Chile - Current economic position and prospects

-R E S T R I C T E D R e p o r t N o. WH-55. FILE COPY This report was Drepared for use within 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 CURRENT ECONOMIC POSITICON AND PROSPECTS QF-CHILE April 12, 1957 Department of Operations Western Hemisphere  CURRENCY EQUIVALENT Currency Unit a Peso Par Value US $1 - 110 Pesos Free Banking Rate US $1 - 580 (April 1957) $1,750 1 million pesos $1,750,000 = 1 billion pesos Free Brokers' Rate US $1 625 (April 1957)  TABLE OF CONTENTS PAGE BASIC DATA SUMMARY AND CONCLUSIONS I. REVIE.N OF THE STABILTZATION IROGRAM A. Prices, Wages and Employment B. Monetary Mleasures 3 C. Fiscal Developments 5 D. Exchange Reform 11 II. PRODUCTIO1NT AND TRADE A. Agriculture 13 B. Mining 14 C. Industry 15 D. Trade and Payments 17 III. GEIERAL PROSPECTS AND CREDINWORTHTNESS A. Stabilization 20 B. Production and Trade 21 C. External Debt and Creditworthiness 23  BASIC DATA Area 286,000 square miles Population (1955) 6.7 million Annual Rate Increase 1.8% 1954 1955 Gross National Product $2.1 $2.0 (billions dollars) Per Capita $320 $298 Est. Government Finances 1952 195, 19`4 1955 1956 1957 (billions pesos) Expenditures 42.0 54.1 82.9 156.0 230.0 338.0 Revenues 36.2 43.7 74.4 137.9 205.0 319.4 Deficit 508 10.4 77 T8T 25.0 1T8. Central Bank Gold and Jan. Exchange Reserves 1952 1953 1954 1955 1956 1957 (millions dollars) At December 31 65.0 65.5 39.4 82.9 76.3 71.8 Mar. Free Brokers' Rate 1957 (Decerrber) 128 220 315 630 600 615 Money Supply (12 month increase) 36% 49% 52% 70% 39% Feb. Cost of Living (Annual Average) 1957 (1953 = 100) 80 100 172 302 471 543 Foreign Trade 1952 1953 1954 1955 9 mo. 1956 Net Exports 404.3 298.2 368.7 419.4 340 Imports (CIF) 388.9 358.3 350.7 398.5 264 Trade Balance 7157. -60.1 +18.0 +20.9 7  -2- BASIC DATA (Continued) Major Exports (1955) Copper 57% Nitrates 12 Iron Ore 3 Small Mines 10 Total Mining 82% Industrial 9 Agricultural 9 Total 100% Direction of Trade (1955) Exports Imports U.S. and Canada 43% 44% Sterling 18 6 EPU 25 21 Latin America 13 24 Other 1 5 100% 100%  SUMMARY AND CONCLUSIONS 1. The Chilean stabilization program -- a series of measures dealing with wages, bank credit, the budget and the exchange system -- has now been in effect for one year. In comparison with 84% inflation in 1955, prices rose 38% in 1956, but much of the increase was due to the elimination of cost-of-living subsidies, the effect of a higher exchange rate on import prices and the absorption of a h6% wage increase at the beginning of the year. 2. The transition from inflation to partial stabilization has been accompanied by unemployment in certain industries, a slowing down in produc- tion as inventories are used and a decline in the volume of business, espe- cially in building materials and associated industries. 3. Although the rate of inflation registered 38% last year, the cost of living has held firm over the last four months viz., November-December 1956 and January-February 1957. To force a more rapid adjustment or stop the inflation in its tracks -- from 84% to zero -- would have created such additional stresses and strains that the program would never have held the slim margin or support it initially received from Congress, labor and the business community. The over-all objective is to stop inflation over a period of time by damping the rate each year. 4. The monetary measures, successfully applied, consisted of quotas to limit commercial bank expansion, plus tighter rediscount requirements and sterilization of import deposits which combined to reduce the liquidity of the banking system. There was some relaxation by the Central Bank in the second half of 1956 with larger credits to the governrment and easier commercial bank credit. But there were offsets, such as sales from ex- change reserves and impounded import deposits, which served as shock absorbers to the expansion of credit. As a result, the money supply was held constant for several months. 5. The fiscal sector now becomes the most critical one. The 1957 budget was originally balanced but the sharp decline of copper prices -- 5 cents per pound in two months -- cost Chile $40 million in tax revenues and precipitated a budget deficit. Ways and means are now being considered to meet the problem and, if they prove successful, the 1957 cash deficit can be kept within manageable limits. 6. The principal source of previous deficits -- enactment of supple- mentary expenditure bills after closing the budget -- has been eliminated. Under the threat of the Presidential veto, new expenditure bills to increase wages of government employees and payments to the military have been almost wholly financed by new taxes. Present expenditure levels are relatively  - ii - inflexible due to social security payments, contractual obligations and reluctance to cut the military budget. In this situation, the long run solution is to increase revenues while damping the inflation rate until the gap is finally closed. 7. The exchange reform has been successful although a temporary exchange stringency now exists due to the reluctance of the exchange authorities in 1956 to raise the exchange rate pari passu with domestic price levels. The error has been recognized and steps are being taken to cope with the expected exchange losses from lower copper prices and to prevent a future recurrence of the present problem. The banking exchange rate is now 580 or, when ex- change taxes are added, 625 pesos per dollar, which is double the import rate of 300 that prevailed a year ago. Import deposit requirements have been raised, a most effective measure (when accompanied by strict credit con- trols and rising exchange rates) to choke off any import boom. Chile has not yet used the $75 million standby credit authorized a year ago. 8. The curb exchange rate has been relatively stable since October 1956 and in early April stood at 625 pesos per dollar. Since it is a free market, the rate is expected to float upward along with the banking rate and a spread of about 10% between the two rates would be considered normal. 9. Gross national production, especially in agriculture, has been stagnating over the last 10 years as the inevitable result of accelerating inflation. A return to stability and the elimination of price controls on basic agricultural products is expected to restore the incentives to produce. The investment climate has greatly improved in recent years and the principal mining companies are undertaking large new investments which will increase export earnings in copper, nitrate and iron ore. 10. The trade and payments position in 1956 was a substantial improvement over the preceding years and the larger exchange earnings were an important factor in easing the economyts adjustment to the austerity measures. Com- mercial and financial arrears have been settled and the present trend is away from bilateralism. 11. In the current year, three problems must be resolved: the absorption of a 25-30% wage increase, while curtailing bank credit to the private sector, a cut back in imports to meet the loss in exchange earnings, and financing the expected fiscal deficit. The break in copper prices before the program could be consolidated may weaken the disposition to maintain the austerity measures for another year, especially with a Presidential election scheduled for September 1958. But the government recognizes the problem and, as noted above, is seeking measures to meet it. 12. If these difficulties can be met, the prospects point to a continua- tion of the stabilization program and the progressive damping of the rate of inflation. The March elections strengthened the political center at the expense of the leftist groups in Congress. It seems probable that the  - iii - stabilization program has now progressed so far and gained sufficiently broad support that even the opposition parties would not attempt to repeal it. 13. In the expectation that the stabilization program will continue and assuming that domestic production will respond to incentives being created, Chile's net exchange earnings can be roughly estimated within the range of $430-510 million by 1960-61. This estimate is based on the further assumption that the world market can absorb the anticipated expansion in the production of copper at a price around 30 cents per pound. 14. Long-term external debt is being amortized at the rate of $10-11 million annually. Since 1948 total debt, including long-term and medium- term, has been reduced about $70 million. By 1960-61 service on existing long-term debt would be 3-4% of the net exchange that Chile may expect to earn at that time. 15. The principal gains to be derived from the stabilization program -- restoration of incentives and the prospect of expanding production -- mean greater ability to support external debt. If the productive powers of the economy recuperate as expected, and if Chile exercises real restraint in incurring new medium-term debt, a substantial increase in new long-term debt should be within Chile's capacity to pay.  I. REVIEW OF THE STABILIZATION PROGRAM A. Prices, Wages and Employment 1. The stabilization program as outlined in the last Economic Report on Chile (W.H. 48b, October 25, 1956) was initiated a year ago and now, after 12 months experience, it is possible to make an interim appraisal. The program was originally designed to restrain the rate of inflation through a series of measures dealing with wages, bank credit, budget problems and the exchange system. The annual rate of price inflation was reduced from 84% in 1955 to 38% in 1956; the price rise levelled off in the closing months and has remained constant from November 1956 to February 1957. 