Itaú BBA - Latam in Depth - CHILE: Life with lower copper prices

Scenario Review - Chile

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Latam in Depth - CHILE: Life with lower copper prices

September 10, 2015

The economy remained weak during 2Q15, and lower copper prices have dampened the expectations for a significant recovery

Please see the attached file for all graphs. 

We are happy to present our new “LatAm in Depth” publication, where we dig deeper into a specific Latin American country, explaining in detail our scenario and looking closer at the evolution of the most important macro and political variables. This month, we focus on Chile and Argentina.

• The economy remained weak during 2Q15, and lower copper prices have dampened the expectations for a significant recovery. We continue to expect GDP growth of 2.2% this year but now see the economy expanding 2.7% next year (from 3.0% in our previous scenario).

• With a stronger dollar globally, lower commodity prices and growing uncertainty over the Chinese economy, the Chilean peso is depreciating against the dollar. The current account deficit narrowed briskly and is now close to zero. We expect an additional weakening of the Chilean peso, but the low current account deficit will likely limit the damage from possible tighter external financial conditions ahead. We see the peso at 700 to the dollar by the end of this year and at 715 by the end of the next.   

• The weakening of the exchange rate and the indexation mechanisms in place are keeping inflation at high levels. Short-term inflation expectations have deteriorated. We now expect a slower convergence of inflation to the target. Our yearend forecasts for 2015 and 2016 now stand at 4.8% (previously 4.0%) and 3.5% (from 3.0%), respectively.

 Despite disappointing growth, the central bank is signaling that it may raise interest rates to ensure that inflation expectations for the relevant policy horizon remain anchored. We now anticipate a hiking cycle to start in 1Q16. We see three 25-bp rate hikes during the first half of next year, bringing the policy rate to 3.75%. 

 Lower copper prices and weaker growth are reducing government revenues and limiting the room for counter-cyclical fiscal policy too. The government will likely reduce the structural deficit more gradually in the years to come.

Chile’s economy is adapting to a more adverse external scenario. The slowdown in China’s economy and lower copper prices come at a time when the government is promoting a number of controversial reforms, which have reduced private sector confidence. Growth is much lower than during the commodity boom, and the real exchange rate is depreciating. High inflation is a collateral effect. Although a credible inflation target and low public debt leave Chile better positioned to face the external shock versus other emerging markets, the room for stimulus has narrowed. Due to the persistence of inflation at high levels, the central bank is signaling rate hikes to ensure that inflation expectations remain anchored. Meanwhile, the Ministry of Finance is indicating a tighter fiscal policy for 2016 as revenues fall. In addition, the administration is now trying to moderate the reform agenda, in a bid to reduce uncertainty.

Moderating the reform agenda amid economic headwinds

Michele Bachelet was elected president in 2014 with a mandate to promote reforms aimed at redistributing income and political power. The ambitious agenda includes a tax revamp to fund additional government expenditure, an educational system reform, a labor-law change to strengthen workers’ rights, a modified pension scheme to benefit individuals, a reform of the electoral system and a constitutional reform (as the current constitution dates from the military period). Since assuming office, the new administration managed to pass the tax bill, the first part of the educational reform – dealing with free basic public education – and a revamp of the electoral system. The tax bill aimed at collecting an additional 3% of GDP progressively by 2018, increasing the burden mainly on corporates and high-income earners, in order to provide funding of the educational reform. The approved education bill bans profiteering by schools receiving public funding and nationalizes establishments managed by local governments, with the state footing the bill in an attempt to eliminate income segregation in the public educational system. Finally, the electoral reform created a more proportional system to apply from the 2018 parliamentary election, and it should reshape the political landscape by providing opportunities for candidates from smaller parties in the future.

But as economic conditions worsened and conflict-of-interest allegations appeared, public support for the government and for the reforms diminished meaningfully. Shortly after taking office, the administration and the president registered their highest approval ratings – upper 50s – in June 2014, but they have since fallen sharply, to the mid-20s according to recent surveys. The flagship educational reform also lost support, from a maximum of 58% last year to 39% in August but above the minimum of 33% in June. The labor reform has also seen falling approval numbers, with a minimum approval in August of 31%, down from the 53% favorable review in January. Discontent with topics ranging from security matters, management of the economy and the indigenous conflict have sharply eroded the government’s appeal over the last year a half.

