Chiles Short-term Performance during Global Recession

In the shorter run: how has Chile performed in the global recession? Was growth affected? How about the balance of payments (especially the current-account balance)? Or the exchange rate? How would you assess the overall impact of the global recession on Chile? If you choose to focus on these questions, you may add outside material on the response of the government to the global recession. For the assignment, I have chosen to write about Chiles short-term performance during the global recession. Since the global economy went through one of the worst crisis (not sure if its over yet!) since the great depression of 1930s, Chile has emerged as one of the few emerging market economies to be in a better position than the others. As I researched into how Chile was able to successfully do this, I could find two key things it had done. First of all, Chile has stuck to a rigorous fiscal rule requiring it to save much of its revenue gained during the time of explosive growth it had when the copper prices were at the highest. Due to this, it has about $20.3 billion (about 12% of GDP) tucked away in main state investment vehicles called Sovereign Wealth Fund (SWF) which provides Chile with an enviable and essentially remarkably positive fiscal profile going into the crisis. That marks a contrast with neighboring Argentina, whose government has financed an increase in spending by nationalizing private pension funds, shredding investor confidence. In addition to the strong fiscal policies of Chilean government they enjoy a favorable demographic momentum that has a strong effect on their macroeconomic performance. What this means is that in Chile the key working age brackets are still growing as a percentage of total population. In many ways, Chile is now moving on the outskirts of the so-called demographic dividend with the age group 25-64 still growing as a percentage of total population whereas the age group 25-44 is declining.

GDP Growth
Even with such strong fiscal discipline and strong economic fundamentals the global economic crisis has not left Chile untouched. On a annual basis, Chile has observed negative growth rates since Q3-2008 (refer Chart 1).

Chart 1

This relatively bleak figure is produced by the expectation that domestic demand will contract at a rate of 4.7% of which the expected decline in gross capital formation of -14.3% which contrasts with a 25.82% expansion in 2008 (refer Chart 2). Chart 2

Trends in Output and Activity

One way in which to differentiate the GDP measures fielded above is to have a look at GDP divided onto sectors to see how output in Chile has evolved over an array of activities as well as to compare this to some form of base value. I have chosen to focus the attention on metal exports, manufacturing, services and agriculture (refer Chart 3). Reviewing the activity the exports of metal ores and services industry went down much more drastically than manufacturing and agriculture explaining the fact that the global recession has had a heavy impact on the demand for Chilean products and services. Chart 3

The External Sector

The analysis of Chile's external balance and the country's currency is of course closely tied to the evolution of international copper prices as Chile is, by far, the world's biggest producer and exporter of copper. Although copper prices have fallen back somewhat in the midst of the global recession relative to the average values through 2006-2008 they are still higher than they were at the turn of the century. The positive effect from copper on Chile's external balance has, at times, been coined as the copper bonanza and Chile's ability to manage this bonanza in a prudent manner is one of the reasons that the country stand out in the current environment. In general, the composition of Chile's external balance look very much like one would expect of course that the current account has been in surplus since 2004 due to the positive impact from the trade balance and thus net exports of copper. Thus, up until the advent of the financial crisis Chile's current account was characterized by a positive trade balance which outweighed a negative income balance to produce a consistent current account surplus (refer Chart 4).

Chart 4

This changed in the latter part of 2008 where Chile posted a current account deficit in Q3 and Q4 as copper prices plummeted and exports in general fell. Basically, the trade balance withered away into a small deficit and with a continuing negative income balance, Chile found itself in need of external financing for the first time in 5 years. It also pushed the current account deficit into deficit for the full year 08 and the central bank, rather surprisingly, expects 2009 to see another CA deficit. In any case, it is difficult to imagine that Chile will have any problem financing a current account deficit due to the huge amount copper savings in the Sovereign Wealth Fund.

Economic Freedom
Chiles economic freedom score is 77.2 as shown in Figure 1 below, making its economy the 10th freest in the 2010 Index. Its overall score is 1.1 points lower than last year, reflecting small declines in six of the 10 economic freedoms. Chile enjoys the highest degree of economic freedom in the South and Central America/Caribbean region. Figure 1 (Source: The Heritage Foundation, Index of Economic Freedom)

