Chile - Recent financial developments and economic prospects

R E S T R I C T E D Report No.W H. 481 This document was prepared for internal use in the Bank. In making it available to others, the Bank assumes no responsibility to them for the accuracy or completeness of the information contained herein. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT RECENT FINANCIAL DEVELOPMENTS AND ECONOMIC PROSPECTS IN CHILE October 25, 1956 Department of Operations Western Hemisphere  CURRENCY UNIT Currency Unit Peso Par Value US $1 = 110 Pesos Free Banking Rate US $1 m 503 '(September 1956) $2,000 = 1 million pesos $2 million - 1 billion pesos Free Brokers' Rate US $1 = 530 (September 1956)  TABLE OF CONTENTS PAGE BASIC DATA SU-1KARY AI\D CONCLUSIONS I. ARTI-INPLATIODTILHY PROGRAM A. Introduction 1 B. Terrmination of the Wlage-Price Link 2 C. Banktin- and i;onetary Developments 2 D. Exchan.e Reform 4 E. Fiscal Developments (a) Situation in 1955-56 6 (b) Fiscal Prospects 8 II. IPLODUCTION ATl TRADE A. Copper 10 B. Nitrate 11 C. Industry 11 D. Agriculture 12 E. Trade 12 III. GENiERAL PROSPECTS AND CI'ZDIT WORTHINESS A. Stabilization 14 B. Production and Trade 15 C. External Debt and Creditwqorthiness 16 IV. ANUE ES A. The Outlook for Copper 19 B. Statistical Tables 22  B1LSIC DATA Area 286C000 square miles Population (1955) 6.7 million Anuual Rate Increase 1.8% 1950 1951 1952 1953 1954 Gross Natlonal Product $2.1 $2.1 $v2. 2 02.2 0$2.3 (billions dollars) Per Capita $344 $345 $352 0333 $340 Budget Government Finances 1951 1952 1953 1954 1955 1956 (billions pesos) Expenditures 27.6 42.0 54.1 82.9 156.0 218.0 Revenues 26.0 36e2 43.7 74.4 137.9 197.0 Deficit 5.8 10.4 8.5 18.1 21.0 Gold & E'cchange Reserves 1952 1953 1954 1955 June 1956 (millions dollars) At December 31 90g.6 92.6 61.2 106.6 118.1 Free Brokers' P.ate (December) 128 220 315 630 530 (Sept.) Money Supply 6 mo. 1956 (12 month increase) 36% 49% 52% 70% 25%o Dec. July Cost of Living 1955 1956 (1953 = 100) 80 100 172 302 394 460 Foreign Trade 1951 1952 1953 1954 1955 6 mo. 1956 Net Exports 323.3 404.3 298.2 360.7 388.1 200.0 Imports (CIF) 361.3 388.9 358.3 350.7 394.7 177.9 Trade Balance -38.0 +15.4 -60.1 +10.0 - 6.6 +22.1 Ma,jor Exports (1955) Copper 57% Nitrates 12 Iron Ore 3 Small MiNnes 10 Total Mining 82% Industrial 9 Agricultural 9 Total 100%  - 2 - BASIC DATA (Continued) Direction of Trade (1955) Exports Imports U.S. and Canada 43% Sterling 1i 6 BPU 25 21 Latin Am,erica 13 24 Ot Jher 1 100%b 100%  SUiThARY AND CONCLUSIONS 1. Chile's anti-inflation program, which was launched at the end of 1955, has to date achieved marked success. Unlike.previous attempts at stabilization in 1953 and 1954, the current program has the support of Con- gress, labor groups and the business community. The program began with effective action in four main sectors: (a) automatic wage-price links, (b) monetary and bank credit restrictions, (c) exchange reform and (d) fiscal measures. 2. Previous legislation in Chile had established a mandatory annual adjustment of wages to meet increases in the cost of living; one of the first steps in the present program was an act of Congress to repeal this provision. The general wage adjustment for 1956 was set at one-half the 1955 cost-of- living increase instead of 100 as in previous years. This policy has now been accepted by the important labor groups with no major strikes or work interruptions. 3. The monetary measures adopted were intended to reduce the liquidity of the entire banking system by sharply curtailing rediscounts and by avoid- ing direct Central Bank advances to the government. In the first five months credit expansion by individual banks had been substantially below the per- mitted ceilings due to the general tightness in the money market, but there has been some relaxation in the third quarter. 4. After many years of direct controls and overvalued exchange rates, an exchange reform was undertaken. The basic banking rate for merchandise trade and certain government transactions was set free and expected to reflect market supply and demand; Central Bank intervention was originally intended only to prevent erratic fluctuations but, in fact, it has held the rate within a very narrow range. An exchange standby fund of ,75 million was set up by the International lionetary Fund, U.S. commercial banks and the U.S. Govern- ment, but this fund has not been drawn upon; on the contrary, the Central Bank has been able to increase its foreign exchange reserves. Imports can be freely made from a list of permitted goods but the expected spurt of pent-up demands for many items did not materialize. The combination of compulsory peso deposits, running as high as 200%, and tight bank credit have effectively restrained importers' demand. 