Chile - An economic memorandum

Report No. 5099-CH Chile: An Economic Memorandum September 24, 1984 Latin America and the Caribbean Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipiernts only in the performance of their official duties. Its contents may not otherwise be disdosed without World Bank authorization.  CURRENCY EQUIVALENrS Currency Unit: Chilean Peso (Ch$) Year US Dollar Peso 1980 1.00 39.00 1981 1.00 39.00 1982 1.00 50.91 1983 1.00 78.79 FISCAL YEAR January 1 to December 1  FOR OFFICUIL USE ONLY GLOSSR OF ABRVIATIONS BECH = Banco del Estado de Chile (State Bank of Chile) BRIF Banco Hipotecario Industrial (Industrial Mortgage and y de Fomento Development Bank) BICE - Banco Internacional y de Comercio (International and Foreign Exterior Trade Bank) BIH = Basic Irrigated Hectare CAP = Corporacion Acero del Pacifico (Pacific Steel Corporation) CIEPLAN Corporacion de Investigaciones (Latin American Economic Economicas para Latinoamerica Research Corporation) CODELCO = Corporacion del Cobre (State Copper Corporation) COHILCO = Comision Chilena del Cobre (Chilean Copper Commission) CONIN = Corporacion para la Nutricion (Corporation for Infant Infantil Nutrition) CONPAN = Consejo Nacional para la (National Council for Food Alimentacion y Nutricion and Nutrition) COCAR = Corporacion del Carbon (Coal Corporation) CONAF = Consejo Nacional Forestal (National Forestry Council) COPEC = Compania de Petroleos de Chile, S.A. (Chilean Petroleum Company) CORFO = Corporacion de Fomento de la (Development Corporation) Producion ENACAR = Empresa Nacional del Carbon (National Coal Enterprise) ENAMI = Empresa Nacional de Mineria (National Mining Enterprise) ENAP = Empresa Nacional de Petroleo (National Petroleum Enter- prise ENDESA = Empresa Nacional de Energia, S.A. (National Energy Enterprise) IDB = Inter-American Development Bank INDAP = Instituto de Desarrollo Agropecuario (Agricultural Development Institute) INE =Instituto Nacional de Estadisticas (National Institute of Statistics) INEOOM = Ingenieros y Economistas Consultores (Engineers and Economists Consulting Group) LANCHILE = Lineas Aereas Nacionales de Chile (National Airline) LIBOR = London Inter-Bank Offer Rate ODEPA = Oficina de Planificacion Agricola (Office of Agricultural Planning) ODEPLAN = Oficina de Planificacion Nacional (National Planning Office) OECD = Organization for Economic Cooperation and Development PEM = Programa de Empleo Minimo (Minimum Employment Program) POJH = Programa Ocupacional para Jefes (Occupational Program for de Hogar Housewives) PREALC = Programa Regional del Empleo para (Regional Employment Program America Latina y el Caribe Latin America and the Caribbean) PROCHILE = Promotora de Chile (Chilean Export Promotion Company) SBIF = Superintendencia de Bancos e (Superintendency of Banks Instituciones Financieras and Financial Institu- tions) SINAP =Servicio Nacional de Ahorro Publico (National Public Savings Service) SOFOFA = Sociedad de Fomento Fabril (Industrial Development Society) UF = Unidad de Fomento (Development Unit) I 1 docment has a restrced distnbution and may be used by recpients only in the performance of ofi oria duties. Its contents may not otherwise be disdosed without World Bank authorization.  SYNOPSIS This economic report reviews Chile's experience in 1982-1983 and traces out the principal economic problems that Chile must confront if it is to regain economic growth in the 1980s. Because Chile is likely to encounter severe foreign exchange and domestic savings constraints to its development in the 1980s, the report analyzes those sectors considered key to generating both. The country's balance of payments prospects are assessed, as is the role of financial system intermediation and external debt service in the gen- eration of savings, domestic and foreign, to finance growth. After an evalu- ation of Chile's prospects, government policies are suggested to stimulate exports and domestic savings to reach an economic rate of growth sufficient to reduce, over the long term, unemployment. Finally, a set of future possi- ble scenarios of Chile's macroeconomic variables is projected to demonstrate the need for, and effect of, alternative macroeconomic approaches.  - I - CHILE: AS ECONthIC NEKORANDUK TABLE OF CONTENTS Page No. GLOSSARY........... ........ . ................. .. . .. . SYNOPSIS....................................................... COUNTRY DATA................................................... SUMMARY AND CONCLUSIONS ............... ................... i-v Main Text CHAPTER I. THE 1982-1983 DEPRESSIONo ................ 1 A. Introduction .............................................. I B. Balance of Payments and External Debt ............... I C. Expenditures and Output ....... .....*...... ..... 3 D. The Financial System ................................ 4 E. Wages and Unemployment .............................. 5 CHAPTER II. THE 1973-1981 EXPERIENCE ........................ . 7 A. Introduction ....................... .......... .................... 7 B. Export-Oriented Growth, 1975-1979 ................... 8 C. Growth and Disequilibrium, 1979-1981 ........... ....... 12 CHAPTER III. PRODUCTION AND GROWTH: SECTOR ISSUES ............ 16 A. The Role of the Public Sector ............... ......... 16 a. Size of the Public Sector....................... 16 b. State Enterprises.........................o.....ee 17 c. Export Earnings ........**................. 18 d. Sector Policy Issues ......................... 18 This report was written by Luis Ernesto Derbez and is based on the findings of an economic mission that visited Chile in November 1983. Besides Mr. Derbez, the mission was composed of: Eric D. Cruikshank, Nahum Biger (Financial System), Gerhard Thiebach (Mining), and Boris Blazic-Metzner (National Accounts). Miss Alexandra Blackhurst typed the report and tables. The report also benefited from work done by a team of industrial economists, Irwin Baskind (Industry) and Manuel Hinds (Financial System), that joined the economic mission in November 1983. A draft report was dis- cussed with the Government of Chile in August 1984.  -2- Fage No. B. The Role of Productive Sectors... ................... 19 a. Mining................ ...... 19 b. Energy .............. 0........... ...... 0.......-...... 25 c. Manufacturing .................................... 28 d. Agriculture .......................... . ............ 33- e. Tertiary Sectors ........... 36 f. External Sector ................... 37 CHAPTER IV. EMPLOYMENT AND WEIXARE ............................. 43 A. Employment Disriuti..nd.o.......................... 43 B. Prices Indiator....... ......................... 46 C. Income Distribution and Poverty ................ ... 47 D. Welfare Indicators ..... *. ... ..... ....... 47 E. Education Resorce..b....io... .......... 49 F. Hou sing ...............Interedation................... 49 G. S g opt ndocl usi................... 56 CHAPTER V. FINANCING GROWTH ..E ............................. 52 A. Introduction ........................................ . 52 B. Public Resource Mobilization .............. O...* ....................... 54 C_. Private Savings and Intermediation ........................................ 56 DE The Financial Crisis and Allocation of Credit .................................. 57 E. Savings Prospects and Policy Issues .......... . ........................ 62 CHAPTER VI. OPTIONS AND PROSPECTS ........................ . ................. 67 A. Introduction ....... *.............................. 67 B. The Basic Projections: General Assumptions....*..... 67 ANNEX The Central Bank Assistance Programs ................... .... 79 STATISTICAL APPENDIX ........................................ .... 84 MAPS Copper Mining Sector Country Map  -3- LIST OF TABLES IN TEXT Page No. CHAPTER I: I.1 Exports and Imports, 1981-1983......................... 2 I.2 M&LT External Debt Evolution, 1981-1983............... 3 I.3 Consumption and Investment, 1981-1983.................. 3 I.4 Changes in Output, 1981-1983 .......................... 4 I.5 Labor Statistics, 1981-1983........................... 6 CHAPTER II: II.1 Public Sector Summary Accounts........................ 7 II.2 Average Rates of Growth ...... ..... ............ . 8 II.3 Tariff Structure Evolution, 1975-1979................. 8 II.4 Evolution of Exports, 1970-1979......................... 9 II.5 Value-Added by Sectors, 1970-1979. .................... 10 1I.6 Changes in Value-Added per Worker, 1970-1979.......... 10 II.7 Investment Figures, 1976-1979......................... 11 I1.8 Evolution of Real Effective Exchange Rate Indices,.... 12 II.9 Total Debt as Proportion of Sector's GDP .............. 13 CHAPTER III: II.1 Public Sector Operations .........................-- . 16 II1.2 Consolidated Accounts of Public Enterprises............. 17 II1.3 Economic Importance of Miningo........................ 