Mission Concluding Statement 

Chile: Staff Concluding Statement of the 2022 Article IV Mission

October 28, 2022

Washington, DC: An International Monetary Fund (IMF) mission met with the Chilean authorities and other counterparts during October 18–27 to discuss recent economic developments and policy priorities. This concluding statement summarizes the mission’s main takeaways.

1. After an impressive recovery from the Covid-19 pandemic, the Chilean economy is undergoing a necessary transition towards sustainable growth. In light of an effective, sizable, and multi-pronged policy response, the economy recovered very fast from the fallout of the pandemic, which resulted in the build-up of macroeconomic imbalances. Amid a positive output gap, inflationary pressures, and an elevated current account deficit, the authorities have adequately tightened macroeconomic policies, while supporting lagging employment and protecting the most vulnerable. GDP growth is projected to decline from 11.7 percent in 2021 to 2.1 percent in 2022 and turn negative at 1.3 percent in 2023, before returning to an estimated potential rate of 2.5 percent over the medium term.

2. The balance of risks is tilted to the downside. External risks include the possibility of an abrupt global slowdown or recession, with an associated spike in global risk premia and commodity price volatility; a possible de-anchoring of inflation expectations in major economies alongside further tightening of global financial conditions; commodity price shocks; or an intensification of spillovers from Russia’s war in Ukraine. Domestic risks relate to high inflation persisting for longer than expected, social discontent over high food and energy prices, or slow progress to meet social demands. The constitutional reform process is expected to continue but uncertainty over possible outcomes has narrowed.

3. Very strong fundamentals and institutional policy frameworks underpin Chile’s resilience and capacity to respond to shocks. On August 29, the IMF Executive Board approved a two-year Flexible Credit Line (FCL) arrangement for Chile in the amount of SDR 13.954 billion (about US$18 billion) to augment precautionary buffers and provide substantial insurance against adverse scenarios. Chile qualifies for the FCL because it has very strong fundamentals and a sustained track record of implementing very strong policies. The economy remains resilient, and the authorities have recovered policy space to respond to adverse shocks. Very strong fundamentals, including due to a low public debt ratio and ample liquidity buffers (comprising international reserves, foreign exchange (FX) liquidity lines, and assets in the sovereign wealth funds), reinforce a favorable medium-term assessment even in the face of significant risks.

4. The Central Bank of Chile (BCCh) has appropriately tightened monetary policy to tame inflationary pressures and remains vigilant to risks to the macroeconomic scenario. Inflationary pressures have been significant, as global price spillovers have been compounded by domestic factors, including a very strong (yet rapidly narrowing) cyclical position, and currency depreciation. Headline (core) inflation reached 13.7 (11.1) percent in September, and two-year ahead inflation expectations stand above the 3 percent target. The BCCh has pro-actively responded by quickly raising the policy rate to 11.25 percent in October (substantially above the neutral rate) and has announced that the policy rate will remain at that level for as long as necessary to ensure inflation converges to target over the policy horizon. IMF staff assesses the monetary stance to be adequate. However, upside risks to inflation prevail, which might require extending the tightening cycle if inflation pressures persist. Effective communication continues to be key to preserving the long-term gains of low inflation and well-anchored expectations.

5. The FX intervention program was successful in addressing risks of disorderly market conditions. The sharp fall in copper prices between June and mid-July triggered a fast and large depreciation alongside unusually high FX volatility. Stress in the FX market was aggravated by capital outflows, and the domestic capital market was less effective in cushioning the shock than in the past, affected by the three rounds of pension withdrawals. To prevent disorderly market conditions, the BCCh launched an FX intervention and liquidity provision program that ran from mid-July to end-September. The program succeeded in reducing FX volatility, restoring price formation signals, and preventing broader spillovers to financial markets and the real economy. Interventions were implemented with high standards of transparency, fully sterilized, and consistent with the monetary policy framework.

6. The exchange rate should continue to play its role as a shock absorber, and a replenishment of external buffers is desirable when conditions allow. As monetary policy rates in major economies continue to rise and global financial conditions tighten further, exchange rate flexibility will remain instrumental to absorb shocks. FX interventions should continue to be used only in exceptional circumstances to prevent disorderly market conditions. The BCCh has ample FX liquidity buffers, including international reserves, FX liquidity lines, and the FCL. When market conditions are conducive, a substantial reserve accumulation program would be advisable to replenish buffers.

7. The financial sector remains resilient, and banks have adequate profitability, capital, and liquidity. The banking sector is sound, despite a sluggish credit recovery, with adequate funding and profitability, and low impairments. The capital adequacy and liquidity ratios are comfortably above regulatory requirements. The non-performing loan ratio remains below the historical average, and banks' profitability has returned to pre-pandemic levels. The adoption of Basel III standards and the establishment of the Financial Market Commission (which consolidated the supervision of insurance, securities, and banks) are further supporting financial sector soundness and resilience. Pockets of vulnerability are focalized among low-income indebted households, smaller firms, and those in sectors more affected by the pandemic and by cost increases (such as construction). Against the backdrop of tightening financial conditions and the unwinding of Covid-19 liquidity measures, closely monitoring vulnerabilities is key to identify early signs of stress and prevent disorderly consequences.