5. In the free brokers' market for tourism and private remittances, the rate dropped from a peak of 340 pesos per dollar in August 1955 to 470 in March 1956, partly as a result of repatriation of capital and partly from the sale of dollars to meet working capital requirements in the tight money market. The broker's rate is currently firm around 530 and the banking rate around 500 pesos to the dollar. 6. In the fiscal sector the government budget continues to be burdened by direct subsidies and operating deficits of government enterprises. The current budget is expected to produce a sizeable deficit, roughlyr, 10-12% of total expenditures, which is somewhat less than the 16% deficit registered in 1955. The general tax law recently enacted will not be effective in time to cover the growing volume of 1956 expenditures. By utilizing tax advances from the copper companies the government was able to reduce its borrowing -1i-  - ii - from the Central Bank in the first half of 1956. The major impact of the fiscal deficit upon the banking system and the loanable reserves of the commercial banks will be registered in the second half of the year. it must be noted, however, that 1956 has been a difficult year for the fiscal sector. It had to absorb large increases in wages and other costs which were carried over from 1955 by the momentum of inflation. There should be much less strain on the budget for 1957 and subsequent years as stabiliza- tion takes hold and subsidies are gradually eliminated for many commodities and services. 7. As a result of new legislation which created incentives for the expansion of production in copper and nitrates, a large investment program is being undertaken by the private companies. In a five-year period, capac- ity should increase 25% above 1956 levels for both copper and nitrate. Copper prices are expected to decline to 30 cents per pound by 1960 (they are currently 36 cents per pound), but the sizeable increase in exports which could follow from the new capacity could largely offset the loss in exchanlge earnings as a result of the price decline. 8. The prospect for foreign exchange earnings by 1960-61 suggests that Chile's net earnings are likely to fall within a range of 0380-p440 million. This rests on two assumptions, first, that the gains already achieved in the stabilization program can be consolidated (partially restor- ing agricultural and industrial incentives and creating remunerative exchange rates) and, second, that the world market can absorb the anticipated expan- sion in copper at a price of around 30 cents per pound. 9. Long-term external debt is being amortized at a rate of 4100-ll million annually, but medium-term credits have been expanding in recent years. A new government policy has been announced whereby supplier credits would not exceed a level of 4450 million. by 1960 service on existing long- term debt plus possible nevw medium-term credits could range from 4% to 10% of expected net exports; the higher figure corresponds to a level of q50 million outstanding on medium-term credits. 10. The service on additional long-term loans of h40 million would represent 1 of expected net exports and,on present prospects, this addition to debt service should be within Chile's repayment capacity. if further progress toward economic stability can be achieved with some levelling off in the general price level, substantial additional long-term creditworthiness should emerge.  I. ANTI-INFLATIONARY PROGRAM A. Introduction 1. Since the last Economic Report (W. H. 9a, September 1953), the Chilean Government made two abortive attempts (in 1953 and 1954) to deal with inflation. it is now engaged in a third effort which, after ten months of operation, is achieving a considerable degree of success. Both the earlier efforts failed for the same basic reason, that is, lack of sustained support of Congress, the labor groups and the business community. The pres- ent program, however, was launched and is being implemented in a different economic and political climate. There appears to have been a rising conviction tnat inflation in the last few years had reached a point where it was weakening the economy and unless halted would soon lead to a collapse with no assurance that Chile's political and social institutions could survive. in this new atmosphere, tne government is dealing effectively with the basic elements that have been weakening the economy. Although the sacrifices demaanded are