Openness to global trade and investment and a dynamic private sector have facilitated steady economic growth. Chile has pursued free trade agreements with countries around the world. The financial sector is diversified and stable compared to other regional economies and prudent lending and regulations have allowed the banking sector to withstand the global financial crisis with little disruption. Other institutional strengths include transparent and stable public finance

management and strong protection of property rights, although protection of intellectual property rights still needs to be strengthened. Chile trails behind other comparable economies in business freedom, fiscal freedom, and labor freedom. Income taxes on individuals remain burdensome. Although overall regulatory licensing is easy, bankruptcy procedures remain cumbersome and costly. Chiles financial freedom score is 70.0 which indicate that the financial system is among the regions and the worlds most stable and developed. Reforms that include capitalization requirements and shareholder obligations have increased competition and widened the range of operations. Twelve foreign banks and 13 domestic banks compete on an equal footing. The four largest banks control about 65 percent of total assets. The state-owned Banco Estado is Chiles third largest bank and accounts for about 15 percent of assets. Credit is issued on market terms. Domestic and foreign banking and insurance companies receive equal treatment. Chiles liberal capital market is the regions largest. Legislation to enhance access to financing for individuals and firms was passed in April 2009. The banking system has withstood the global financial turmoil well because of prudential lending and sound regulations.

Employment
In terms of the labor market Chile cannot escape the fact that the crisis has taken its toll. The unemployment rate is currently at 8.7% for Jan 2010 and has been consistently above the 6% mark for a few years (refer Chart 5). Given the fact that Chile entered the crisis running at 7-8% the lagged effect of the recession on the labor market may push the unemployment rate to uncomfortable levels. Chart 5

The number of persons employed has declined from its previous levels in 2009 whereas the registered number of persons in the labor force has increased during the same period. These figures highlight one of the challenge with having a large and growing labor force in the sense that you need to maintain momentum in order to be able offer the jobs which the people rightfully demand. Of course, a growing labor force is a good thing in itself, but in the current environment we should not rule out the case that it can become a source of "unrest" and fierce political debate.

Policy and Inflation

Turning the analysis to the inflation, the inflation rate in Chile was about 8% in 2008 and with nominal interest rates below the inflation rate the economy was experiencing negative real interest rates (refer Chart 6). Since then the inflation rate has steadily declined to about -1.4% during the end of 2009 well below central banks inflation target of 3% plus minus 1 percentage point. The central bank is likely to delay increasing its benchmark interest rate, which it has held at the current record low since July 09. Chart 6 (Source IMF)

Shown in the Chart below is the currency exchange rate of Chilean Peso versus the USD. As you can see the Peso is strengthening against the USD and it is further forecast for a strong growth.

Chart 7 (Source: finance.yahoo.com)

Fiscal Position
On the fiscal front Chile is in a much better position than most. Alongside the measures taken on the monetary front the government has, so far, initiated US $4 billion package of government spending and tax cuts. According to the budget office the budget deficit will amount to 4.1% of 2009s GDP, a position one finds it difficult to believe that Chile will have trouble financing. On June 15, 2009 Chile's fiscal authorities announced a bond issuance worth $ 1.7 bn as well as its intent to use $4 bn from its offshore savings to fund spending. Lower rates will not necessarily encourage Chiles banks, some of which are foreign-owned, to lend. So officials are also trying to inject cash and confidence into the banking system. They have done this in two ways. The Central Bank, which has ample reserves, has auctioned dollars. And the government has given a $500m capital boost to BancoEstado, a state-owned entity which is the third-biggest commercial bank, to allow it to expand lending, especially for mortgages and small businesses The most important aspect of this strategy of prudence has been the joint commitment across political leaderships to maintain a structural fiscal surplus of 0.5% of GDP. Between 1996 and 2006, Chiles public balance averaged 1.5% of GDP and coupled with a substantial amount of the copper windfall parked in the SWF Economic & Social Stabilization Fund (FEES) it has granted Chile with a net debt position of -11% (i.e. a net credit position of 11%).

Conclusion

In conclusion, I believe that the Chilean economy is best positioned to capitalize from a global recovery. The openness of the Chilean economy made it one of the most vulnerable to the global slowdown, certainly after Mexico. But the strength of its domestic fundamentals helped the economy withstand the global shock. Clearly, there are downside risks here and these come mainly from any adverse shocks Chile might suffer from another global fallout or simply the risk that global growth won't recover to the extent many are currently expecting. Yet, it is important to point out here that Chile's relative strength has two sides. On the one hand there is no doubt that the presence of Copper and the important of this commodity in the global value chain as well as the sound management of the windfall from this. On the other hand Chiles has strong demographic growth of its working population which puts Chile in the forefront of the rest of the Latin American countries.