8. The authorities’ fiscal overperformance in 2022 was remarkable. The headline fiscal balance is expected to reach a surplus of 1.6 percent of GDP (the first surplus in a decade), compared with a deficit of 7.7 percent of GDP in 2021. This extraordinary consolidation was underpinned by the removal of Covid-19 stimulus measures and strong revenue collection (partly due to one-off factors). The government also replenished US$6 billion in the sovereign wealth fund and reallocated spending to support the most vulnerable within the budget envelope, including: (i) measures to mitigate the impact of high energy and food prices; (ii) employment subsidies in lagging sectors; and (iii) targeted transfers to households.

9. The 2023 draft Budget focuses on social spending and public investment consistent with the authorities’ pre-announced medium-term fiscal plan and debt sustainability. Amid a negative output gap, the draft Budget envisions higher mandated spending on universal guaranteed pensions and other social areas, and aims to increase public investment and foster productivity within a sustainable medium-term path. At the same time, IMF staff estimates that the 2023 fiscal stance would be expansionary when both inflation and the current account deficit are elevated. To support the disinflationary process and current account convergence, it would be advisable to save any stronger than projected revenues and wait to disburse unallocated funds. The authorities’ commitment to a multi-year fiscal consolidation plan to achieve a broadly balanced structural fiscal position and keep gross public debt below a prudent ceiling of 45 percent of GDP over the medium term is essential for maintaining sustainability. This would require a fiscal consolidation of about 3 percent of GDP over the next five years, in line with the authorities’ commitment, accompanied by targeted measures to protect to the most vulnerable.

10. Efforts to refine Chile’s very strong fiscal framework are welcome. Recent enhancements to parameters in the structural balance rule, the adoption of medium-term fiscal targets, the introduction of a prudent debt ceiling, and the disclosure of the sensitivity of fiscal projections to macroeconomic shocks support Chile’s long-standing fiscal framework. The introduction of an explicit escape clause and a natural disaster fund, under consideration by congress, are also a positive step. Further enhancements would be desirable, including on the analysis and management of assets and liabilities and of fiscal risks; and the supervisory and advisory role of the Autonomous Fiscal Council.

11. Social spending reforms should advance as yields from tax reform materialize in line with medium-term fiscal objectives. The tax reform plan is ambitious and comprehensive. It pursues worthwhile goals, including raising revenues for an expansion of social services; increasing the progressivity of the tax system; simplifying and lowering compliance costs; reducing incentives for aggressive tax planning; and fostering a green economy. The reform to the personal income tax would reinforce one of the weakest pillars in the system, but the exemption threshold would remain high, and tax rates for low and middle brackets modest, by international standards. Moreover, cross-country experience suggests that the expected yields from tax administration and the wealth tax could be difficult to realize. To preserve fiscal sustainability, higher spending should advance conditional on revenue performance and medium-term fiscal consolidation goals.

12. Pension reform remains critical to tackle inadequate pensions. The introduction of a guaranteed universal pension addressed challenges for the most vulnerable retirees. However, many Chileans still face inadequate pensions, a predicament aggravated by the pension withdrawals. Replacement rates for middle-income households compare unfavorably with international standards due to low contribution rates and contribution density, as well as a retirement age that has not kept up with life expectancy. Critical aspects to be considered in pension reform include: (i) the scope to expand the universal pension in a sustainable manner; (ii) an increase in contribution rates and their destination (individual accounts versus a redistributive pillar); (iii) measures to improve contribution density, particularly for younger cohorts, and reduce informality; (iv) increases in the retirement age; and (v) the role of Pension Funds (AFPs). New pension withdrawals should be avoided.

13. After sizable pension withdrawals, the authorities are considering measures to deepen capital markets. Pension funds have played a key role in capital market deepening, serving market segments not covered by other institutional investors, favoring local equities and corporate bonds, showing more appetite for longer-term maturities, and acting as shock absorbers. However, pension withdrawals and uncertainty about the future of AFPs have hurt the depth and liquidity of the domestic capital market. The envisaged pension reform should be mindful of the capital market and macroeconomic implications, including the need to increase aggregate savings and finance long-term investment. The authorities’ plans to establish a repo market, develop a primary dealer system, promote fintech (supported by the new Fintech Law), and foster the internalization of the Chilean peso could provide additional avenues to deepen capital markets. Enhancing productivity and innovation are also key government priorities.

14. A broader use of green taxes should support Chile’s ambitious climate agenda. Chile continues to enhance its climate strategy, including though the recent Framework Law on Climate Change, and is a global leader in the issuance of ESG bonds. It has committed to decommissioning coal-fired power plants by 2040 and achieving carbon neutrality by 2050. Chile was also a pioneer and remains one of the few countries in Latin America and the Caribbean that implemented a carbon tax. IMF simulations suggest that a gradual increase in the carbon tax to at least US$60/tCO2e by 2030, coupled with higher excises for diesel, would be needed to reach Nationally Defined Contribution goals, while a carbon tax of US$150/tCO2e would allow Chile to stay on track to net-zero. These estimates would need to be re-calibrated if combined with complementary measures to curb CO2 emissions. The proceeds from carbon pricing (of up to 2 percent of GDP) could be recycled for targeted transfers and public investment to offset the impact on vulnerable households and boost potential growth.

The mission sincerely thanks the authorities and other counterparts for the excellent cooperation, warm hospitality, and engaging discussions.