severe, there is a widespread appreciation of the fact that failure of thls program would almost certainly lead to economic and perhaps political crises which could be even more painf-ul. 2. To appreciate the progres made under the present program, one must realize the extent of Chile's chronic inflation, which has been accelerating rapidly in recent years. in the decade 1940-49 the cost of living rose approximately 400%; the actual rates of change in later years may be seen below: Year Cost of Living lndex Annual Rate of (1950 = 100) increase 1950 100 15.1% 1951 122 21.8 1952 149 22.1 1953 187 25.4 1954 322 72.2 1955 570 77.0 When the first seven months of 1956 are compared with corresponding periods in earlier years, it appears that the rate of increase has been sharply reduced from rates of 38% in 1954 and 40% in 1955 to 17% in 1956. Although the general price level is still rising the significant fact is that for the first time in years inflation has been checked and there is promise of relative financial stability. 3. The success which has been achieved can be attributed to four principal elements that were lacking in earlier attempts or were cancelled out by policies working at cross purposes. They were (1) termination of the automatic wage-price link, (2) effective restrictions on bank credit, (3) exchange reform and (4) preliminary fiscal measures.  - 2- B. Termination of the Wrfage-Price Link 4. Earlier attempts to deal with inflation foundered on the legis- lative requirement that massive wage increases based on the cost-of'-living index be granted across-the-board every January. The legislative intent had been to restore real earnings by increasing money wages in the same percentage that the cost of living had increased over the preceding twelve months. However, no system of monetary restrictions or direct controls could absorb the shock of wage increases as high as 70% in 1954 and 1955, with no relation to productivity. Judging 'oy previous experience not much cculd be expected from traditional monetary, fiscal or exchange measures until this automatic link could be broken. 5. The break was achieved in December 1955 by a measure, passed by both Houses of Congress, effecting the outright repeal of the automatic adjustment. A transitional arrangement was made whereby the January 1956 adjustment was limited to one-half of the 1955 cost-of-living increase. As a corseouence, wage settlements were quickly reached with a maximum increase of 46% over January 1955 levels. A general strike called in protest failed, partly for lack of popular support and partly due to aggressive action by "he government under temporary siege powers. Nleanwhile, the reduced wage adjustment helped to slow down the rate of increase in labor costs, thus paving the way for other measures. C. Banking and Monetary Developments b. The termination of the automatic wage-price link was accompanied by the strict application of traditional monetary methods and the govern- m'ent's avoidance of direct borrowing from the banking system. The combined effect of these measures has been to reduce the ability of the banking sys- tem to expand credit. 7. Commercial banks had long been accustomed to using rediscounts from the Central Bank as a permanent increase in their w-iorking capital. Examination of statistics in earlier years indicates that the banking sys- tem, under insistent inflationary pressures, had usually been loaned up with scarcely any seasonal variation in rediscounts outstanding. The first mone- tary step to be taken, therefore, was to break this traditional reliance upon rediscounts. This was achieved by promulgating a series of penalty rediscount rates; for rediscounts up to 50%o of capital and reserves of the rediscounting banks the usual rate, 4.5% still applies; as a bank's redis- counts rose from 50% to 75% of capital and reserves, the rate was progres- sively increased to 9%; for all rediscounts over 75% the 9% rate applied. The banks were given a three month period of grace in which to adjust them- selves for some of the largest institutions had rediscounts as high as 145% of capital and reserves at the end of the year. 8. In the case of private commercial banks, the adjustment was little short of extraordinary as may be seen from the figures below:  - 3 - Recent Changes in Rediscounts Outstanding (billions of pesos) Private Commercial Banks Banco del Estado Rediscount Capital and as Fraction Date Reserves Rediscounts Capital Rediscount December 31, 1955 9.2 8.0 87% 6.8 March 31, 1956 9.9 6.0 61 6.4 June 30, 1956 10.5 3.9 37 6.2 Six month decline 4.1 0.6 Percentage 51% i