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PolicyOctober 28 2009

The only way is up for Chile

Santiago: centre of one of the most dynamic economies in South AmericaWith one of the most liberalised economies in the world, prudent policies, and trading links with the Far East, Chile is poised to emerge from the downturn as a Latin American front-runner. Writer Jason Mitchell
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The only way is up for Chile

Chile has one of the freest economies in the world and is at the forefront of developing Latin America's links with Asia.

Jim O'Neill, the legendary head of global economic research at Goldman Sachs, who coined the term 'BRIC' at the start of this decade as a convenient shorthand for the world's most exciting emerging markets (Brazil, Russia, India and China), recently said that those economies are now too big and too developed. He added that they will continue to be important motors of economic growth but that there are other emerging markets that will be the new tiger economies. He believes Chile is among those economies, together with Mexico and Indonesia - or 'MIC' in shorthand.

"In the emerging markets, we expect many economies to see above-trend growth through 2010, with Chile and Israel at the top of the list and the BRICs, Indonesia and Mexico also in that camp," says Mr O'Neill.

"Chile has had impressive economic growth," says Jerome Booth, head of research at Ashmore Booth, the private equity manager that invests in emerging markets. "It is an economy that has clearly benefited from an important self-insurance by building up its reserves."

In many ways, Chile has been the model for the Latin American region for a long time. Brazilian analysts say that the country was an important example for Brazil in the late-1990s and that the Latin giant followed many of the much smaller country's economic and political strategies. This led to Brazil's rise as an economic heavyweight this decade.

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Jerome Booth, head of research at Ashmore Booth

Model economy

Chile has had investment grade since the start of the 1990s, it has one of the highest numbers of free-trade agreements in the world, it was one of the first Latin American countries to strike a free-trade agreements with China, and it is currently negotiating its membership of the Organisation for Economic Co-operation and Development (OECD).

"Chile is the benchmark for all the countries of the world," says Javier Santiso, director of the OECD Development Centre. "It sets best practice. It accumulated so much from the copper bonanza - 68% of gross domestic product (GDP) - that it is able to run the best countercyclical policy in the world. It is already a tiger."

He adds that he has great respect for Andrés Velasco, the Chilean finance minister, for having stuck to his guns in terms of economic policy. Two years' ago Velasco and President Michelle Bachelet were heavily criticised by many local economists and analysts for not spending more of the profits of Codelco, the world's biggest copper producer, on public policy programmes. Last November, the country suffered massive industrial action by public sector workers.

However, the leaders managed to put these attacks to one side, and today, during the international financial tsunami, the country is in a position to adopt the world's best counter-cyclical policy. The government has been reducing taxes and giving subsidies and hand-outs to the poor. President Bachelet has approval ratings above 60% and Mr Velasco is one of her most popular ministers.

"The MIC countries certainly offer opportunities for growth," says Ivan Narandja, director of wealth management at Cornhill in London. "And Chile certainly ticks all the boxes: it has low inflation, it is highly stable, it has very good capital ratios and very good returns on equity. Much of Latin America is an economic basketcase, but Chile has all the fundamentals right."

He adds that it is the only investment-grade country to have been upgraded to A1 from A2 by Moody's since the credit crunch started.

Chile is the longest country in the world and has one of the most diverse geographies of any nation: the Atacama desert in the north is said to be the hottest place on earth, while in the south it has the beautiful Patagonian region. It is cradled by the Andes and a spectacular view of the snow-capped mountains can be had from capital city Santiago. The world's worst earthquake to date took place near Santiago. Chile is one of the new world's most important producers of wine and the quality of life for people that live in the Las Condes neighbourhood of Santiago is considered to be one of the best in the world. The district is home to a new W, the iconic five-star hotels run by US leisure group Starwood.

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Jose De Gregorio, president of the Central Bank of Chile

Social cohesion

Chile has progressed a great deal since democracy was introduced in 1990, but social tensions remain high. Many poor people and the indigenous population, mapuches, feel left out of the country's economic prosperity. As Mr Velasco says, these issues need to be addressed if Chile is to remain a stable country in the long term and attract the sort of foreign direct investment and portfolio capital flows that it is targeting.

Mr Velasco gives the example of Finland as a small country that has succeeded by the interchange of high technology and believes Chile could move in that direction. Other Chileans are pushing for the country to become much more involved in the refinement of copper, rather than just selling its raw materials to importing countries that then refine it themselves and earn a fortune from doing so. In this way, Chile can move along the supply chain and add value.

"Finland is a great example," says Simon Alexander Legge, head of wealth management at Cornhill. "But for Chile to move in this direction it must get its public educational policy right. It is the key. With it, the country will be more stable socially and the nation's talent can be properly tapped, so that it can make the sorts of advances it wants."

Chile has more than 1 million unemployed or underemployed people. One of its biggest problems during the past decade has been the gradual tightening of the labour laws. This makes it harder for companies to fire people but it also makes it tougher for small businesses to hire new staff. Improvements to the labour laws is one of the priorities targeted by Sebastian Piñera, the right-wing coalition Renovación Nacional's candidate for the presidential elections, which take place on 13 December. Mr Piñera is the favourite to win.

