Chile’s Economy – Steady as She Goes

BBC’s travel program Fast Track had a story about how Santiago has been working hard since the earthquake to (re)build its position as a cool global city. I have never been to Santiago (let alone Chile) so I cannot say whether there is any position to rebuild or whether Santiago isn’t simply moving up and ahead regardless of the recent blow to tourism in the wake of the earthquake. However, what I can say for certain is that when it comes to Chile’s economy at large it is in no need to rebuild anything; it is both global, cool and very strong.

Enviable Economic Performance

Let us begin taking stock on the performance of Chile’s economy in the past two years compared to the US and the EU16 in order to see that while the crisis indeed has been global (and still is) notable divergences are present.

Chile’s economy contracted through three quarters from Q4-08 to Q2-09 but has since returned to  growth and, crucially, seems to have returned to trend growth unscathed from the fangs of the economic crisis which will have wide repercussions in the rest of the OECD for many years. In this sense, Chile entered the crisis unlevered and with sound demographic fundamentals which precisely gives the economy the ability to reach escape velocity and quickly resume positive output growth. As a backdrop it is exactly this pulling power which many economies in the OECD don’t have which again means that for us to find a solution to this we have to find a way to export our way out of trouble but since this is not possible for everyone at the same time it does represent us with a unique challenge.

This is not the case however in Chile where the economy expanded at a hearty pace of 11.3% and 13.7% in Q4-09 and Q1-10 respectively (yoy), numbers which are bound to be considerably lower going forward especially since the effect of the earthquake in February will cast a shadow over Q1 GDP figures which may still be revised down considerably once the full effect has been factored in. The alternative is that the effect will be moved forward into Q2 numbers, but this is ultimately an accounting question.

Moving closer to real time developments the main activity index (the IMACEC) indicates a steady and ongoing expansion of Chile’s economy even after the blip which occurred as a result of the earthquake (showing up in the March reading as it happened in end February).

In May, the IMACEC stood at 130.9 (2003 = 100) which is the strongest reading in the index’ history and further encouragement has also come from the fact that May was the first month in which industrial production showed a proper increase on an annual basis after having moved sideways in Q1-2010; industrial production expanded 3.3% on the year. This points to an economy on a strong footing although some might note that at this pace and with the headwinds currently facing the global edifice the only way from here is down. I would agree in the main here as Chile may well give back some of the fine H01-10 performance as we move into H02-10 but Chile should be able to stand its ground  and will expand at a healthy clip in 2010.

This view is supported by recent upward adjustment of economic expectations across the board even if the current expectations of continuing interest rate tightening may be overdone.

Regards, the evolution of GDP in 2010 the expectations remains fixed at around 4.5% to 4.8% which is around trend output according to the central bank’s estimations. The 4.25% target for the monetary policy rate in 12 months implies a steep tightening schedule from the current level of 1.5% and many analysts have voiced caution that interest rate will climb this much in a 12 month horizon. This view reflects both the fact that the central bank may be too linear in the way it has set its 12 month target interest rate as well as it reflects the market’s perception that appreciation of the Peso may become an issue as the yield advantage of Chile increases relative to the USD and Euro.

Strong Fundamentals

So, I am arguing that Chile is doing fine and that she is likely to continue the recent impressive expansion which is likely to put Chile even more at odds with what is expected to be a slowdown in the developed world. However, do the fundamentals back this?

Indeed they do and the focus should be on two aspects; demographics and a sound management of copper windfall.

If we begin with the former there are naturally many ways to spin a story on the graph below.

One could for example point to the fact that the population share of 20-49 is  peaking right at this moment and is set to decline hereafter which means that Chile might just be running on the last fumes of full capacity. But this would be missing the big picture I think. In this sense, I think the main point to take away here is the remarkable stability of the population share aged 35-54 throughout the next 40 years (estimated of course, but we are fairly sure that this fits unless we get some kind of exogenous shock). I am emphasizing this because this particular age group has been found [1] to correlate well with GDP per capita levels and growth. The key to Chile’s relatively stabile demographic trajectory is to be found in a very favorable demographic transition (at least when it comes to economic growth). Consider then that from 1983 to 2009 fertility in Chile decline from 2.5 children per women to around 2 in 2009. This trajectory is actually what one would expect if applying basic transition theory, but in the real world only a few economies have made the transition to achieve a somewhat stabile level at replacement fertility. The general rule is that fertility undershoots replacement level and has mighty difficulties recovering if at all.

This, more than anything, makes Chile stand out and as an emerging economy turning developed this aspect of the Chile’s economy and thus the absence of a very quick and steep fertility transition is, to me, a key reason for Chile’s success.

Another reason for Chile’s strong economic performance is its copper reserves but more than anything the proper management of this to avoid Dutch disease and to build up a strong fiscal position and indeed a sovereign wealth fund in which large chunks of the copper windfall has been stashed away. Naturally, this does not make Chile less dependent on copper as such, but it means that the economy has been able to avoid adverse effects from the volatility in growth that often comes from relying on commodities for revenue (and growth). In numbers, In numbers, Chile has historically aimed at an annual fiscal surplus of 0.5%/GDP to act as a counterweight to the incoming copper revenues. Between 1996 and 2006, Chile’s public balance averaged 1.5% of GDP a position much better than that held by its peers in East Asia and Latin America. From 2005 to 2007 the structural surplus as a percentage of GDP was 1% and around 0.5% in 2008. However, the pure fiscal surplus, in 2008, as a percentage share of GDP stood at 8.1% which is quite extraordinary on any measure. Although the crisis and the earthquake are sure to have made a dent in these impressive figures the fact remains that on a gross basis Chile’s government debt remains very low (6% of GDP in 2009 and 2010) whereas the net debt level is firmly negative (i.e. book value of financial assets exceed that of financial liabilities).

Upwards and Onwards

Does this mean then that there is nothing stopping Chile? Actually, yes.

A renewed severe global slowdown or even a relapse into the financial crisis as well as continuing uncertainty surrounding Chinese momentum and thus copper prices are all factors that could derail Chile’s economy in some way or the other. However, it is fair to assume that in the event of an external shock Chile should fall less and rebound more strongly than many other economies and this means that Chile is likely to perform well in relative fashion.

Certainly, I don’t want to come of off as complacent but looking at the evidence before and with the qualifier that Chile is not hit by a surge of severe earthquakes (which of course will accumulate in the loss of output) I really cannot see where the stumbling block lies for Chile. In this sense it seems, for now, to be steady as she goes in Chile.

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[1] – See this for example.