2. The elements which accounted for the rise in prices in 1956 were (1) the 46% wage adjustment across-the-board which was decreed in January 1956; (2) the continued budget deficit and the credit expansion by commercial banks which created the liquidity necessary to finance the rise in prices; (3) the exchange reform enacted in April 1956 (which lowered the value of the peso from 300 to the dollar to 500 to the dollar) affected the prices of imported goods in general, while the elimination of preferential rates resulted in even greater price increases for some commodities; (4) the elimination of direct subsidies to certain cost-of-living items allowed the index to reflect free prices for the first time in years; and, finally, (5) skepticism over the eventual success of the program led to price increases whenever the speculative curb exchange rate showed a tendency to weaken. 3. The various measures undertaken had a direct effect on the volume of business and employment. Normally, Chile has registered unemployment averaging 2-3% of the industrial labor force, but by the end of 1956 this had risen to 6-7%. The increase was concentrated in the construction and building supply industries and to some extent also in textiles where the trade practice had always been to maintain sizeable stocks for the purpose of realizing inventory profits with the ever-rising price level. The skepticism in the early months about the whole program meant that many manufacturers did not begin to curtail production and to drawdown inventories until the autumn. Industrial power consumption in the Santiago-Valparaiso area did not decline until September. Comparisons of one month with the same period in the preceding year, show a decline in industrial power of 11.8% in September, 13.8% in October and 15.5% in November. The decline was not general for all firms in a particular industry. With the two largest producers of cotton textiles, for example, one showed no change in October/November 1956 in comparison with the previous year, while the other registered a decline of 24%. Evidently, firms behaved differently possibly reflecting different inventory positions or price policies. The fact remains, however, that pockets of unemployment have appeared and while these are almost inevitable during the transition period, they do aggravate the political problem and could become an issue in the Presidential elections of 1958.  - 2 - 4. The substantial reduction in real wages -- consumers' purchasing power -- that was implicit in the wage adjustment of January 1956 (wages increased only 50% of the cost-of-living increase registered in 1955) has been accompanied by a decline in the total volume of business for a number of firms. For the 10 months ending October 1956 sales of paint were down 35-40o% in physical terms; cotton piece goods were down 9%; woollen goods 16%; electric bulbs were down 21% and so on. On the other hand, edible oils increased and sugar sales remained unchanged in spite of the substantial price increases that resulted from the exchange reform and the recent spurt in world sugar prices. As a result of these declines and the accompanying credit restrictions, prices of industrial stocks in the Stock Exchange are substantially below previous levels; for example, Papeles y Cartones stock declined 30% comparing the quotations in the second half of 1956 with the corresponding period in 1955. In some extreme cases, a company could be purchased for as little as one-third of its total net asset value. 5. The volume of unemployment would be even larger were it not for the fact that a number of firms have reduced the hours of work rather than lay-off people. But the result has been, nonetheless, a reduction in total earnings in the fact of constant or rising prices. 6. In the light of these developments Congress was reluctant to follow the President's directive that 1957 wage adjustments across-the-board should be limited to 25% -- i.e. roughly two-thirds the price rise of the preceding year. The new legislation as finally enacted accepted the President's figure of 25% for government employees but voted a 30% increase in the wages of private employees which is roughly 80% of the increase in the cost of living last year. This represents a further reduction in real wages, i.e. consumers' purchasing power, and it remains to be seen whether the volume of business continues to decline in 1957 and whether the pockets of unemploy- ment will continue to grow. The government is acutely aware of the political implications of rising unemployment and certain remedial measures, e.g. invest- ment in low cost housing, are being considered. 7. The stabilization program has been unable to stop the inflation in its tracks but the responsible opinion in both government and business circles is that stability can be achieved by successive damping of the inflationary pressure. For instance, the January 1956 wage increase of 46%, together with other adjustments noted above, resulted in a price rise of 38% during 1956. 8. It is true, of course, that the recent wage increases of 25-30% across-the-board will create a new upsurge of costs and since employers cannot absorb the full impact of this increase out of profits or productivity, prices must inevitably rise. Nevertheless, it is conceivable that a wage increase -- in the 1957 pattern -- could be absorbed with a moderate price rise during the current year, especially since the impact of eliminating exchange sub- sidies and price controls on certain cost-of-living commodities, e.g. milk, sugar, kerosene, etc., has already been registered in the present price index. To hold inflation to a steadily decreasing rate, however, will require a continuation of strict monetary controls and renewed efforts to restrain the fiscal deficit.  -3- B. Monetary Measures 9. The monetary measures included in the stabilization program con- sisted of monthly quotas to limit the expansion of each commercial bank, tightening of rediscount requirements to reduce liquidity and, finally, the sterilization of deposits required on imports under the new exchange system. 10. During the first half of 1956 these monetary measures were eminently successful. As of June 30, rediscounts outstanding were reduced 26% below the position at December 31, 1955, while the compulsory import deposits (9.3 billion pesos) were more than enough to offset the inflationary impact of central government borrowings (8.1 billion pesos). The result was a sharp reduction in the liquidity of the entire banking system and until the month of June many commercial banks were unable to utilize expansion quotas assigned to them. Although the money supply increased 25%, the cost of living at the end of June 1956 had increased only 14% as against 37% for the same six months of 1955. 11. In contrast, the third quarter of 1956 was marked by relaxation in the monetary sector. Additional government borrowing from the Central Bank became necessary, although the monetary impact was again largely offset by the further build-up in the compulsory import deposits. The liquidity of the banking system was increased by expansion in rediscounts but the sales of exchange which exceeded purchases by the Central Bank were a major offset to this new liquidity. As a result, the commercial banks were kept within their monthly quotas and, in spite of this relaxation, total Central Bank credit increased only 2 billion pesos or 3% over June 30 levels. But prices began to rise rather sharply partly because of the increased liquidity and partly due to seasonal factors; the period June/September is the Chilean winter and foodstuffs are in short supply. In brief, the cost of living at the end of the third quarter had risen to 32%, more than double the June 30 position, and concern was expressed in many quarters that the whole stabilization pro- gram was in danger. This apprehension was strengthened by the decline in production which, as noted earlier, became conspicuous in September for the first time, 12. In the fourth quarter the relaxation continued and was accelerated in November and December, especially to the private sector. Pressures were building up on all sides for a more liberal credit policy. Although the domestic price level had been rising, the total money supply was unchanged from June 30 to the end of October, being held at 159 billion pesos. Further- more, seasonal pressures developed as credit needs for spring planting were superimposed upon existing demands. 13. In the face of these accumulating pressures, the monetary authorities were compelled to give ground. By the end of December rediscounts jumped, Central Bank loans to the private sector increased, and the government was compelled to draw on the Central Bank -- the first time since July. There were, however, two offsets to this sizeable increase in liquidity; first, additional sales of foreign exchange over purchases absorbed pesos and, second, compulsory import deposits rose still further. On balance, total  - 4 - Central Bank emission, including rediscounts, private loans and government borrowing, registered a net increase of 9.2 billion pesos or 14% in the three months ending December 31. 14. The results of the entire year, including quarterly changes, are set forth in the table below: Central Bank Expansion 2/ 1954 1955 Quarterly 1956 Quarterly (Billion (Billion Increase (Billion Increase Pesos) Pesos) Pesos) End of Quarter: March 31 36.4 11% 55.5 5% June 30 42.1 15 63.8 15 September 30 43.2 2 65.9 3 December 31 32.7 52.9 22 75.1 14 Annual Increase 62% 42% 2/ The net addition of rediscounts, purchases and sales of exchange, and direct loans to government and business minus compulsory import deposits. 