Jose De Gregorio, the Chilean Central Bank president, says he is confident that the worst in terms of the decline in real activity is over and that the economy is now entering a recovery.

"I believe the bottom was in April," he says. "I expect the economy to grow above trend next year, at between 4.5% and 5.5%. That is far from a boom, as the economy is just returning to normal after such a big contraction."

In the bank's latest inflation report, Mr De Gregorio rejected the idea that the economic slowdown and the recent falls in consumer prices were deflationary, because of the reasonably high growth forecast for next year. He says there is still a lot of uncertainty regarding the rapidness and dynamism of the expected recovery.

Stimulus prospects

In terms of monetary policy, Mr De Gregorio emphasised that if the economic risks rise and deflation looms, the bank could consider additional monetary stimulus. However, he believes in the most likely scenario, the bank will begin to gradually lower the current monetary accommodation during the second quarter of next year.

However, Mr De Gregorio points out that it is a delicate situation, as the bank does not want to withdraw the stimulus too soon, in which case the economic recovery could falter. Room must be left for the economy to recovery. On the other hand, the bank does not want to stoke up any inflationary pressure and miss its key inflation target. The cost of getting that balancing act wrong could be great.

"A key and recurrent issue in many investors' minds is how soon and how fast will the central bank start to normalise monetary conditions?" says Alberto Ramos, a Chile analyst at Goldman Sachs.

"The yield curve implies that the central bank will start to hike the policy rate approximately at the end of the current year and will continue to push rates higher throughout 2010 [by about 325 to 350 basis points].

"Activity is unlikely to pressure inflation for a couple of years. The economy is likely to show broadening signs of a rebound during the second half of this year and to follow a gradually firming trend during 2010. The negative output gap accumulated up to the second quarter of 2009 is quite substantial."

Mr Ramos says that the below-trend growth performance of the economy since 2008 created a large amount of slack. This is manifested by an unemployment rate above the neutral level and low capacity utilisation rates in industry. He adds: "Even if the economy rebounds vigorously - which is still far from certain - it would take at least a couple of years with growth above 5% to 6% to burn all the slack accumulated in the economy up to Q2 2009 and for the upward real business cycle to start pressuring inflation up."

Mr Ramos does not exclude the possibility that the Chilean peso will experience appreciation pressures in the midst of the global dollar weakness. This would lead to stronger terms of trade and a better domestic economic outlook. It would also help to anchor down inflation. "A cyclical recovery is under way throughout the region," says Roberto Attuch, a Latin American banks analyst at Barclays Capital. "Although Brazil's recovery has been going on for a few months, green shoots have recently been taking root in countries that have been slower to rebound, such as Chile and Mexico."

Economists believe it unlikely that the Chilean central bank will start to put up rates this year, out of fear that this would put the brakes on economic expansion. Even if credit flows begin to rebound strongly in the first half of next year, the economy is likely to continue to need stimulus and the bank will only remove this once it is convinced that the economy has turned the corner. The main test will be the beginning of the end of the high unemployment.

"The earliest the central bank could start to remove the current exceptional level of monetary accommodation is the first quarter of 2010," adds Mr Ramos.

"But more likely the first move will take place later than that. In all, while the easing cycle was aggressively front-loaded we expect the hiking/rate-normalisation cycle to start slowly - small hiking moves in order to gradually signal to the market a move to a more neutral monetary stance - and to be somewhat back-loaded."

Chinese connections

Currently, Santiago feels like a boom town. There is a large amount of new construction happening throughout the centre of the city, especially in the El Golf neighbourhood of Las Condes. A glamorous new skyscraper called Titanium is nearing completion. Santiago is likely to start receiving much more investment from Asia and the Middle East.

Chile has been very careful over the years to nurture its relationship with China. Former president Augusto Pinochet was one of the first leaders in the world to attempt to build a rapport with Communist Party chairman Mao Zedong. This now helps China when it comes to trade with Chile. However, many local analysts believe that trade is not enough: the Chinese have been very slow at investing in Chile, despite repeated promises (in fact the Chinese foreign direct investment in Chile last year was virtually non-existent).

Chile also does not have a large Chinese-speaking population: Peru has a sizeable one and that has been one of the important factors in Peru's success at capturing Chinese investment. Peru is the only other country in Latin America to have an free-trade agreement with China.

However, Chile is not just looking at China: it is also reaching out to India, Indonesia, Malaysia, Pakistan, the Philippines, South Korea, Taiwan, Thailand and Vietnam.

Chile would like to be the Latin American hub with Asia and the Middle East - it wants to be the main entrepôt for investors from those lands coming into the Latin America sphere. Chile also enjoys the best airline in Latin America, Lan, and it is keen to improve its links with Asia.

Chile also has one of the largest standing armies in the Americas, which has never lost a war. The day following Independence Day - 18 September - a large military parade takes place through central Santiago. Chile values its relationship with the rest of Latin America, especially Brazil, but it realises that it is a Pacific Rim country and that the main investment and trade flows this century will be among countries surrounding the Pacific.

Chile is one of the final frontiers of the Americas and it is a country that has been prepared to make a stand. It has achieved it by developing Latin America's most advanced economy and it will continue to do it by opening up to Asia, the Middle East, and the rest of the world.

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