Brief Economic Outlook for Chile

Chile shows increasing evidence of acceleration in economic activity: real GDP expanded by 5.8% y/y in the first quarter of 2007. Buoyed by solid gains in exports (up 22% y/y in the first quarter), the current account surplus more than doubled from a year earlier to a record-high US$3.3 billion. It is worth noting that while foreign direct investment recorded a net inflow of US$3.1 billion during the period, foreign portfolio investment saw a net outflow of US$4.4 billion; this trend will likely persist as local pension funds increase their share of foreign investments.

Looking ahead, the government’s economic team is confident that the country has
shifted onto a path of faster growth and contained inflation. According to the latest Monetary Policy Report , the monetary authorities expect the economy to expand between 5 and 6% in 2007 with an upward bias and inflation to decline towards 2% through the end of the third quarter. Yet, the country is not – and will not be – completely immune to financial market shocks resulting from domestic policy changes or disruptive external events despite its improving macroeconomic environment.

The administration of President Michelle Bachelet unveiled a project that will increase the eligible foreign investment content for private pension fund management institutions (so-called AFPs) to 45% from 30% (to be eventually increased to 80%); AFPs had US$97 billion under management
as of April 2007. This measure follows a change announced earlier this month that broadens the universe of eligible foreign financial instruments (now including exchange traded funds or ETFs).

In part because the above reform implies a currency-mix re-allocation in favor of currencies other than the Chiliean peso (CLP), the CLP and CLP-denominated securities markets reacted negatively to the news. A more structural factor pressuring the Chilean peso is the decrease in copper prices.

According to an IIF report, Chile’s has displayed fiscal surpluses for the last four years. In 2006, the surplus achieved 7.8% of GDP, due to high copper prices (and to the country’s countercyclical fiscal policy). Chile also posted a record primary surplus – 8.5% of GDP – in 2006. The strong fiscal performance was mainly due to a sharp increase in revenues than to a decrease in spending. It is important to notice that the Chile’s one percent structural fiscal surplus rule imposes a ceiling on spending assuming potential GDP growth rate of 5% and copper prices of $1.21lb. In turn, the structural surplus rule allows spending to grow 9% in 2007. IIF explains:

“It is important to notice that a group of Chilean economists recommended that the government reduce the 1% structural fiscal surplus to zero over the next four years. The resources released would be used to improve education and social spending. While the proposal is aimed at lifting the country’s productivity and growth potential, higher government spending is likely to appreciate the exchange rate and negatively affect the country’s competitiveness.”

According to the Minister of Finance, had it not been for implementation of the 1 percent structural surplus and the placement of these resources abroad, the exchange rate would have ended 2006 more appreciated. In turn, the proposal of spending the structural surplus requires that the government to convert their dollar revenues (held abroad) into pesos, thereby appreciating the domestic currency. So far, the government is avoiding any large scale pesification of its fiscal surplus. However, it remains to be seen how they will spend the structural surplus without appreciating the exchange rate.