15. At the end of December the total cost-of-living index showed an increase of 37.7% for the entire year in contrast with 84% in 1955. For the first time in years the cost-of-living index actually declined in November and December, reflecting the constant money supply which had been maintained from June to October and the increased availability of foodstuffs from spring crops. It remains to be seen what effect the monetary relaxation in the last quarter will have upon prices in the new year, although January and February prices remained constant, marking the fourth consecutive month of stability. 16. The major defenses in the monetary sector are being maintained, although, as noted above, the Central Bank authorities permitted some relaxa- tion. In terms of the over-all strategy of the stabilization program, the monetary authorities felt that it was wsise to beat a tactical retreat before the accumulating pressures viz. by relaxing liquidity and loosening commercial bank quotas to meet normal seasonal requirementsand to check growing unemploy- ment. Failure to yield could have aroused massive political opposition, alientated the conservative business community and thus endangered the entire program. The fact remains, however, that credit has probably been granted too freely to the private sector, enabling it to avoid or at least postpone the necessary adjustment to the new regimen. Of total bank credit expansion in 1956 (Table 3A in the Appendix), the private sector took 58% and the government 42%.  - 5 - 17. Another tactical retreat arises out of the fiscal situation. The central government and some semi-fiscal agencies, such as the railroads, have substantial amounts owJing for goods and services rendered by the private sector. Firms supplying the government find their working capital tied up and are compelled to seek additional barik credit, thereby absorbing part of the commercial banks' quota and leaving less credit for the private sector. At present, the monetary authorities are determining the extent of these unpaid accounts with the expectation of opening special credits to the govern- ment and its agencies in order to pay the private suppliers. This would result in a further increase in liquidity. 18. The system of monthly quotas for commercial bank expansion is con- tinuing into the new year. The January 1957 quota, for example, is 5% of loans outstanding in the base period, December 1954, which represents an allowable increase of 3.0 billion pesos (as compared with 2.5 billion in January 1956) for all commercial banks and the Banco del Lstado; this is double the quota that prevailed in November and December 1956 before the Central Bank had to relax requirements. It must be recalled, however, that prices rose 38% in 1956 so that a nominal quota of 3.0 billion pesos in January 1957 is a smaller amount in real terms than 2.5 billion in January 1956. Thus, as the domestic price level continues to increase, the effective monthly quota is progressively reduced even though its amount in pesos remained unchanged. In addition, the quotas are being scaled downward in succeeding months, as they were in 1956, so the pressure will be tightened. 19. The monetary sector was able to absorb a sizeable fraction of the inflationary pressures generated in 1956. The principal "shock absorbers" were two: the build-up in compulsory import deposits and the drawdown in foreign exchange reserves. As Chile enters 1957, however, it can expect less help from these items. The average rate on compulsory import deposits has recently been increased 75% so a further build-up may be expected. At the same time, disposable exchange reserves are low so no more pesos can be absorbed by further drawdown of reserves. In brief, unless other offsets can be found, the impact of fresh inflationary pressures will be communicated directly, and in full force, to the price level. In view of this situation, the prospects in the fiscal sector -- the major source of new inflationary pressures -- are of the utmost importance. C. Fiscal Developments 20. The major sources of inflationary pressure in recent years have been two: the wage adjustment every January with the resultant cost-price spiral and the chronic deficits in the fiscal sector, including the regular budget and semi-fiscal entities such as the railroads. As noted earlier, the annual wage-price spiral, while not eliminated, has been progressively reduced and as stabilization is gradually achieved, this source can be com- pletely eliminated. With respect to the fiscal sector, however, the immediate prospects are less favorable. Unless the gap between revenues and expenditures can be reduced to manageable proportions the fiscal sector will  - 6 - ccntinue to generate ini'lationary pressure, and retard the successive damping of the wage-cost spiral. In brief, the fiscal sector is the critical point on which the success of the stabilization program depends. 21. The year 1956 closed with total revenues of 205 billion pesos and total expenditures of 230 billion pesos, leaving a deficit in the regular budget of 25 billion pesos or 11% of total expenditures. The government's budgetary obligations to the Social Security Institutes and pension funds were funded by issuing 5-year peso bonds instead of cash payments. Thus the monetary impact of this deficit was held to 16 billion pesos, which was financed by borrowing from the Central Bank, by reducing cash balances and by placing government notes with commercial banks. 22. In addition, there are semi-fiscal agencies outside the regular 'budget that produce sizeable deficits. The largest of these is the State Railroad where the operating deficit in 1956 was about 12 billion pesos. 23. The budget originally enacted for 1957 provided for ex-penditures of 256.2 billion in pesos and 66.6 million in dollars, or a total equivalent of 292.9 billion pesos. The totals cannot be directly compared with 1956 because certain revenues and expenditures treated as extra-budgetary items last year have now been blanketed into the regular budget. Apart from this change, however, it is estimated tnat the 1957 budget is approximately 40% greater than 1956 expenditures. Since this is roughly the increase in the price level, the new budget, in real terms, is about the same as last year's. 24. The original budget assumed a copper price of 35 cents per pound and a volume of 1 billion pounds which is equal to the record production of 1956. But U.S. copper prices now range from 32 cents for the large U.S. producers to 31 cents for independent smelters and European prices are about 30 cents (as of +-arch). Since Chile's copper exports are divided more or less equally between the European and the U.S. market the average copper price is 31 cents; after deducting transport costs the effective f.o.b. price is about 30 cents. As a result of this copper price decline, it became necessary to revise the estimates, at least on the revenue side. Original Budget Revised Budget December 1956 March 1957 Dollars Pesos Dollars Pesos (Million) (Billion) (Million) (Billion) Revenues $130 221 $90 221 Expenditures 66 256 59 256 Balance *$ 64 - 35 + $31 - 35 Dollar balance converted + 35 + 18 Deficit 0 - 17 j/ Original budget converted at 550 and revised 'budget at 580 pesos per dollar.  The decline in copper prices from 35 to 30 cents per pound cost Chile approximately $4O million or 22 billion pesos. It is estimated, however, that physical output will increase 15% over 1956 levels which brings the peso shortfall to about 17 billion as noted above. 25. One of the principal reasons for large budgetary deficits in recent years has been the enactment of supplementary expenditure bills by Congress once the regular budget has been approved and apparently financed. The President has taken the firm position that such expenditure bills must now contain their own financing, failing which he will veto the legislation. This proposition received a severe test in January when Congress, on the eve of a critical national election, enacted two expenditure bills. One provided a 25% wage increase to government employees costing 29.8 billion pesos and the other established a system of salary increments for years of military service, known as "quinquenios", at an initial cost of 15.3 billion. As a result of the President's strong position, these two bills, costing 45.1 billion pesos, carried their own financing up to 98%. The additional revenues are derived from increased levies on sales, foreign exchange, income and property plus excise and stamp taxes. 26. Substantial credit is due to the President for this achievement. If he can insist upon this policy for the remainder of his term in office, one of the principal causes of budgetary deficits will be eliminated. Once the adjustment to copper price is achieved, the fiscal prospects for the next few years appear to be manageable. 27. The total budgetary position may now be summarized below: (Billions of Pesos) Revenues Expenditures Deficit Regular Budget 1957 275.6 292.9 17.3 25% Wage Increase 28.5 29.8 1.3 Military Supplementary Pay 15.3 15.3 0 319.4 338.0 18.6 As already noted, the expected deficit is almost entirely due to a sharp drop in copper prices.  - 8 - 28. In addition to the current deficit, Chile also has uncovered obliga- tions carried over from previous fiscal years which cannot be postponed. Ways and means are now being explored to clear up these internal arrears and put the fiscal house completely in order. The amounts involved are as follows: Billions of Pesos 1957 Estimated Deficit 18.6 Carry-over of Obligations 23.7 Debt to Central Bank 15.7 58.0 The present plans are still tentative, but the Minister of Finance is con- sidering a variety of measures. With respect to the deficit anticipated in 1957, the budget is being reviewed for a possible cut of 10-15% in expenditures largely by postponing certain items, e.g. uniforms for the Armed Forces. Other measures being studied include a compulsory internal loan and consolidation ofobligations to the pension funds and Central Bank which would eliminate the carry-over from previous years. 