Chile may outshine its regional rivals with an economy that has matured since its democratisation in 1990, but there is still work to be done to raise the living standards of the general population, as Jason Mitchell reports.

Chile, the most successful economy in South America, needs major structural reform if it is to enjoy the kind of economic growth seen in the countries of east Asia.

In many ways, Chile is the economic and social model for neighbours such as Brazil and Argentina but it has a long way to go before its population can experience a First World standard of living. The economy is expected to grow by 5% this year and 4.5% in 2005 but per capita income is still only $5700 a year. Average unemployment is 9.2% but is 32.5% among 15 to 19-year-olds.

Joydeep Mukherji, a Chile analyst at Standard & Poor’s (S&P), says: “Chile has the strongest public institutions in Latin America, but the country needs major structural changes if the standard of living is going to improve dramatically. Much more technology is embedded in industry in east Asia, for example. The semiconductor industry has been incredibly important to economic growth in countries such as South Korea and Taiwan. Chile and Latin America generally need many more graduates going into this field. We just aren’t seeing that.”

According to S&P, Chile has the best sovereign credit ratings in Latin America, with an AA local currency rating and an A foreign currency rating. It has a history of careful macroeconomic management and institutional reform, supported by politicians across the political spectrum.

Sound behaviour

The independent central bank has maintained inflation at around 3% for many years. The government’s policy of running a structural budget surplus of 1% of GDP over the course of a business cycle has helped to shield the economy during periods of low economic growth. The public sector debt burden is also modest at 38% of GDP.

Armen Kouyoumdjian, an analyst and business consultant based in Santiago, says: “Singling out General Augusto Pinochet for [responsibility for] Chile’s success gives him too much credit. Civilian governments have carried out many reforms that have had a positive impact on Chile’s economy as well.”

The country’s success since it became a democracy in 1990 is mainly due to its political stability. It has a two-coalition system made up of the governing four-party Concertación and the two-party Alianza coalitions. Both groups back pro-growth policies and rules-based fiscal and monetary policies (including the budget surplus rule) but diverge on taxation and government spending. President Ricardo Lagos, who heads the Concertación coalition, was elected in 1999 and will remain in power until elections in December 2005. (For an interview with Mr Lagos, see The Banker’s November issue).

“Chile’s performance should not just be attributed to Pinochet,” agrees Vladimir Werning, a Chile analyst at JPMorgan Chase. “President Lagos has concluded a series of important free trade agreements. The economy has matured and we have seen growing deregulation of capital flows.”

Legislative framework

The strong rule of law in Chile has provided a framework for the country’s economic success. One of the biggest problems in neighbouring Argentina, for example, has been a lack of respect for contractual law, most starkly manifested by a $132bn default on its sovereign debt in 2001, which continues to discourage inward investment in the country. Chile – which has a population of 15.2 million – should experience a strong economic recovery this year after growth of 2%-3% a year during the past three years.

“Economic activity is accelerating in seasonally adjusted terms, thanks to persistent improvement in both domestic and external demand,” adds Mr Werning. “Lately though, some drags have surfaced on consumption, the main driver of domestic demand. Consumer confidence has edged down and employment growth has been lacklustre.”

Chile has a relatively narrow economic base, making it sensitive to sharp changes in the terms of trade. Despite an open trade regime and recent free trade agreements with the US and the EU, commodities account for a large proportion of the export base. The country is the world’s biggest exporter of copper, which constitutes more than one-third of export earnings (down from 75% in 1973).

“What is interesting about Chile is that it has managed to diversify its economy in a way that Venezuela – dependent on oil – and Peru – dependent on minerals – have not been able to do,” says Mr Mukherji. “When copper prices fall, the economy does not go bust but when the prices go up, the economy booms.”

Fausto Spotorno, a senior economist at the South American fund manager Delphos Investment, says: “The global price of copper increased by 33% between the fourth quarter last year and the first quarter this year. Chile’s economic performance can be explained by the favourable international prices. The problem is that they will not continue at these high levels forever.”