19 III.4 Chile's Rank in World Mining Output and Reserves ...... 20 II.5 CODELCO - Production by Mine, 1976-1982 ............... 21 I.6 CODELCO - By-Product Output, 1976-1982................0 21 1I1.7 Financial Results of Companies Producing Copper - January-September 1982-1983o......................... 22 III.8 Production of Molybdenum Concentrates................. 23 II1.9 Production of Gold and Silver, 1977-1982.............. 24 II1.10 Authorized and Actual Foreign Investment, 1975-1983... 24 III.11 Gran Mineria Investment, 1976-1983...................... 25 III.12 Petroleum Production and Consumption, 1979-1983o....... 26 III.13 Production of Coal, 1975-1982 .......-................. 27 III.14 Index of Manufacturing Production............o..oo 29 III.15 Forest Hectares Planted per Year, 1977-1982........... 30 III.16 Industrial Fisheries Processing, 1976-1982o.oo...o...o 30 III.17 Indices of Manufacturing Value-Added in Constant Prices by Main Subsectors, 1977-1983......,,,,.,,,.... 1 III.18 Agricultural Trade Balance..o..........-.0.00.00-0 34 III.19 Area Cultivated with Traditional Crops-....ooosusee 34 III.20 Livestock, Poultry and Dairy Productionduction.....we 35 III.21 Value, Production and Area Cultivated with Fruits.. 35 III.22 Change in Value-Added and Employment in Selected Tertiary Set o r s 37 III.23 Composition of Exports, 1981-1983...1-.1. 983..... 38 III.24 CODELCO - Sales of Copper and Copper By-Products...s.. 38  -4- Page No. III.25 Iron Ore Exports, 1975-1982......... ...... 39 III.26 Main Categories of Semi-Manufactured Exports .......... 40 III.27 Volume of Exports of Selected Fruits..., ... .. 40 III.28 Real Effective Exchange Rate Indices .................. 42 CHAPTER IV: IV.1 Labor Force Evolution, 1970-1980................... 43 IV.2 Labor Statistics, 1979-1983......................... 44 IV.3 Number of Participants in Government Work Programs.... 44 IV.4 Employment Generation, 1965-1982.... 45 IV.5 Overall Index of Real Wages and Salariesa......... 0-0 46 IV.6 Price Indicators, 1982-1983....................-... 46 IV.7 Fiscal Expenditures, 1976-1982-6.19.......0..-..... 48 IV.8 Partial Welfare Indicatorsdooisecatoe....ee.......or s 48 IV.9 State Subsidies to Private Primary Schools....o..... 49 IV.10 Housing Starts, 1978-1982.7....81.0..0.........-.... 50 IV.11 Projected Housing Investment Program. ................. 51 CHAPTER V: V.1 Foreign, Domestic Savings and Investment, 1977-1983... 54 V.2 Savings - Investment Balance, 1979-1983.............. 54 v.3 Summary Operations of the Public Sector, 1977-1983... 55 v.4 General Government Expenditures, 1979-1983........... ... 56 V.5. Ratios of Money and Quasi-Money to GDPo.o.o......... 56 v.6 Credit to Private Sector, End Year .................... 58 v.7 Credit Concentration ......o..e .... ....o. 60 V.8 Chilean Banks - Risk Analysis, September 30, 1983.... 61 V.9 Chiiean Financieras - Risk Analysis, September 1983. 61 V.10 External Interest Payments, As of End-1983, 1984-1990. 62 V.11 Authorized and Actual Direct Foreign Investment, 1977 1983...o................. o........o................ 63 CHAPTER VI: VI.1 Direction of Trade, 1981-1983....................... 70 VI.2 Estimate of Future World Copper Demand....... ......0. 71 VI.3 LME Copper Price Projections, 1984-1990.............. 71 VI.4 External Debt - Schedule of Payments as of December 31, 19898...3ooo. ...o....ooo.o.o 72 VI.5 Projected National Accounts Variables.-o- les......... 73 VI.6 Projected Current Account Balance, 1984-1990 .......... 74 VI.7 Projected Capital Flows and Financial Requirements, 1984-1g99O ...................................... 75 VI.8 Sensitivity Analysis for Higher and Lower OECD Growth 76 VI.9 Low Debt Scenario - Payments Reduction from 1985 tz 1990 O .........oo.......................eo o e o o o .e o v g s o o....oo. 77 VI.10 Current Account Balance and Debt Service Ratio under a Low Debt Scenario, 1984-1990...... o-......... .... 77 VI.11 High Inflation Scenario Results, 1984-1990..o..... o.... 78  -5- Page No. LIST OF CRAMIS IN TEXT 5.1 Financial Savings and Interest Rate Variations, 1979- 1 983.............................................. 