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Scenario Review - Chile

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Looking at global factors

April 12, 2018

With improved domestic conditions, the main risks to the expected recovery come from abroad.

Please see the attached file for all graphs.
 

Confidence remains strong at the start of the year. Signs of an investment rebound and improving labor market also bode well for the expected economic recovery. Risks to our 3.6% growth forecast for this year (1.5% last year) mainly come from the moderation of external tailwinds. The consolidation of investment and stronger exports are likely to lead to 3.5% growth in 2019.

With inflationary pressures limited, we see no need for the central bank to initiate its normalization cycle for the time being. We expect a stable policy rate of 2.5% for this year, with four 25-bp hikes next year, taking the policy rate to 3.5%.
 

Investment recovery

Activity picked up in the final quarter of 2017, aided by recovering investment and private consumption. GDP increased 3.3% year over year, an acceleration from the 2.9% in 3Q17 (revised from 2.2%) and the highest growth rate since 4Q13.

Gross fixed investment posted its first annual gain in 4Q17 since 2Q16. In the quarter, gross fixed investment increased 2.5% (-0.9% in 3Q17), driven by the 10.8% increase in machinery and equipment. Meanwhile, accumulation of inventories (mainly of manufactured goods) contributed 0.9 percentage point to the total GDP gain, likely in anticipation of better growth. Overall, durable consumption continued to be a firm driver of activity, rising 8.8% (12.2% in 3Q17), while service consumption rose 2.3% (from 0.7% in 3Q17). Total private consumption growth was 3.1% in the quarter (2.4% previously). Meanwhile, an import recovery led to a drag on activity from net exports (-0.7 percentage-point contribution).

Sequentially, activity posted its third consecutive quarter of growth. GDP expanded by 2.6% qoq/saar in 4Q17, following a 9.3% expansion in the previous quarter (when mining rebounded following the end of a strike in the sector). 

Activity got off to a solid start this year. The monthly GDP proxy posted growth of 3.7% year over year in the first two months. Mining is the driver, partly due to a low base of comparison, but the rest of the economy is also improving. Business and consumer confidence remained in good territory during 1Q18, pointing to sustained activity ahead.
 

In support of consumption, the labor market is showing further promising signs. Public employment remains the main creator of jobs, but the formal private sector is also showing indications of improvement, growing 1.6% (-0.7% in 4Q17). Even so, the unemployment rate picked up in February (to 6.7% vs. 6.4% one year earlier), as the labor force grew 3.0% (the highest rate since 2011), with the participation rate increasing 0.7 percentage points from February last year. We view the higher participation rate as a signal that more workers expect to find jobs.  

We expect GDP growth of 3.6% this year, more than doubling the 1.5% posted last year. High copper prices, strong global growth, low interest rates and low inflation amid increased confidence will support the recovery, factors that will more than offset a tighter fiscal policy. Growth of 3.5% is seen for next year. Risks to our forecast come from the potential escalation of global trade tensions.

Limited external vulnerabilities

The current account deficit narrowed in 4Q17, aided by an improved trade balance. The current account deficit in 2017 was 1.5% of GDP, close to the 1.4% recorded in 2016. Our own seasonal adjustment shows that the current account deficit remained small in 4Q17, at 0.2% of GDP. 

Recovering copper prices – despite falling volumes – explain the strong trade surplus for the year. The USD 4.9 billion trade of goods-and-services surplus in 2017 was the highest since 2011 (USD 8.3 billion), well above the USD 2.2 billion surplus in 2016. Copper prices gained 28.4% from 2016, while exported volumes contracted 3.3%, as the mining strike at the beginning of the year took a toll on copper production. Likewise, industrial exports expanded 7% from 2016, mostly due to price gains. Meanwhile, import growth for the year was widespread, due to both volumes (+5.5%) and prices (+4.9%), especially those of fuel products. The income balance posted a USD 10.8 billion deficit in 2017 (USD 7.0 billion in 2016), favored by improved profits for foreign companies, particularly in the Mining sector. 

Despite improvements in the second half of the year, foreign direct investment failed to fully fund the current account deficit in 2017. Last year, foreign direct investment was the lowest since 2003, at USD 6.4 billion (USD 12.4 billion in 2016 and USD 21.0 billion in 2015). The bulk of foreign investment came from profit reinvestments by foreign-owned companies operating in Chile. Net direct investment during 2017 was USD 1.6 billion, below the USD 4.9 billion recorded in 2016, failing to fund the current account deficit for the second year since 2015. Portfolio investment in Chile came in at USD 3.3 billion for 4Q17, an improvement from the USD 0.8 billion one year ago, leading to a USD 9.8 billion inflow in 2017, the highest since 2014 (USD 12.8 billion). 