Bachelet implemented a cabinet reshuffle in May, as the administration sought to boost confidence in politics and the economy. Rodrigo Valdes was appointed Finance Minister, and since taking office he has worked to improve dialogue with the private sector and has indicated he will try to make the reforms under discussion more business-friendly. In particular, regarding the approved tax reform, the government has issued rulings aimed at simplifying its application. Additionally, the Finance Minister will submit a bill by the end of the year to further simplify the new tax system. Even so, the goal of gaining 3% of GDP in extra revenues is unchanged.

A labor bill is currently under discussion in the Senate. The reform seeks to strengthen collective bargaining and therefore the role of unions. Under the current law, benefits obtained by unions are automatically extended to non-unionized employees and firms can replace workers on strike with temporary workers. Following a vigorous debate, the lower house mostly sided with union demands, discarding calls from the private sector, the political opposition and moderate factions in the governing coalition for a more business-friendly bill. The administration could incorporate some moderate elements during the discussion in the Senate, although worker replacement during strikes appears to be off the table. We anticipate the passing of the bill before the end of the year but not before an intense discussion and, possibly, more public demonstrations.

On the educational front, bills focusing on the teaching-career system and free higher education are at the core of the discussion. Currently, negotiations on the career bill are ongoing with the teachers’ unions opposing linking pay and promotions to evaluations. The second bill is still in a pre-parliamentary stage as the administration evaluates how and at what pace it can provide free higher education. The negative impact of low growth and copper prices on government revenues will likely force the government to implement the education reform more gradually than initially planned. Given the complexity of the debated matters, the authorities are now expecting to have all education reform bills approved by mid-2016.

In the current environment, other reforms lose priority. The reform to create a public pension fund manager (to compete with the private sector ones) is being considered by Congress, but we anticipate no significant discussion until the expert committee summoned by the president presents its final recommendations. While the government has started discussions with players in the sector, no concrete advances have been made yet. The administration has also committed to a public discussion that would eventually lead to a constitutional reform, but it remains unclear how changes would be implemented (a constitutional assembly, a specialized commission within the parliament or some other alternative).

Low growth state

Chile’s economy remained weak in 2Q15. GDP grew by only 1.9% year over year in 2Q15, down from 2.5% in 1Q15. Sequentially, the economy was flat from 1Q15, showing that the recovery seen in 4Q14 and 1Q15 was transitory. Internal demand grew by a modest 2.0% year over year and 0.2% qoq/saar, lifted by inventory accumulation. So excluding inventories, internal demand performed even worse (0.9% yoy and -2.7% qoq/saar). Gross fixed investment remains the main drag on internal demand (-3.0% yoy and -8.1% qoq/saar), but private consumption (-0.3% qoq/saar) and government consumption (-4.8% qoq/saar) also contracted from 1Q15. Meanwhile, real exports fell by 4.9% year over year and by 15.3% qoq/saar in spite of a solid performance of mining volume exports. In particular, manufacturing exports were down by 13.4% from 2Q15. We note that strikes at ports during the quarter may have contributed to the significant inventory accumulation, on one hand, and to weak exports on the other. In July, the Imacec (monthly GDP proxy) expanded by 2.5% and expanded 0.1% from June.

Lower copper prices are the main reason behind the economic slowdown in Chile. In fact, gross fixed investment – largely in mining and mining-related sectors – drove growth during the commodity boom years. It expanded by an average 9.2% annual rate from 2003-13, while the GDP grew 4.7%. But more recently (from 1Q14 to 2Q15), it contracted 5.6%.

The fall of oil prices is a mitigating factor. Chile’s energy imports were 5.7% of GDP during 2014. Although the (positive) exposure to copper and other metal commodities is much larger (15.9% of GDP in 2014), oil is performing worse than copper, bringing some relief to national income.

The deceleration in Chile has both a cyclical and a permanent component. Lower demand for investment and the resulting multiplying effect on the rest of the economy has been an important drag on demand. While it is true that the unemployment rate was flat year over year in July, at a low 6.6%, other indicators show a much less dynamic labor market. Waged employment excluding jobs in public administration and defense (which are growing at an unusually strong 7% year over year) are growing lower than they did during 2011-13, in spite of a recent pickup. Also, according to the employment survey in Gran Santiago produced by Universidad de Chile, waged employment is down 1.5% year over year in 2Q15 (while the unemployment rate is also virtually flat from one year before). But the deterioration of copper prices also has a negative impact on potential growth, not only through a lower investment rate (and therefore weaker capital accumulation), but also on total factor productivity growth.