29. The revenues of the government are derived partly in dollars (income taxes and custom duties paid directly by the large mining companies) and partly in pesos. The peso revenues are obtained from the sale of "surplus" tax dollars to importers at the going exchange rate and from internal taxa- tion. The principal budgetary revenues (dollars and pesos combined) are indicated below: Revenue Sources: 1957 Taxes: Income Taxes: Copper and Nitrate 23% Other 14 37% Property 4 Sales 16 Customs Duties 21 Excise 15 Stamp 3 Property and Services 4 100%  30. On the expenditure side, the largest single item is National Defense which takes 28% of both dollar and peso budgets. As a gesture on the dollar budget Congress required the President to reduce the size of military missions abroad by one-half, which will achieve some small saving. But the largest share of the National Defense dollars is earmarked for acquisition of military equipment some of which represents contractual obligations. The President has, as yet, shown no disposition to economize in this direction and the Congress is similarly unwilling to enforce sizeable economies despite the claims of leading political parties. In the peso budget the military estab- lishment, together with the National Police Force (Carabineros), account for 28% of the total. But with 90% of this marked for wages, food and clothing, there is not much prospect for massive economy other than a reduction in the size of the Armed Forces. The President has indicated an intention to reduce the size of the annual conscription and it remains to be seen whether this will be done. 31. The other principal items in the dollar budget are earmarked for the linistry of Finance and the Ministry of Economy. Ihese allocations represent long-term service and amortization of medium-term credits for semi-fiscal entities such as the Fomento Corporation and government-owned bus lines. For the most part these are contractual obligations undertaken in earlier years, so there is little margin for economy in the immediate period. 32. A scrutiny of the capital budget in pesos, however, suggests that some economy could be achieved simply by postponing new projects for at least a year, or until the inflationary pressures have been fully checked. For example, two items in the Fomento Corporation budget, to finance an additional sugar beet factory and to start a government-owned cellulose plant, could save almost 2 billion pesos. The President has shown little disposition to resist the political and bureaucratic pressures brought to bear on such projects, so they are transmitted to Congress and incorporated in the budget. 33. One of the principal problems the government must face to achieve budgetary equilibrium is the increasing burden of transfer payments and the rigidity which has been built into the budget on account of social security legislation. The sharp increase in transfer payments in the last year or two also reflects a new program of subsidies to private schools. Hitherto the government's contribution to education had been limited to universities plus the regular budget for public schools under the Miinistry of Education. The growing importance of these items in recent years may be seen in the comparisons below: Budget 19 1956 1957 Current Expenditures 57% 53% 46% Debt, Social Security Transfers and Subsidies 27 30 35 Capital Expenditures 16 17 19 100% 100% 100%  - 10 - 34. A second obstacle confronting the government in dealing with its fiscal problem is the large size of the public administration. In 1956 there were 226,533 public employees or roughly 10% of the entire labor force in Chile. The details may be seen in Table No. 8 presented in the Appendix. The principal categories are national defense 28%, health and social security 20%, transportation (including 25,972 employees in railroads) 18%, education 15% and general administration 15%. The burden of the public administration is not limited to the number actually employed but, in view of the social legislation and generous pension provisions, it is possible for these employees to retire at full pay. Thus, the fiscal burden increases automatically even if the size of the public administration staff be held unchanged. Upon retirement the government is committed to pay full salary to the former employee as well as full salary to the one who replaces him in the public administration. This burden is all the more serious because there is no prospect for relief, short of an absolute reduction in the total number of public employees over a period of time. Even then, no immediate economies can be achieved since anyone retired continues to draw full pay. Moreover, whenever annual wage adjustments are made for government employees similar adjustments are required for pensioners. 35, In view of the fixed charges on the budget resulting from the costs of social legislation which cannot be quickly reduced and, in view of the popularity of the Armed Forces which inhibits Congressional action, the prospects for sizeable cuts in expenditures are indeed slim. The only recourse, therefore, is to increase revenues. 36. Customs duties which provide 21% of total peso receipts will be increasingly productive as higher peso values are imputed to imports; for instance, imports valued at 300 pesos to the dollar a year ago are now valued at 580 pesos and as the exchange rate rises during 1957 additional revenue can be expected, not only from customs duties but also from the sale of govern- ment tax dollars at the higher rate. Sales and excise taxes constitute 31% of total receipts and although income taxes, excluding large mining companies, represent only 14%, revenues will continue to grow with the national income. Finally, the government is devising taxes to tap new revenue sources, especial- ly in the agricultural sector which has been virtually tax-exempt in the past. 37. In brief, the Chilean tax structure is moderately diversified, although heavily weighted with regressive taxes, and there is great room for improvement in tax administration. The government is now absorbing about 14% of the national income but the taxable capacity that could emerge once the economy breaks out of its present stagnation is substantial. Given the inflexible pattern of expenditures, the long run budget solution may be found in letting revenues "grow up" until they cover the expenditure level. This assumes, of course, that inflation is progressively checked so that govern- ment expenditures will not spurt ahead every year, creating new gaps as fast as the old ones are closed.  D. Exchange Reform 38. The principal elements in the exchange reform were elimination of import licensing in favor of a permissive list, the establishment of a free bank rate of exchange which was intended to fluctuate with market conditions, and a system of' compulsory deposits for imports. While the over-all plan for exchange reform as a part of the stabilization program was well conceived, several difficulties arose in its execution during the second half of 1956. 39. The first of tlese difficulties came when the monetary authorities attempted to fix the exchange rate instead of allowing it to fluctuate. At the outset of the system in April 1956, the initial rate was set at 494 pesos to the dollar which represented an average of the free market rates during the month prior to the new system. Although domestic prices continued to rise the rate was held roughly to this level and, as it became increasingly over- valued, importers fo-und it advantageous to expand their demands on the permis- sive list. In the first few months of the new system, the compulsory deposit requirement, ranging from 5% to 200% of the import value, effectively checked import demand; however, as bank credit was relaxed in the second half, it became easier to finance deposit requirements. 40. The exchange rate difficulty was compounded by the existence of repressed demands for certain items which had been virtually unobtainable under the old import control system. In the period April 19 to November 30 $3.6 million in sewing machines, $7.5 million in delivery and pickup trucks, $7.7 million in agricultural machinery and 47.6 million in agricultural machinery spare parts entered the country. Finally, the world price of copper declined sharply from 46 cents during the first six months to 43 cents in July and then to 36 cents by October with a resultant cut in foreign ex- change earnings. 41. As a conseauence of these four factors: overvalued exchange rate, increased bank liquidity, repressed import demands, and reduced exchange earnings, all converging in the second half of 1956, Chile now faces a temporary exchange stringency that is aggravated by the latest decline in copper price. The monetary authorities, however, recognize the problem and have taken some steps to meet it. In the first place, the exchange rate has been allowed to rise to the present level of 580 pesos to the dollar; after adding foreign exchange taxes, this becomes an effective rate of about 615 pesos, more than double the rate of 300 pesos that prevailed a year ago. The authorities, moreover, have announced their intention to keep the rate rising pari passu with the domestic price level. Thus, they should prevent a recurrence of the overvalued rate that contributed to the present difficulty. 