57 5.2 Bankruptcies in Greater Santiago, I/81-III/84..e..e.. 59  -6- CWllwI DATA - OCIsE Page 1 of 2 AREA 1iL1TICI 00Tm (mid-1963) Total- 756,826 kr2 11.7 maillion (.ld-19853 154 ir km2 Rate of Growth: 1.5% (Ifrom 1970-1982) 245 per kW2 of raole lend PUATI0 OVPACTERISTICS 11962) EJLTH (1960) Crude Blrth Rate (per 1.000l 23.9 PopulatIon per physiclan 1,340 Crude Death Rate (per 1.0001 6.1 PopulatIon per hospital bed 365 Intent Mortality (per 1.000 live births) 23.4 INCOME DiSTRRIUTiCN (1966) DISIRIWKi0N OF LAW OWOlItP S of national Income, highest quintile 51 S of farms. Below 5 ha.: Iowest quintile 4 Above 50 ha.: ASS TO PIPED sAL1 t1960) ACSS TO ELECTRICITf (11960) S of population - urban 94 S of population - urbon 94 - rural 40 rural . MNTITION (1975) EDUCATI1 (19821 Celorie Intake as S o requirements 117 Adult literacy rate 94.2 Per capita proteln Intake (grams per day) 78 Primary school onroilient S 95.0 GII PER CWITA IN 1983: 1/ USSI ,971.5 6WSS ITIGNV PROirD IN 1983 2/ AIU.L RATE OF mam iS, outslt 197 prices) USS Hin. _ 1975-80 1980-83 GP at Market Prices 17,430.4 100.0 7.6 -5.4 Gross Domestic Investment 1,569.7 9.0 19.6 -31.8 Gross National Saving 143.0 1.0 18.4 -27.7 Current Account Balance -1,504.0 9.0 Exports of Goods, NFS 4,699.0 27.0 15.1 2.8 Imports of Goods, NFS 4,235.0 24.0 19.3 -12.9 omUr. LABOR FORCE A- PRUCT WIITf IN 1962 Value Added Labor Force V.A. Por torker USS Mln. S MR. S 3USS Agricuiture end Mining 2,960 12.0 0.51 18.0 5,803.0 Induostry 4,725 20.0 0.36 13.0 13,125.0 Services 5,280 14.0 1.19 42.0 2,756.0 Unallocated 13.175 54.0 0.76 27.0 17,335.0 Total/Average 24,140 100.0 2.82 200.0 6,560.3 GOYERmm FiN,mm General Gowerisent PublIc Sector (CHSBIn.) S of GDP (CHSBIn.) S of GOP 1983 7983 1980-83 1983 1983 1980-83 Curren Receipts 431.4 28.0 31.0 474.8 31.0 31.0 Current Expenditures 475.6 31.0 29.0 475.6 31.0 29.0 Current Surplus *4.2 -3.0 2.0 -0.8 0.0 2.0 Capital Receipts 31.3 2.0 1.0 29.2 2.0 1.0 Capital Ecpendltures 34.5 2.0 5.0 75.6 5.0 2.0 External BorrowIng (net) -1.8 0.1 1.0 -15.2 -1.0 -0.4 1/ Tne per capita GP estimate calculated by the converslon technique of the 1983 World Atlas. All other conversions to dollers ae at the ennuel envere exchonge rate prevelilng during the period covered. 2J?tAli 1985 values In the table ale prellainary. not available not opplIcable 9/1e/a4  -7 COum DATA - CtILE Page 2 of 2 nS. CAEDIT MD PRICES 1977 1978 1979 1980 1981 1962 1963 (Banking Systew) (Billion OI5 outstondIng end perlod) Maney and Quasi Money 41.1 56.1 99.1 168.5 318.9 345.5 339.1 Bank Credit to Public Sactor 21.9 30.3 46.0 59.3 61.6 113.6 170.3 Bank Credit to Private Sector 27.2 62.9 118.1 221.6 306.6 564.5 374.7 (Percentages or tndox Numbers) Money and Quasi Money as S of GDP .14 .18 .11 .24 .41 .50 .38 General Price Index {1978i100) 63.9 89.5 119.3 161.3 193.0 212.2 270.1 Annual percentaeg changes In: 92.0 40.0 35.0 35.0 20.0 10.0 27.0 General Price Index Bank Credit to Public Sector 178.0 38.0 52.0 29.0 4.0 84.0 50.0 a8ik Credit to Private Sector 301.0 131.0 88.0 88.0 36.0 84.0 -34.0 BALACE OF PAIISEs tERO1WID5E ElPRTS CAvrap) USS MI 1. 1961 1982 1983 1961 -8 % Exports of Goods, NFS 5,505 5,026 4,699 Copper 1,761.0 46.0 imports of Goods, NFS 8,872 5,345 4.235 Paper and Cellubs. 206.0 5.0 Resource Gap deficit - -3.367 -319 464 Flshmeel 255.0 6.0 Frults 217.0 6.0 Interest Paymnts (net) -1.423 -1.946 -1,395 sMood 134.0 4.0 other Frctor Payments (nat) -1,123 -217 -47C All Otier Cnacdltles 1,244.0 33.0 Net Transters 45 45 .97 Balance on Current Account -4,868 -2.437 -1,504 Totat 3,817.0 100.0 Dlrect Foreign Investnt 376 365 152 MLLT EXImEi- O , DEC1 31. 196 Net ILT Borrowing (Public) 3,390 1.415 1,000 Dlsburse_mnt 5,188 2,674 1,900 Pubilc Debt, Incl. guaranted 7,070 Amortization 1,79e 1,259 900 Non-Guarenteed Private Debt 8,831 Subtotal 3.766 1,789 1,152 Total Outstanding end Dlsbursed 15,901 Nat Credit IW -65 40 614 Other Capital (net) 215 93 -300 DEBT sERVICE RATio Ftl 196 Oter items n.e.l. 1.261 -710 -503 5 increase In Reserves -309 1,234 541 (- - gain) Public Debt, Incl. guaranteed 20 Gross Reserves (end yr.) 3,798 2,564 2,023 Non-uaranteed Private Debt 25 Nat Rnerves (end year) 2,035 574 452 Total Outstanding end Disbursed 45 RALE II ESCIS (End 1983) 1811)DF WWING. (IC ch 31, 19W) OilS1im USS) lORD IDA USSI.OC - t15S87.51 OutstanJing and Dlsbursed 213.9 19.4 Undisbursed 162.2 - C61.00 - USS10.014 Outstanding Incl. Undlsbursed 376.1 19.4 not avallable not applicable LCIPA 9f18/84  SUNNARY AND CONCLUSIONS i. During 1976-1980, following a recession and later a liberalization process, the Chilean economy boomed, attaining a seven percent yearly rate of* GDP growth, This response to sweeping