Uncertainty over the reform agenda can also explain part of the deceleration. Business and consumer confidence has been low. In our view, the largest portion of the worsening in sentiment is actually a result of the deterioration in external conditions (lower copper prices and their impact on growth). However, a central bank study published in the 2Q15 monetary policy report found that macro factors (domestic or external) fail to significantly explain the confidence drop registered in the second half of 2014.

We expect Chile’s economy to expand by 2.2% this year. However, considering that copper prices deteriorated further, we now see a 2.7% expansion in 2016. In our scenario, lower domestic uncertainties contribute to a modest recovery.

A fast adjustment in the current account deficit

The current account deficit kept narrowing in 2Q15. The current account balance for the second quarter posted a surplus of USD 761 million, bringing the four-quarter rolling deficit to USD 0.3 billion (0.1% of GDP), an improvement from the USD 3.0 billion (1.2% of GDP) deficit in 2014 and 3.7% in 2013. In 2Q15, the four-quarter rolling trade balance of goods and services deteriorated slightly but remained above the levels seen from 2012 to 2014, while the income deficit narrowed to its lowest level in more than 10 years.

The fast external adjustment in Chile is happening in spite of lower copper prices. The negative impact of a lower copper price on the current-account balance is mitigated by the large share of mining in the stock of foreign liabilities. So, as returns on these investments fall, the income balance narrows. Lower oil prices (which are falling more rapidly than the price for copper) are also helping. In fact, the commodity trade balance (defined as agricultural and mining exports minus energy imports) has been broadly stable during the first half of this year. Finally, the weakening of the exchange rate and lower internal demand growth are reducing the non-energy imports (by 15.3% year over year in 2Q15) and also helping to narrow the income account deficit by reducing the dollar return on foreign investment in non-tradable sectors.

The reduction of the current account deficit is happening while foreigners are still maintaining an appetite for Chilean assets. In 2Q15 foreign direct investment (FDI) was robust (USD 4.5 billion in 2Q15 and USD 22 billion over the past four quarters), so net direct investment (FDI minus Chilean direct investment abroad) stood at USD 8.3 billion over the past four quarters (3.3% of GDP). Foreign portfolio investment was also strong, at USD 2.9 billion (USD 13.5 billion over the past four quarters, one of the highest levels on record), boosted by debt issuance of the government and companies in the external capital market, according to the central bank.

External debt keeps rising fast. External debt reached USD 147.9 billion in 2Q15 (around 58% of GDP), up from USD 145.7 billion by the end of 2014 and USD 132.6 billion by the end of 2013. So, external debt net of reserves and other public sector foreign assets (such as the stabilization fund) is not low (34% of GDP). However, around 30% of total external debt is made up of inter-company loans, which carry low rollover risks.  

With a stronger dollar globally, lower commodity prices and growing uncertainty over the Chinese economy, the Chilean peso is depreciating against the dollar. However, the solid external position of the economy is limiting the damage from the more adverse external scenario. Since the beginning of the year, the Chilean peso has depreciated less than other commodity-linked floating currencies in the region (such as the Brazilian real and the Colombian peso) and in line with the Canadian dollar and Australian dollar (commodity currencies of countries with strong fundamentals).

We now expect the Chilean peso to end this year at 700 to the dollar. For 2016, the strengthening trend of the U.S. dollar will likely bring the exchange rate to 715 by year-end. The weaker currency combined with the modest recovery will likely keep the current account deficit at very low levels (we see the deficit stable at 0.1% of GDP both this year and the next).

A slower convergence of inflation to the target

Annual inflation rose in August (to 5.0%), so it is further away from the upper bound of the target. High inflation in Chile has been driven by the weakening of the currency. Tradable inflation rose to 5.1% in August (from 4.4% in July). However, the depreciation is spilling over to other prices through the indexation mechanisms in Chile. So, non-tradable inflation (4.9%) and wage inflation (6.2%) are also high, even though they are currently below this year’s peaks.