42. In the second place, the compulsory deposit requirement has recently been raised on all import categories except the most essential. The advance deposit now ranges from 100% to 400% of the value while the rate on delivery and pickup trucks was raised to 600/o, which will effectively choke off the demand for such items. A close watch is being kept over the permissive list so that deposit reouirements can be changed again, if neces- sary, to forestall new import pressures.  - 12 - L43. On the negative side, the expansion of bank liquidity that was per- *ritted in November and December may facilitate financing of new import demands and thus aggravate the problem. Although commercial banks are allowed to finance only a fraction of the compulsory import deposits, it has been impos- sible to enforce this regulation. Thus, when rediscounts rose 10 billion pesos between June and November, about 6 billion pesos found their way into the compulsory deposits and were thereby sterilized. 44. The free brokers: exchange rate has fluctuated between 470 to 640 pesos during 1956; at year-end it was about 600 pesos. The principal items on the demand side in the free brokers' market are (1) speculative capital movements which reflect the state of confidence in the stabilization program, (2) purchase of exchange for imports through the free port of Arica, estimated at $12-16 million annually, and (3) smuggling of cattle from Argentina, the proceeds of which are remitted through the free rmarket. On the supply side a principal source has been the sale of dollars by the large mining companies to finance the peso counterpart of their expanding investment program. For the copper companies alone, this represents a sum of $52 million being fed into the free brokers' market over a period of five years. By arrangement with the monetary authorities, the copper companies are placing small amounts of dollars in the market every day to avoid wide fluctuations and to exert a steady dow-nward pressure on the free exchange rate. As a result of balancing these factors, the brokers' market has held reasonably steady; early April the free rate was 625 and, by coincidence, equal to the effective import rate of 625. The consensus among bankers and businessmen in Santiago is that a spread of perhaps lO between the two rates would be considered normal. 45. During the period from August through November the monetary authorities drew dow,n reserves by about 36 million in an attempt to support the free brokers' market. Such intervention succeeded in breaking the rate sub- stantially on one or two occasions but, in view of the lows level of the Central Bank's exchange reserves, it is not in a position to allocate its dwindling resources to this purpose. Opinion in the Central Bank is divided on the issue of whether, in principle, the free market ought to be supported at critical moments in view of the widespread psychological effect of sudden gyrations in the free rate. For the present, however, the steady flow of copper investment dollars seems to provide the necessary stabilizing influence. 46. Chile has yet made no use of the standby credit of $75 million which was established upon opening the new exchange system in April 1956. The credit recently came up for review by the International Monetary Fund and it has been extended for another year.  - 13 - II. PRODUCTION AND TRADE 47. Gross national production in Chile in recent years has been in- creasing very slowly, less than 1% per year in real terms per capita. In 1955, the year of maximum inflation, national income in real terms actually turned down despite the very favorable terms of trade for copper and the highest level of net exports in the postwar period. The growing disposition in recent years to emphasize consumption while, as an inevitable result of chronic inflation, with price controls which reduced the incentives for invest- ment has finally caused national production to level off. Gross capital formation continued to decline from a peak of 17.4% of GNP in 1947 to 10% in 1953, 7.6% in 1954 and approximately the same in 1955. At these latter rates, net capital formation is certainly negative. 48. In view of the gradual payalysis which has overtaken the Chilean economy, it is probably too much to expect a drastic change in a single year under the stabilization program. Moreover, the vigor of the anti-inflation program, particularly the monetary measures, has undoubtedly caused postpone- ment of some capital expenditures that promote productivity. Because of the uncertainty in the domestic market, the increased unemployment and the declin- ing volume of business in certain industries, the past year will probably register another period of stagnation, although the national income statistics will not be known for some months. A. Agriculture 49. In agriculture, the area planted in 11 principal crops in 1956-57 was 3,120,000 acres or the same amount as the preceding year. There is some evidence, however, fragmentary, that the policy of stabilization and other liberal measures designed to create incentives, such as the elimination of price controls on basic agricultural commodities, have already started the process of rehabilitation. The effects of the new policy are immediately discernible in some conmodities while for others it will take a year or two before the producerst confidence is restored. In the case of milk production for example, the freeing of prices has resulted in an immediate increase in supply. Yields are rising as farmers now find it profitable to feed more concentrates to their dairy herds while the supply of liquid milk, instead of being fed to animals on the farm, is now made available to the market. This has happened in the months since April 1956. 50. In the case of wlheat, the response to the new incentives will take more time. The shift in policy from a ceiling price to a minimum support price was not made effective until wheat land had already been sown for the current agricultural year. Thus, wheat acreage shows virtually no change in 1956-57 as compared with the previous year. It seems likely, however, that the farmers will respond to the new price policy for it not only  - 14 - eliminates a fixed ceiling but permits local producers to get world prices, which are substantially higher than the controlled domestic price in recent years. 51. The policy of free prices has now been extended to practically all agricultural products. For such commodities as fruits, beans, onions, garlic, barley, oats and lumber, which are the principal agricultural export items, the new policy should provide an increase in exports each year. Moreover, an effective exchange rate of 580 pesos to the dollar in contrast with 300 pesos a year ago should, in turn, increase the attractiveness of the export market. 52. Finally, the implementation of the agricultural development program, and especially some improvement in the transportation sector which has become a major bottleneck, will permit production of such staples as meat, cereals, fats and edible oils to expand. Sizeable exchange savings can then be realized since large imports of these staples are now required to meet domestic consaumption. B. Mining 53. The improved investment climate in the last twio years has stimulated private investments designed to expand production in copper, nitrate, iron ore and other minerals. The outlook in copper is most important in view of the immediate impact on Chile's balance of payments. The two major companies, Anaconda and Kennicott, have ermbarked on a program to invest $130 million over a five-year period wrhich will increase productive capacity to 530,000 metric tons by 1960. Actual production in 1956 was 445,000 metric tons (in compari- son with wartime peak production of 462,000 metric tons in 1945), and already reflects some of the expansion to be derived from the current investment program. 54. The equal treatment which copper companies are now receiving on the exchange rate is giving Chile one of the lowest cost of production figures in the world. All dollars brought in to finance the local cost of new capital investment may be sold at the free brokers' rate, currently 625. With respect to operations, the two major companies have indicated that roughly one-half the total cost of production is in local currency. Thus, the depreciation in the exchange rate from 300 pesos to 580 pesos, at which "cost of production" dollars are sold, effected a sharp reduction in total operating costs. It is not difficult to understand, therefore, why Anaconda cut its TT.S. production 12-13% late in 1956 at the same time it was expanding output in its Chilean holdings to record levels. In addition to the favorable cost prospect, the large copper companies also have a substantial tax incentive to increase their production. The flat income tax rate of 75% levied on these companies is geared to a base period of production and as tonnages increase above this base, the effective tax rate is correspondingly decreased. Thus, in the case of Anaconda's principal subsidiary, the Chile Exploration Company, the effective tax rate has now been reduced to 63% with the produc- tion of 270,000 metric tons in 1956 in comparison with a base figure of 154,000 metric tons.  - 15 - 55. In addition to the expansion programs of the two large mining companies, the favorable investment climate and the low cost prospects are bringing companies into Chile for the first time such as Cerro de Pasco and Hochschild. While their operations will be limited to the category of "small and medium mines" their output can add ano-ther $20 million to Chile's exchange earnings. Meanwhile, the governmrent-owned copper refinery at Paipote con- tinues to produce at capacity, 15,000 metric tons annually, utilizing concen- trates from small mines in the region and earning $10 million in foreign exchange. Construction of a second refinery is under consideration. 