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Emerging Markets

Vindicated

Chilean officials are wary of seeming to preach to other countries on how to survive the current economic crisis. But then they hardly need to: the facts speak for themselves

Tight-fisted. This was one of the charges that used to be made against Andres Velasco, Chile’s finance minister since March 2006. Instead of hoarding Chileans’ money, he should be using it to improve their living standards, complained critics.

That was when the price of copper – by far the largest of the exports that accounted for 40% of Chile’s GDP last year – was running at up to $4/lb, an historic record, and the country’s fiscal coffers were brimming with the windfall income. Today, the story is very different.

Since mid-2008, copper has set another new record: that of tumbling more quickly than ever before, and Chile is probably already in recession. According to preliminary central bank figures, GDP contracted by 0.1% between the second and third quarters of last year and, ahead of the publication of official figures, the drop is thought to have reached around 5% in the last quarter.

Investment – in which mining plays a key role – and demand for consumer durables showed a particularly sharp contraction in late 2008. And with unemployment expected to reach at least 10% in the coming winter, retailers are steeling themselves for a broader weakening of consumer spending.

But Minister Velasco’s popularity – and, with it, that of president Michelle Bachelet –has climbed steadily as the price of copper has dropped. According to Adimark-GfK, an opinion research company, 54% of Chileans now approve of the government’s economic management, up from just 32% in September.

There is even speculation that the crisis could give the centre-left government coalition, the Concertacion, its fifth consecutive term of office. Much could, of course, change before the presidential election in December – unemployment is only just beginning to rise – but the coalition’s chances certainly look better than they did a few months ago.

Rather than tight-fisted, the government’s austerity now looks farsighted. And thanks to its money in the bank, Chileans hope that, although they will undoubtedly suffer this year, they will do so less than most of their neighbours.

Between 2007 and 2008, the government accumulated close to $20 billion – or 12% of GDP – in a sovereign wealth fund, the Economic and Social Stabilization Fund (FEES), on which it will be drawing to finance a $4 billion stimulus plan announced in January. The central bank, with almost $23 billion in international reserves, is also well buttressed against the crisis.

Most Latin American countries used the region’s six years of sustained growth through to 2008 to strengthen their fiscal positions and the quality of their macroeconomic policies. “The region is on a very different footing today,” says Velasco. “In previous crises, policy management and financial systems magnified the external shock, and we haven’t seen that this time.”

But Chile is the “best of the pack”, according to senior economist at Goldman Sachs Alberto Ramos. Peru is following a similar route, he notes, but still has to consolidate its policy framework and has higher political risk.

As well as protecting its citizens against the worst of the crisis, Chile can also hope to do so without damaging – and if the government invests wisely, perhaps even improving – its future growth prospects. Fiscal austerity has turned Chile into a net sovereign creditor, and unlike so many other countries that are trying to spend their way out of the crisis, it will not have to do so on the back of borrowed money.

Years of homework

“Most emerging markets would benefit from the framework that Chile has established because it makes good policy easier and aligns incentives,” says Velasco. “What’s important is to stick to the rules through the cycle.”

Chile’s comparative protection from the crisis is, however, not only the result of the fiscal austerity of the past few years. It has its roots back in the early 1980s.

That was when Chile’s banking system collapsed, a crisis in which there has recently been a revival of interest as industrialized countries have sought lessons for dealing with their own banking crises. According to a paper published by the Research Service of the US Congress in September, Chile’s bank crisis had a cost “comparable in size to that perhaps facing the US today”.

Its bailout of the system was not only successful in restoring confidence and liquidity fairly quickly and in giving viable borrowers a chance to recover. It was also an example of how to avoid moral hazard by obliging survivor banks and their shareholders to share part of the cost: banks had to buy back non-performing loans acquired by the central bank and, in the interim, they were forbidden from distributing profits.

But with hindsight, the single most important result of the crisis was a tightening of bank regulation. Combined with conservative lending practices – too conservative, according to critics – this laid the foundations for a robust system that is today an important line of defence against the international crisis.