changes in trade and pricing policies led to the belief -tlat Chile's free market strategy would permit continuous economic growth, alleviation of extreme poverty and full employment by 1985. Today the country is slowly emerging from a two-year depression blamed by many on the same free market strategy hailed in 1981. Whether measured in terms of unemployment (25 percent), real GDP (down 14 percent in 1982, almost one percent in 1983), financial distress (possibly half the productive sector technically insolvent, as well as the largest commercial banks), or external debt burden (US$17 billion), the 1982-1983 depression may be considered Chile's worst experience in the last fifty years. i.- The depression can be partly attributed to the 1981-1982 world recession. Chile's terms of trade turned strongly against it; during 1981- 1983, Chile suffered USS1.2 billion in terms of trade losses, equal to eight percent of 1983 GDP, owing largely to extremely low prices for the country's main exports (copper, forest products, fruits). Government policies, how- ever, aggravated these effects. The result of this combination was a depres- sion of grave consequences. Chile faces now a huge increase in the nation's external debt and the bankruptcy of much of the domestic financial and non- financial private sector. Paradoxically, although blamed by some for the de- pression, trade liberalization did not only not cause this depression, it may be Chile's only means to regain export-led, economic growth. ill. Much of the problem stems from pegging the exchange rate while opening the capital account, which brought about unsustainable trade deficits during 1980-1981. The resource gap reached ten percent of GDP in 1981 and was financed through massive increases in external debt. Chile's external debt, which had remained moderate until 1980, was estimated in December 1983 at US$17 billion (US$1,460 per capita). Interest payments alone represented seven percent of CDP. This large external imbalance partly precipitated the balance of payments crises of 1982-1983 and the burden of foreign debt pay- ments will retard the economy's recovery. iv. In December 1982, Chile - supported by the IMF - developed a short-term stabilization program. However, In January 1983, a financial crisis triggered by massive bank insolvency and huge short-term capital out- flows forced the Government to intervene' (take control of) the largest pri- vate commercial banks and to provide them rapidly with liquidity. This in- creased credit by US$1 billion in siX weeks. Nevertheless, by following an even more austere emergency program drawn up in March with the IMF, the Government was able to comply with the targets of its original program by September 1983. In July 1983, the Government finalized negotiations on its external debt with international banks. An agreement in the amount of USS4.7 billion was reached providing Chile with a rescheduling of 1983-1984 amorti- zation payments over eight years, with four years grace, and US$1.3 billion in new loans to cover the expected 1983 current account deficit. v. During 1983 there was a drastic drop in imports; this brought about a USS1 billion trade surplus and a current account deficit of only USM1 bil- lion. This improvement, combined with the restructuring of the external  - ii - debt, resulted in a small increase in gross reserves. Domestic demand continued its decline and GDP fell for a second consecutive year, but only slfghtly. Open unemployment remained at 16 percent, real griss fixed invest- ment dropped 15 percent from 1982, and real per capita consumption was down 8.5 percent from its already depressed 1982 levels. vi. Economic recovery started in late 1983, albeit at a slow pace. Production increasea in trade-related activities as the changed exchange rate policy and increased public investment had its effects. Unfortunately, an unparalleled financial disarray which has brought to the brink of bankruptcy Chile's corporate and financial sectors and the external debt burden make that incipient recovery very fragile. vii. The major issues confronting the economy are unemployment, con- straints on foreign exchange, and a need to increase savings and fnvestment rapidly. This report analyzes those issues and those government policies considered key in tackling them, and recommends policies which may strengthen the current incipient economic recovery. viii. Because increased