We expect the current account deficit to remain contained this year. A gradual recovery of internal demand and robust copper exports support our projection for a current account deficit of 1.2% of GDP this year.

Exchange rate keeps inflationary pressure contained

Inflation remains low. The 1.8% inflation in March (2.0% in February) was characterized by a further dip in tradable inflation, to 0.9% from 1.3% one month earlier, while non-tradable inflation was broadly stable, at 2.9% (a low level). Core inflation (excluding food and energy prices) was also stable, at 1.6%, and below the lower bound of the target range. Our diffusion index remained low and continues to reflect limited price pressure.

We see inflation staying below the 3.0% target during the year, with a year-end forecast of 2.5%. A gradual acceleration to 2.8% by the end of 2019 is anticipated once the output gap narrows.

In no rush to hike

The central bank’s first inflation report (IPoM) for 2018 suggests that the central bank is comfortable keeping rates steady for the time being. The board unanimously held the policy rate at 2.5% in March, and the IPoM showed that the board’s updated baseline scenario sees rates evolving in line with the results from available surveys, holding steady at 2.5% until at least the start of 4Q18. At the time of the report’s publication, the analyst survey projects one hike before year-end, while the trader survey points to a hike taking place between 4Q18 and 1Q19. Both surveys see the policy rate reaching 3.5% in two years. Also, one change from the December IPoM was the indication that the start of the tightening cycle will unfold as “macroeconomic conditions consolidate the convergence of inflation to the target,” with no explicit reference to a date when this would occur. In the previous IPoM, the central bank noted the likely start of the normalization process would be in 2H18 (as the output gap started to narrow). The central bank has been on hold since May last year (following a swift 100-bp easing cycle), with rates in clear expansionary territory (neutral nominal rate estimated to be between 4% and 4.5%).

An improved external scenario, recovery in private sentiment and favorable financial conditions along with solid growth by the end of 2017 led the central bank to upgrade its growth outlook for 2018. Activity is seen increasing between 3.0% and 4.0%, a half a percentage point increase in the range since the 4Q17 IPoM. The central bank sees risks to its growth scenario tilted to the upside. The baseline scenario sees headline inflation hovering around 2% until 1Q19 with a year-end rate of 2.3% for this year. Overall, the risks for inflation are deemed balanced. However, the central bank notes that the recent evolution of the exchange rate has led to lower inflation expectations, and the board will continue to monitor the implication of this on the convergence of inflation to the target (read by us as its diluted easing bias).

The central bank’s baseline scenario is broadly in line with our expectations for growth and inflation. We also expect a broad-based activity recovery this year, along with low inflation. In this context, rate cuts are unlikely, but there is no urgency for rate hikes. Therefore, we do not expect a tightening cycle to start before 1Q19.  

Taxes and pensions on the menu

Less than a month since Sebastián Piñera took office (March 11), Minister of Finance Felipe Larraín noted the expected tax reform will focus on simplifying the system and providing greater certainty. Mr. Larraín has consistently added that the reform will be revenue-neutral, but he said that this does not mean some tax rates won’t be touched. During the campaign, lowering the corporate tax rate by around 2 percentage points was targeted. The minister aims for the reform to take place this year. Regarding fiscal commitment, Mr. Larraín acknowledges the need to push fiscal accounts toward equilibrium levels in the medium to long term, adding that this path is something still to be determined and that there is a period (90 days) during which to issue the decree with a fiscal commitment for the next four years. Looking forward, an extended discussion of Chile’s fiscal institutions is looming, especially after revisions were made to the 2015-2017 cyclically adjusted (aka, structural) balance estimates. This followed the reassessment of revenues and copper prices.

Another key reform this administration will tackle is the pension system. Labor Minister Nicolas Monckeberg noted that the government intends to submit the reform during the first half of this year. Monckeberg indicated that contributions to the Solidarity Pillar – which finances the pensions of vulnerable and middle-class individuals – and incentives to women and middle-class workers close to retirement age will be the main points of the reform project. A 40% increase in the Solidarity Pillar will likely be part of the reform. The minister has stressed that there will be an increase in the individual pension contribution of 4 percentage points charged to the employer. Finally, there will be a special supplement for women and for middle-class workers who are about to retire or who have already started to draw on their pensions. The objective is to implement this initiative as law this year.


 

João Pedro Bumachar
Vittorio Peretti
Miguel Ricaurte


 

Please see the attached file for all graphs.



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