56. The nitrate industry is also responding to the favorable legislation and exchange treatment provided in the last two years. The Anglo-Lautaro Company, a foreign corporation which accounts for 65% of total nitrate produc- tion, has undertaken an investment program aggregating $25 million over the next five years. The foreign exchange has been provided by an Eximbank loan of $16 million and the domestic currency cost of $9 million equivalent will be financed by the company out of current peso earnings. Negotiations are under way to borrow pesos generated from the sale of agricultural surplus commodities, in which case the nitrate investment program can be accelerated and completed in three years instead of five. The investment will increase output by 10% annually and utilize by-products to a total value of $10 million. Moreover, production and port handling costs will also be reduced, thereby improving the competitive position of the company with respect to synthetic nitrates pro- vided, of course, that the exchange rate adequately reflects domestic cost-price levels. The second largest producer, Cosatan, with 20% of the output, also received an Eximbank loan of $11.8 million with the same objectives of extend- ing production, developing new by-products and reducing operating costs, which could add another $4-5 million to Chilets exchange earnings. 57. Sizeable deposits of iron ore are being developed in northern Chile. In years past, iron ore exports grossed $8-10 million annually, of which roughly one-half was returned to Chile. Exhaustion of original deposits and development of the Huachipato steel mill which required substantial ton- nages, reduced total exports to $3 million. The favorable market prospects and -the stimulus of the new exchange rate is now bringing a minor boom in the iron ore region. The nitrate company cited above, Cosatan, is also developing iron ore deposits and the prospective volume of exports at current prices will contribute $10-11 million to Chile's balance of payments. Meanwhile, explora- tion for other minerals, e.g. tungsten, mercury and manganese, is going forward with foreign private capital. If preliminary findings in these minerals can be developed into proven reserves, Chile may substantially increase its export earnings in the next few years and, at the same time, reduce its present dependence upon copper. C. Industry 58. Chile has the basic natural resources needed for an industrial economr: petroleum, iron ore, coal, timber and water power. In the long run, development in the industrial sector is only limited by the extent of the domestic market and ability to meet competition in the export market. Since  - 16 - the natural resources cited are of high quality and readily accessible to economical sea transportation, Chile offers favorable prospects for development. 59. With respect to petroleum, the production of crude in the Magallanes region at the southern tip of Chile has been steadily increasing. If the fuel imports of the large mining companies are excluded, 1956 production provided approximately one-half of domestic requirements. The Chilean Government, moreover, has introduced legislation into Congress designed to open the field to foreign private capital, although reserving the Magallanes region to a government-owned company which has been responsible for the development to date. While such proposed legislation will arouse substantial opposition among the nationalist elements in Congress, it is indicative of the government's efforts to improve the investment climate. 60. The Huachipato steel mill, originally established as a government enterprise, was converted in 1956 to private ownership and control with government reduced to a minority interest. Two Eximbank loans of $3.3 mil- lion (1956) and $16 million (1957) will permit expansion in open hearth and rolling mill capacity. Steel products are now being exported to eleven countries but principally to Argentina under a bilateral trade agreement. The plant is well managed and, as expanding production reduces costs, remunera- tive exchange rates should eventually assure the company of some part of the export market without the artificial device of bilateral trade agreements. 61. Chile's coal production is principally in the hands of two private companies which have solicited IBRD financing to cover part of their sub- stantial expansion program. The growing domestic market has absorbed almost the entire production, leaving little margin for export. A small quantity does move to Argentina, although Chile is at a transport disadvantage in that market in competition with U.S. and British coal. 62. Electric power capacity hlas doubled in the last decade and an extensive expansion program has been financed by the government-owned company Endesa, partly with its own resources and partly with long-term credits from the IBRD. Development in the past has been slowed by the problem of keeping power rates abreast of rising inflationary costs, but legislation is now in Congress to remedy this problem by providing more flexible methods of rate adjustment. In response to this continuing improvement in the investment climate, the American and Foreign Power Company is embarking on a new expan- sion program with additional thernal plants to supplement the Endesa program. 63. Finally, the prospects for timber, both as lumber and raw material for the paper and pulp industry, are attracting considerable interest. The new plants of the Papeles y Cartones will save about $10-11 million in imports and contribute about $3 million to export earnings at present newsprint prices. Meanwhile, the extensive pine plantations developed in southern Chile are growfing apace and many have reached a marketable stage, Other private firms are considering paper and pulp operations in Chile which, if costs can be held competitive, offer considerable promise for future exchange earnings.  - 17 - D. Trade and Payments 64. Balance of payments statistics for recent years are given in Table 5 of the Appendix. Chile has been under continual pressure with chronic deficits on current account in 1953 ($70.2 million), 1954 ($1 million) and 1955 ($7.1 million). During these years exchange control and import licensing were the principal measures used to contain the rising flood of imports stimulated by easy bank credit and overvalued exchange rates. At the same time, exports, particularly of agricultural and industrial products, found it increasingly difficult to enter the world market with the unremunera- tive exchange rates then prevailing and bilateral trade agreements were under- taken in an effort to create special markets. 65. While balance of payments estimates are not yet available for 1956, trade statistics for the first nine months of 1956 and earlier years indicate a substantial improvement. January-September (Millions Dollars) 1954 1955 1956 Exports (Gross) $291 $325 $391 Imports 280 279 264 Trade Balance $ 11 $ 46 $127 Estimates of net exports for this period are yet not available, but even on a gross basis it is evident that the trade balance in the first nine months of 1956 was much stronger than in the same period 1954 or 1955. The rise in exports can be largely attributed to the high copper prices prevailing in 1956. 66. The substantial increase in exchange earnings has been an important and continuing factor in the stabilization program, easing the adjustment of the entire economy to the austerity measures. The improved position also made it possible to reach a satisfactory settlement on the commercial and financial arrears with various creditors. These arrears had accumulated over previous years, as far baclc as 1952, when exchange earnings were insuf- ficient to permit private remittances. The table below indicates the settlement with the two principal creditors.  - 18 - Settlement of Principal Commercial Arrears (Millions Dollars) F u n d e d American and Preferential Rate Paid 1956 Petroleum Foreign Power Total 31 - 1.1 1.1 60 1.4 - 1. 110 4.4 .3 4.7 200 1.0 2.9 3.9 $3.6 $6.8 $4.3 $11.1 The creditors accepted non-transferable internal dollar bonds paying 5% interest with semi-annual amortization over a five-year period. 67. During 1956 there appears to have been a shift in the direction of trade away from the channels of bilateralism that operated during the years of overvalued exchange rates and import licensing. One of the largest traders, Germany, has recently been transferred to a convertible currency basis and discussions are under way for a change in the French agreement. Considerable resistance is being met in cases like that of France, however, where importers are apt to pay dollars for Chilean copper but not for Chilean nitrate. Marketing nitrate has been a major problem in recent years in the face of world competition from synthetics; with the exception of nitrate exported to the United States (45%) most of the remainder has been sold through bilateral agreements. It remains to be seen whether the present exchange rate is sufficiently remunerative to permit nitrate exports without artificial stimulus. 