Short-term inflation expectations are deteriorating. According to the central bank survey with economic analysts, expectations for the next 12 months are now at 3.5% (up from 3.2% in July and 3.0% in June). For the relevant monetary policy horizon, economists’ expectations remain anchored at the target, while asset prices and those from surveyed traders have risen above 3% recently

The recent upside surprises on inflation combined with the further weakening of the currency led us to increase our inflation forecasts both for the end of this year and by the end of the next. We now see inflation at 4.8% by the end of 2015 (from 4.0% in our previous scenario) and at 3.5% by the end of 2016 (from 3.0% previously).

Preparing to lift off

The central bank unanimously held the policy rate at 3.0% in its August monetary policy meeting, but the minutes show that the board also debated a 25-bp rate rise as an option. This is the first time since October last year, when the previous easing cycle ended, that two options have been considered. By introducing a dual-policy option, the board gains degrees of freedom to hike rates if necessary. The staff’s argument for a rate hike option is to ensure that inflation expectations remain anchored at the relevant two-year policy horizon.

In the September Monetary Policy Report (IPoM), the central bank’s baseline scenario assumes that the policy rate will follow a path similar to that implied from asset prices. This means that the removal of monetary stimulus could start between the end of this year and the start of 2016, as clarified by Governor Vergara during the presentation of the report to the Senate. In the June report, the central bank’s baseline scenario considered rate hikes to start during 1H16.

The guidance on higher rates is in spite of a skeptical view over the likelihood of a meaningful economic recovery. The central bank lowered its 2015 GDP growth forecast range for this year to 2.0%-2.5% (previously 2.25%-3.25%). For 2016, the central bank sees a pickup to 2.5%-3.5%. However, the central bank views the balance of risks for activity forecasts titled to the downside.

In addition, the central bank lowered the medium-term GDP (trend GDP) forecast to 3.5% (from 4.0%-4.5% in the 3Q14 report). The central bank made it clear that, in the short term, potential growth is even lower. So, the output gap in Chile is currently narrower than indicated by the 3.5% trend GDP estimate.  

We now expect a hiking cycle in Chile to start in 1Q16. We see three 25-bp rate hikes in the first half of next year, so our forecast for the year-end policy rate is 3.75%. In our previous scenario, we saw no rate hikes this year or next. As inflation has been persistently high, board members will likely increase rates to ensure that inflation expectations for the relevant policy horizon remain anchored. In fact, in the minutes of the most recent decision two members noted that the persistence of inflation at high levels puts the central bank’s credibility at risk. One of them warned that reacting late to changes in inflation expectations would ultimately be more costly.

Balanced budget in 2018: A challenging goal

Fiscal policy will also contribute less to growth. In 2014, the administration set the 2015 budget with a GDP growth assumption of 3.6% for this year and copper prices averaging USD 3.12/lb. Due mostly to the 4.3% assumption for potential growth, there was room for a fiscal stimulus. So, the budget was set with a 1.9% nominal deficit target for the central government (1.1% adjusting for cyclical factors), up from a 1.6% deficit in 2014 (0.6% accounting for cyclical factors). As both growth and copper prices disappointed (average copper price during the first eight months of 2015 stood at USD 2.63/lb), the government revised the growth and copper forecasts for this year to 2.5% and USD 2.75/lb, respectively, so the targeted nominal deficit increased to 3.0% of GDP.

For 2016, the government will work with lower estimates for potential GDP growth and long-term copper prices. The government recently released the forecasts for these variables by the committees. For 2016, the potential GDP growth assumption is 3.6%, while the long-term copper price was set at USD 2.98/lb. So, fiscal policy for next year will be more constrained. The government will submit the 2016 budget before the end of September. We expect real expenditure to grow roughly in line with GDP, bringing the nominal deficit to 2.7% of GDP (a modest reduction from our 3.1% forecast for this year) and the structural deficit to 1.4% (1.6% of GDP this year).   

Reaching the zero structural deficit target by 2018, a goal announced by the administration late last year, is becoming more challenging. The deterioration of copper prices and economic growth is offsetting many of the gains from the tax reform (3% of GDP expected by 2018).   

Initial debt conditions are benign. The central government is still a net creditor. Total net public debt equals -4.1% of GDP. In gross terms, the Chilean state owes less than 14% of GDP, with public external debt accounting for a mere 2.5% of output.


João Pedro Bumachar

Miguel Ricaurte

Vittorio Peretti


Please see the attached file for all graphs. 

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