However, the country’s reliance on copper should not be overstated because non-copper exports are rising at more than 20% a year and the copper sector’s increased profits are largely being channelled abroad rather than reinvested. A reversal in copper prices would not alter domestic consumption much.

Still, to transform its society, Chile needs to develop a long-term economic strategy based much more on services and technologically advanced goods. Spending on research and development is only 0.6% of gross domestic product, compared with 2.7% in Korea and 4.4% in Israel. The government doubled spending on education in the past few years but this has not improved examination results – most of the extra funding was absorbed by higher salaries for teachers.

Education concerns

Mr Mukherji says: “The transition towards a growth strategy less dependent on resource exports depends on improving education levels. Although the coverage and enrolment levels in universities have improved markedly in recent years, concerns remain about the quality of instruction.”

The government recently began reforms to modernise and de-politicise public services, which should boost the legitimacy of public institutions, including regulatory bodies. A recent law reduced the number of presidential appointments in the senior civil service to 700 from 3500.

Restoring confidence

Other recent initiatives, including a tightening of election spending laws, should restore public confidence after financial scandals in early 2003 involving the central bank and fraud at a government development bank, CORFO, in league with a private sector institution, Inverlink.

“The scandals highlighted shortcomings in governance but did not undermine political support for the government,” says Mr Mukherji.

At the beginning of August, a court in Santiago suspended a probe into the financial affairs of General Pinochet. A recent US Senate report had alleged that the Riggs Bank helped General Pinochet to hide $8m while he was under house arrest in the UK on charges of crimes against humanity. However, he has been stripped of his immunity from prosecution and another judge is investigating other allegations of fraud and bribery.

In November, the Chilean army for the first time accepted responsibility for human rights violations carried out during General Pinochet’s dictatorship. This was a reversal of the army’s previous position, which had held that the abuses were excesses carried out by individual officers. Mr Lagos heralded it as an “historic step” towards national unity.

Chile’s banking sector had a successful start to the year. In the first quarter, earnings increased by 11% and loans by 8.8% – consumer lending rose by 18.2%, while commercial loans advanced by 5.1%. Three out of the 25 banks operating in the country made losses and another six had lower earnings. Return on equity rose from 16.8% last year to 18.2%.

Enrique Marshall, the superintendent of banks and financial institutions in Chile, says: “The banking system continues functioning with perfect normality. The institutions show good financial health. Banking activity shows growth of 8%-10% a year and retail banking is particularly dynamic.”


 Enrique Marshall: banking activity is growing and the retail segment is particularly dynamic

Raimundo Monge Zegers, head of corporate strategy at Banco Santander Santiago, says: “In general, the panorama for banks is auspicious because of the strength of the economy and low interest rates that have fuelled the demand for credit. However, we are seeing rising levels of competition between the banks and other enterprises such as big stores and supermarkets. There is also growing disintermediation, whereby big corporate clients are being directly financed by pension funds, insurance companies and so on.”

Chile was the first country in South America to sign a free trade agreement with the US, which came into effect in January this year. It should give a major boost to the economy in the longer term.

Arturo Tagle, chief planning and administration officer at the Banco de Chile, says: “This accord will eliminate all customs tariffs between the two countries within 12 years [85% of them were eliminated when it came into effect]. It is estimated that trade between the two will increase by some 30% in the first year alone.”

Open field

The country is expected to remain politically stable in the run-up to the presidential elections next year. Mr Lagos, whose popularity has returned after the scandals last year, cannot stand for re-election. The Concertación coalition already has eight people in the race for candidacy but there are no front-runners at the moment.

Concertación won 48% of the vote against 37% for Alianza in municipal elections on October 31. However, the right-wing opposition candidate, Raul Alcaino, won the key mayorship of Santiago – a boost for outgoing Mayor Joaquín Lavín, who is expected to be the opposition presidential candidate.

Chile looks as though it will remain the role model for South America in terms of economic performance and political stability. However, it needs to create a knowledge-based economy to raise significantly the living standards of its people.


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