exports and domestic savings are essential to im- prove Chile's growth prospects for the rest of the decade, exchange rate and trade policies will be extremely important. Efficiency and production in- creased substantially during 1975-1980 in export-oriented and import-compet- ing firms when tariff decreases were compensated by a managed floating ex- change rate. On the other hand, during 1980-1981, pegging of the nominal ex- change rate appreciated the peso, encouraging imports and the use of foreign savings, and discouraging domestic production and savings. After the massive devaluation (from Ch$39/US$l to Ch$66/US$1) of June-September 1982 was fol- lowed by a crawling exchange rate policy aimed at keeping the real exchange rare constant, exports of wood, fishmeal, fruits and manufactured goods - all capable of rapid expansion - recovered. Import-competing goods have al- so benefited. As a result, manufacturing value-added increased two percent in 1983, and has been growing at a 10 percent annual rate in the first quar- ter of 1984. Initial reports indicate that the 1983/1984 agricultural har- vest will be 15-20 percent higher than the previous one. Continuation of the exchange rate policy is, therefore, vital as a strong incentive to potential investors in export-oriented and imoort-competing activities. ix. Tariffs were doubled in 1983 from ten to 20 percent mostly to in- crease fiscal revenues. Pressures are now building to use tariffs as a pro- tection for domestic producers. Chile's experience has shown that tariff protection has an anti-export bias and does not necessarily reduce import de- pendence. Such a change in the tariff system may ultimately affect exchange rate policy, reduce exports and limit Chile's longer-term growth and employ- ment prospects. x. Another important issue will be the allocation of the economy's very scarce resources between the goals of public employment generation, re- activation of the private sector, and restoration of the financial system. Because of its size, the public sector will likely play a major role in the economy's recovery. During 1977-1981 it provided substantial savings which allowed non-inflationary credit expansion to che private sector. Its mining operations provide over 60 percent of the country's export earnings. Final- ly, some public enterprises and banks are among the few large Chilean enter- prises not bankrupt.  - iii - xi. While the Government was eager to reduce the role of the State in both production and pricing, it was equally determined to improve the quality of, and access to, social services to the poor. The income distribution poL- icies and programs of prior governments - such as price controls, public housing, direct subsidies and broadly-based social expenditure programs - not only had some perverse growth effects, but often had been of equal or, ln some cases, greater-benefit to the urban middle class than to the poor. From the mid-seventies on, although the Government spent less on the social sec- tors than predecessor Governments (public social outlays only reached 1972 levels in real per capita terms in 1980), it carefully targeted its spending on the extreme poor. xii. Many of this Government's approaches have been successful; some were innovative. Treatment and rehabilitation centers for severely under- nourished children and preschool nursery programs for the poor are examples of promising new approaches to nutrition. Fortified and protein enriched milk distribution programs for infants, preschool children and pregnant and nursing mothers reached over 80 percent of children under five. Nursery schools integrating nutrition, medical care, and education for the most dis- advantaged preschool children have been expanded rapidly. One important re- sult of the health program is that the infant mortality rate has been about halved over the past dozen years. xiii. As the economy entered the depression, unemployment soared. Open unemployment - which stood at eight percent in 1981 - rose to 19 percent in 1982; it was 16 percent by end-1983. In 1975, to alleviate unemployment, the Government created an emergency work program (PEN). In 1982, another program (POJH) was instituted to provide further relief and jobs for heads of house- holds. Both programs serve as employers of last resort. Notwithstanding their low salary payments (around US$26 per month in PEM and US$40 in POJH), both programs have