68. The pressure to abandon bilateralism arises partly on principle -- as a consequence of the exchange reform and the desire to achieve a single unitary rate -- and partly from the realization that Chile can ill afford to be a creditor nation with substantial balances in Spain ($3.7 million), Brazil ($3.9 million) and Argentina ($14.4 million). These three agreements total $22 million which Chile is momentarily unable to recover. Chilets net position on all bilateral agreements shows a credit of $16.0 million at year end, in contrast with an $8.5 million credit at the end of 1955 and a deficit of $15.5 million at the end of 1954. These balances are taken into account in estimating total exchange reserves. (See Table 1). 69. The trade position has also been influenced by the importation of U.S. surplus commodities, principally wheat, cotton and edible oils. The 1956 agreement anticipated total sales of $34.6 million but Chile is having difficulty in absorbing this quantity of surplus commodities and deliveries are running behind schedule. In the case of cotton, for example, the  - 19 - sizeable stocks already acquired have been congesting the port warehouses in Valparaiso in view of the cutback in textile production noted in Part I of this Report. It appears that some items will bulk large in total imports. In the years 1954 and 1955 for example, Chile's total imports of wheat were $17.2 million and $15.5 million respectively. As of November 30, 1956, how- ever, Chile had acquired only $7.5 million in wheat and was expecting delivery of $9.5 million in U.S. surplus wheat. Evidently this amount offers a sub- stantial if short-lived contribution to the balance of payments. 70. The proceeds from the sale of the surplus commodities are available (up to 80% of total sales, i.e. $27.7 million equivalent) for peso loans to the Chilean Government for economic development. A bill is now before Congress stipulating the sectors and/or investment projects into which these resources will be directed including roads, ports and agricultural processing plants.  - 20 - III. GrNqRAL FROSPECTS AND CREDITWORTHINESS A. Stabilization 71. The prospects for obtaining some measure of economic stability in Chile must be related to the time factor. When the program was launched a year ago no one seriously believed that inflation could be stopped in its tracks; the over-all strategy was one of reversing the trend and checking the psychological expectations which all sectors of the economy, agricultural, industrial and commercial, had acquired after years of chronic and accelera- ting inflation. More drastic measures to reduce inflation from a rate of 84% to zero in a single year would have created such structural stresses and strains accompanied by videspread unemployment that no support would have been forthcoming. 72. The fact that Ibanez has never had a majority in Congress has left the government with a precarious political base from which to launch the several parts of the program and for maintaining the line when pressures began to accumulate. The elections held 6n March 3 for one-half the Senate and the entire Chamber of Deputies had special importance as a preview of the political alignment for the Presidential elections in September 1958. The principal result was a shift to the center with the greatest losses sustained by the left wing parties. The new Chamber of Deputies is divided more or less equally between proponents of the stabilization program and those in opposition, while in the Senate, support was strengthened by one or two seats. It seems likely, however, that the stabilization program has progressed so far and gained sufficiently broad public support by now, that even the opposition parties would not attempt to reverse it. For the remainder of his term, however, the President must continue to operate with coalitions of parties, including participation in the Cabinet, to further his stabilization program. 73. In the labor sector, tacit support was offered at the opening of the program, but the willingness to accept substantial cuts in real wages (1956 wages rose 50% of the cost-of-living increase during 1955) cannot be rep5eated indefinitely. The 1957 wage adjustment was approximately 80% of the 1956-rise in-cost of living and is, in effect, a-second reduction in real wages. Unless the gains achieved to date can be consolidated in 1957, labor will probably not accept a third reduction in real wages when the review comes in January 1958. 74. Apart from the political situation and the increasing restiveness of labor, the stabilization program still finds solid support in the commercial and industrial community. At the-aninual meeting of the Chilean National Association of Manufacturers in December, for example, strong resolutions were adopted supporting the-government's program. Moreover, these groups are the strongest critics of the government's fiscal management and point out that  - 21 - credit restrictions have become unnecessarily severe in their impact because of the government's failure to balance its budget. Aside from this issue, however, tighter curbs must still be placed upon bank credit to the private sector, perhaps limiting such expansion to the minimum necessary to finance the 1957 wage increase and seasonal requirements. 75. The two principal problems that must be resolved in 1957 are in the foreign exchange and the fiscal sectors. The foreign exchange position of Chile, while precarious at the moment, can be managed if the exchange authorities are willing and able to maintain the exchange rate at a realistic level, that is, allow it to rise pari passu with the domestic price level. The present difficulties are a direct result of an inflexible exchange rate during much of 1956. 76. The most difficult prospect is found in the fiscal sector. On the one hand Chile is already facing difficulties because the Ministry of Finance, in spite of much counsel to the contrary, prepared the 1957 budget on the assumption of a 35 cent copper price; the dollar receipts originally estimated at that price were just enough to close the budget gap. The subsequent drop of about 5 cents per pound will mean a net deficit of about 18.6 billion pesos in 1957 or 5-6% of total expenditures. On the other hand, the President's ability to insist upon the financing of any supplementary expenditure bills has now been successfully tested in Congress and the 1957 deficit will, for the first time in years, be traceable to external factors rather than internally generated. Moreover, the Minister of Finance is considering measures for the non-inflationary financing of the expected deficit. If he succeeds, the monetary impact of the deficit should be kept within manageable limits. This is all the more important because, unlike 1956, the monetary system will find it difficult to absorb the impact of inflationary pressures originating in the fiscal sector. The controls on commercial bank credit have been effective and the Central Bank can be expected to hold the line with only minor adjust- ments to meet normal short run requirements, such as financing the harvest and seasonal movements. 77. It is important to watch the month to month progress in reducing inflation, recognizing all the short run factors which might adversely affect the price indices, e.g. weather, harvest conditions and marketing difficulties. But one must also note that some permanent gains have already been consolidated, in the external trade and payments sector, which augur well for the future. B. Production and Trade 78. As noted in the previous Economic Report, Chile has been developing its long run industrial economic prospects over the last 10 years by founding primary industries -- petroleum, steel and power -- that are based on domestic raw materials. In spite of this progress, total production, as noted earlier, has been gradually stagnating, especially in agriculture, as a result of the cistortion in investments, overvalued exchange rates and arbitrary price inter- vention by the government. The significance of the stabilization program for national production will depend, in the final analysis, on its ability to restore incentives, expand output and improve the balance of payments prospects.  - 22 - Progress registered in 1956 with e]imination of price controls on basic com- modities and adoption of a more realistic exchange rate, should soon be reflected in expansion of production and trade. 79. On the assumption, first, that the stabilization program continues to progress and, second, that domestic production responds to the incentives being created, Chile's net exchange earnings can be roughly estimated within a range of $430-510 million by 1960-61. By that time the investment program of the large mining companies will be completed and the agriculture and transport development program will be adding its impetus to national production. Average Net Exports * Estimated Net Exports 1950-54 1955 1960-61 Low HL Copper $ 125 $ 258 $ 210 $ 260 Nitrate 55 48 50 55 Iron Ore 4 2 10 15 Small Mines 20 42 40 45 Industry & Agriculture 80 72 120 135 $284 $422 $430 $510 S Net exports represent the amount returned to Chile, deducting the earnings and transfers of the large mining companies. The nitrate figure is also net after service on recent "self-liquidating" Eximbank loans. The copper estimate is production minus sales (4125 million) for domestic fabrication. 80. The upper limit on copper represents full production (including the new facilities presently under construction) at an average price of 30 cents per pound; the lower limit is based upon 80% of capacity. In comparing the projection with 1955 results, it appears that the decline in price from the high level of 1955 is about offset by the expansion in volume expected by 1960-61; thus with copper at 30 cents net earnings in that year could be roughly the same as in 1955. If copper prices average higher than the 30 cents per pound as ed here, net exchange earnings would run substantially above this range. e At 35 cents a pound, for example, the copper return would be increased by $40-50 million.  - 23 - 81. The industrial and agricultural estimate assumes an expansion of existing trade by the eventual elimination of export quotas and the restora- tion of some exports that have been priced out of the market by overvalued excl-ange rates. In addition to such export earnings, however, notice should be taken of the exchange savings that could result from the agricultural and transport development program. As domestic production in such staples as meat, cereals and edibleoils increase, imports of these foodstuffs, which currently burden the balance of payments by $35 million, can be reduced. Moreover, this development will lend additional flexibility to the pattern of import requirements and make Chile's balance of payments more manageable in future years. C. External Debt and Creditworthiness 82. In the period since 1948, at which time Chile negotiated the resump- tion of service on its external bonded debt, long-term debt has declined from $341.6 million to $257.7 million as of June 30, 1956, a reduction of $84 mil- lion equivalent or 24%. Including total debt (long-term and medium-term), the net reduction was $69 million or 20% as may be seen below: Changes in External Debt (Millions of Dollars Equivalent) December June 1948 1956 Difference % Long-Term $ 341.6 $ 257.7 - $ 83.9 - 24% Medium-Term 52.1 67.2 + 15.1 + 26 Total Debt $ 393.7 $ 324.9 - $ 68.8 - 20% It should be noted that Chile's external debt in 1948 was very large and the annual service burden was certainly onerous, absorbing about 14% of net ex- ports in the face of a mounting inflation and stagnating production. 831 Over the next five years, 1957-61, the amortization on long-term debt continues at approximately $10 million annually which means a second reduction of about $50 million by the end of 1961. Thus by 1960-61, the year in which any new loans would begin to amortize, Chile will have paid off $134 million in long-term debt since 1948 and will have assumed new long- term debt of $30 million ($15.0 million Endesa loan and about $15 million for two coal loans), making a net reduction in long-term debt of about $100 mil- lion in 12 years.  - 24 - 84. The total debt outstanding as of June 30, 1956, the last estimate available, is given below; it excludes the IMF drawing of $12.5 million in 1953 and Exi.mbank loans of $19 million to the steel company (recently trans- formed into a private corporation) without government guarantee. (Millions of Dollars Equivalent) Consolidated Bonded Debt $ 168.1 IBRD 31.7 Fximbank 57.9 Italian Colonization 1.1 Privately placed supplier credits (including military) 66.1 $ 324.9 85. The estimated service on total external debt for the next few years is given below; approximately 80% represents dollar obligations with the remainder in other currencies. Service on Total External Debt (Government and Government Guaranteed) (Millions of Dollars Equivalent) Long-Term Medium-Term Total Amortization Interest Total 1956 11.2 9.2 20.4 20.5 40.9 1957 11.3 8.8 20.1 16.6 36.7 1958 12.1 8.5 20.6 11.8 32.4 1959 9.5 8.1 17.6 7.5 25.1 1960 8.4 7.9 16.3 4.5 20.8 1961 9.4 7.6 17.0 2.6 19.6 1962 9.8 7.1 16.9 2.6 19.5 1963 10.4 6.5 16.9 0 16.9 1964 10.9 5.9 16.8 0 16.8 86. Medium-term credits continue to bulk large in annual service and, at the time of the last mission to Chile, the government's attention was called to the heavy burden undertaken for the next few years. A decree has recently been promulgated establishing a special commission to advise the President on this problem. Every official agency must get the approval of the commission before it can assume any foreign debt, but it remains to be  - 25 - seen how firm this group can be in reducing the rate at which new medium- term credits are incurred. Strong representations have been made by the mission that the margin for new long-term debt in the next few years will depend, in substantial part, upon the amount of medium-term credits which are undertaken. 87. The medium-term credits outlined above are only those incurred or guaranteed by the government and semi-fiscal agencies. There are also medium-term credits owed by the private sector, not guaranteed, in an amount of $35.6 million plus internal dollar bonds payable over the next five years to private companies in an amount of approximately $12 million. As noted in paragraph 66, the latter item represents the settlement of commercial and financial arrears which had accumulated in recent years and since these bonds are internal obligations owed to Chilean corporations and not transferable, they are excluded from the official external debt statistics. 89. As may be seen from the table above, total service requirements drop very sharply after the first three years. By 1961 annual service on long- term debt will be reduced to $17 million equivalent which is only 3-4% of the net exchange that Chile may expect to earn at that time. Furthermore, the principal gains to be derived from the stabilization program -- restoration of incentives and the prospect of expanding production -- mean greater ability to support external debt. If the productive powers of the economy recuperate as expected, and if Chile exercises real restraint in incurring new medium- term debt, a substantial increase in new long-term debt should be within Chile's capacity to pay.  - 26 - TABLE 1 GOLD & FOREIGN EXCHANGE RESERVES (Hillions Dollars Equivalent) Central Bank Dollars Payments Other Gold and Agreements Banks Total Sterling (net) December 31, 1951 45.2 7.9 - 1.2 19.4 71.3 1952 41.7 24.3 - 1.0 25.6 90.6 1953 41.9 24.8 - 1.3 27.1 92.6 1954 42.5 12.4 - 15.5 21.8 61.2 June 30, 1955 42.0 25.4 - 3.1 20.1 84.4 December 31, 1955 44.4 30.0 8.5 23.7 106.6 June 30, 1956 45.6 43.5 6.7 22.2 118.1 December 31, 1956 45.7 16.6 13.9 11.2 87.4  - 27 - TABLE 2 CENTRAL BATK: REDISCOUINTS AND LOANS TO BANKS (Billions Pesos at end of Period) Commercial State Percentage Banks Bank Total Increase Annual: December 31, 1951 1.9 2.7 4.6 it 1952 2.6 3.5 6.1 32.6 1953 2.4 3.7 6.1 0 1954 3.9 7.1 11.0 80.3 1955 8.0 9.8 17.8 61.8 1956 10.4 17.1 27.5 54.5 Semi-Annual: December 31, 1954 3.9 7.1 11.0 June 30, 1955 4.6 5.o 9.6 - 12.7 December 31, 1955 8.0 9.8 17.8 85.4 June 30, 1956 3.9 9.2 13.1 - 26.4 December 31, 1956 10.4 17.1 27.5 110.0  - 28 - TABIE 3 COLf!EXRIAL BANK CRFLIT OTJSTANDING (Billions Pesos) Private State Percentage Banks Bank Total Increase Annual: December 31, 1951 16.0 9.6 25.6 It 1952 19.2 11.9 31.1 21.5 ,, 1953 24.6 15.9 40.5 30.2 1954 33.1 24.9 58.0 43.2 1955 51.3 35.9 87.2 50.3 "! 1956 61.4 49.4 110.8 27.0 Semi-Annual: Decemnber 31, 1954 33.1 24.9 58.0 June 30, 1955 47.3 24.5 71.8 23.8 December 31, 1955 51.3 35.9 87.2 21.4 June 30, 1956 55.1 38.7 93.8 7.6 December 31, 1956 61.4 49.4 110.8 18.0  - 29 - TABLE 3A BANK C 5EDIT OUTSTANDING (Billions Pesos) Central Private State Percent- Bank Conmercial Bank Total age Banks December 31, 1955: Government 19.9 1.3 4.5 25.7 26% Private 4.7 50_3 19.3 74.3 74 Total 24.6 51i6 23.8 100.0 100% December 31, 1956: Government - 37.5 1.9 8.5 47.9 31% Private 12.9 64.9 27.4 105.2 69 Total 50.4 66.8 35.9 153.1 100% Increase during 1956: Government 17.6 .6 4.0 22.2 42% Private 8.2 14.6 8.1 30.9 58 Total 25.8 15.2 12.1 53.1 100% 2/ Central Bank loans to government in 1956 include direct peso advances (30.6 billion) and peso advances against a foreign exchange loan (6.9 billion).  - 30 - TABLE 4 MONEY SUPPLY AND PRICES Money Supply Percentage Cost of Percentage (Billions Increase in Living Increase in Pesos) 12 months Index 12 months (Year End) (Annual (January- Average) December) Annual: 1951 24.4 32% 65 23% 1952 33.1 36 8o 12 1953 49.3 49 100 56 1954 75.2 52 172 71 1955 127.3 70 302 85 1956 176.2 39 471 38 Percentage Percentage Increase Increase Semi-Annual December 1954-June 1955 46% 37% June 1955-December 1955 17 34 December 1955-June 1956 25 14 June 1956-December 1956 10 21  - 31 - TABLE 5 BAIANCE CF PAYMENTS 1951 1952 1953 1954 1955 Net Exports: Large Mining Companies $197.7 $273.3 $19037 $270.7 $309.3 Other 125.6 131,0 107c5 97.7 110.1 Exports 323.3 404.3 298.2 368.7 419.4 Imports (CIF) 361.3 388.9 358.3 350.7 398.5 Trade Balance - 38.0 + 15.4 - 60,1 + 18.0 + 20.9 Net Services - 5.7 - 7.5 - 10.1 - 17.1 - 12.0 Current Account - 43.7 + 7.9 - 70.2 + .9 - 7.1  _ 32 - TABLE 6 EXCHANGE RATES (MID-YEAR) March 1952 1953 1954 1955 1956 1957 Large Mining Companies 19.37 19.37 19.37) ) ) Government 31 ) ) 110) ) ) ) ) ) ) Banking 43 ) 200) ) ) ) 110 110 ) ) ) Special 50 ) 500) 495 580 ) ) ) ) Commercial 60 ) 200 300) Brokers' Curb 125 181 314 627 525 615  - 33 - TABLE 7 GO'VERNMENT FINANCE (Billions Pesos) Expenditures plus Ordinary Increase in unpaid Receipts Obligations Difference 1951 25.1 28.6 - 3.5 1952 32.3 44.7 - 12.4 1953 38.9 57.6 - 17.7 1954 63.5 91.2 - 27.7 1955 123.0 146.6 - 23.6 1956 205.0 230.0 - 25.0 1957 estimate 319.4 338.0 - 18.6 j Not comparable with information printed in "Basic Data"; latter include consolidated borrowing from Banks and exchange profits as "revenue".  - 34 - TABLE 8 PUBLIC ALMINISTRATION 1956 Drunici- Central Semi- pal Govern- Fiscal Govern- Total % ment Agencies ment Administration 14,456 6,009 13,845 34,310 15.1 National Defense Military 36,675 - Carabineros 27,299 - _ 53,974 28.1 Education 30,232 4,735 - 34,967 15.4 Health & Social Security 3,080 43,168 _ 46,248 20.4 Transportation Ports 3,714 - - Railroads - 25,972 - Urban Buses - 3,251 - Air - 1,381 - Coastal Shipping - 291 - Others 4,564 - - 40,151 17.6 Industry, Mining, Commerce and Housing 1,251 4,403 - 5,654 2.5 Agriculture 1,940 267 - 2,207 .9 123,211 89,477 13,845 226,533 100.0%