True, it suffered a liquidity crunch in early October as international lines of credit – particularly short-term financing for foreign trade – dried up. But with temporary help from the central bank and the finance ministry – which converted some of its overseas assets into local bank deposits – the problem was soon resolved.

Demand for loans has since dropped, but the banking system is now fulfilling its proper role in supporting economic activity, says central bank board member Enrique Marshall. The proof that liquidity has been restored is, he says, the fact that commercial banks are no longer using a dollar-swap facility launched in October. According to Marshall, another change that has proved important is the autonomy granted to the central bank in 1989. “That helped to generate credibility,” he notes.

Autonomy was also followed by the introduction of an inflation-targeting monetary policy that further increased its credibility, and by a gradual increase in the amount and timeliness of the information that the central bank makes available to the market. In 1999, a floating exchange rate was also introduced, facilitating the economy’s adjustment to external shocks.

Chile’s strong fiscal accounts also predate the present government. They have their origin in an anti-cyclical ‘structural surplus’ budget policy introduced in 2000 under president Ricardo Lagos. Under this policy, the government distinguishes between ‘structural’ or long-term revenues and the temporary variations in income – up or down – that result from cyclical swings in GDP growth and international copper prices. In upswings, the latter are saved – hence the $20 billion in the FEES – for use during downturns.

Over the past eight years, this policy has not only reduced the cyclical volatility of fiscal spending, helping to ensure the continuity of social programmes, but also the volatility of GDP growth. And it means that Chile will be able to run significant budget and current account deficits this year without raising too many concerns about its macroeconomic stability.

Cashing in

It is Chile’s institutional credibility and strong fiscal position that have allowed the central bank to “act with the assertiveness of many G10 banks,” says Ramos. Since January, it has slashed its benchmark interest rate by a massive 600 basis points from 8.25% to 2.25%.

With inflation still running at 5.5%, outside the central bank’s medium-term target of 2–4%, that’s a gamble, says Ramos. But the market is prepared to give Chile the benefit of the doubt, he adds, whereas such an aggressive reduction in countries with less credibility and weaker fiscal positions would probably be seen as too risky.

The finance ministry welcomed the central bank’s hard-hitting monetary easing as complementing its own efforts to stimulate flagging demand. It wants to see early results ahead of the winter when unemployment typically shows a sharp seasonal increase.

Its stimulus plan has already brought some relief to the country’s 1.7 million poorest families who, in March, received a cash hand-out of 40,000 pesos (some $67) for each child. “It’s the biggest bonus ever in Chile’s history, and we can be pretty sure of it actually being spent,” says Velasco.

There have also been calls for a temporary reduction in VAT, but that is opposed by Minister Velasco. “Most VAT is paid by better off people so the effect is dubious, and measures such as the bonus are more likely to have a swifter impact on demand.”

In designing the stimulus plan, which is worth the equivalent of 2.8% of GDP, the government aimed for a broad package. As well as the hand-out, it includes tax relief for families and small businesses and an additional $700 million for public infrastructure that aims to create at least 70,000 new jobs.

The plan has been widely praised as putting money where it should have the greatest impact and, in some cases – such as new incentives for workplace training – as favouring future productivity gains. Analysts have also concluded that it contains little or no pork-bellying.

The plan also includes $1 billion to finance new investments by Codelco, the state copper company. That promises to have a longer-term spin-off in that it has provided a powerful incentive for Congress to speed up approval of a long-in-the-making reform of Codelco’s corporate governance.

But in a crisis, it is important to spend fast as well as wisely. Indeed, the government recognizes that its plan will only be as good as its ability to implement it.

The early signs are positive, however. “We’ve already completed the paperwork for 92% of all public investment for this year, with a view to starting the actual work within the first half,” reports Velasco.

But while the speed with which Chile can cash in on its advantages is of the essence now, its experience is also a lesson in slowness – the slowness of the step-by-step, measure-by-measure perseverance required to achieve economic resilience and the consensus that underpins it. “There isn’t a David Copperfield trick; development takes a generation or more,” concludes Alberto Ramos.

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