodity prices, but the peso’s climb this year has been particularly marked. By mid-March, the exchange rate was running at close to 430 pesos to the dollar, down from a start-of-year level of almost 500 pesos (and a peak of 750 pesos in 2003).

The effect is far less startling when the peso is measured in real terms and against a basket of Chile’s trading partners’ currencies, rather than just the dollar, and the exchange rate is, in fact, far more competitive than in the run-up to the Asian crisis, argues Minister Velasco. “Given the tremendous increase in the terms of trade and where the price of copper is today...the fact that the [real] exchange rate is barely off the average for the last 18 years is a testimony to our prudent fiscal policies and decision to save a good chunk of our copper windfall abroad,” he says.

But still, he admits, the strong peso “warrants careful attention”. And so too will the cross winds of slower growth and inflation as the government – the fourth of the centre-left coalition that has held office since 1990 – attempts to steer a safe course to the port of municipal elections in October which will, in turn, provide an early indication of the temperature of the next presidential election in 2009.

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