played a substantial role in reducing open unemployment in 1983 by occupying over 500,000 participants (around 10 percent of the work force) during May-September 1983. These programs could usefully be continued until the employment generation effects of the public works program is large enough to absorb the work force currently employed by them. xiv. The economic depression had a major impact on public finances. Af- ter generating overall surpluses during 1975-1981, deficits (of about three percent of GDP) occurred during 1982-1983. Moreover, public savings were negative in those years and, unless action is taken, could be minimal during 1984-1985. Current expenditures will be difficult to restrain because of large unemployment benefits and the difficulties of reducing wage and salary expenditures as well as social security payments. Current revenues will rise at a slow pace. Copper taxes, seven percent of current revenues, will con- tinue to be affected by expected low copper prices. Indirect taxes, almost half of current revenues, will grow only at the pace of the economic re- covery. Finally, nontax revenues which represent 19 percent of current revenues may also increase slowly in the near future. On the other hand, capital expenditures of both general government and public enterprises will have to be increased to strengthen economic recovery and increase exports. In sum, the public sector may well be in net demand for credit, at least during 1984-1985.  - iv - xv. A public investment program taking into account the impact of cop- per prices on Government earnings, the financing and timing of public invest- ments, and the desirable level of current expenditures, considering Chile's urgent social needs will be essential. High on the Government's priorities should be investme5ts to expand productive employment and output in export- related activities (energy and mining). It is also crucial to improve the public sector's medium-term planning process while preserving the efficiency of the short-term budget mechanism. xvi. One major item on the Government's agenda must be the solution of the domestic financial crisis. The major uncertainties which affect private sector perceptions relate to the solution of the current indebtedness. In many cases, t'=e insolvency of the corporate and financial sectors is one of the major factors delaying investment. By 1982, the private nonfinancial sector had an external debt estimated at US$4 billion; the private financial sector had an external debt estimated at US$7 billion. The 1982-1983 devalu- ations greatly increased the real peso burdens of this debt and paralyzed the private sector. In 1983, the Central Bank, after intervening the banks, in- troduced a program aimed at alleviating the debt burden of domestic corpora- tions. By end-1983, nearly US$1 billion of short-term private debts had been renegotiated using special credit lines of the Central Bank which provided slightly subsidized interest rates, three-year grace on principal, and one- year grace on interest payments. In 1584, an enlarged version of this pro- gram was announced. These credit lines may be difficult to continue given the costs involved. Hence, increased domestic savings are essential tor the long-term solution of the financial crisis. xvii. In May 1984, a solution for the intervened banks, mostly involving the capitalization of the emergency credits from the Central Bank into equity -;as announced. This solution may create a sounder debt to equity ratio for the institutions involved, restoring depositors' confidence in the financial system. It may also encourage foreign creditors to transform their debt into equity. However, such capitalization needs to be accompanied by a restruc- turing of the corporate sector debt. While it would be imprudent to place all financially-distressed firms into bankruptcy, the current rescheduling schemes have deferred the necessary transfer of assets within the economy and slowed the speed of economic recovery. A more selective approach focusing on the most potentially viable firms would be more appropriate. xviii. Chile's external debt was about 80 percent of its 1983 GDP; inter- est payments on it were more than 40 percent of exports. It now represents a major obstacle to recovery. Increased domestic savings and exports will be necessary if the country is to achieve a five percent rate of growth - nec- essary for employment generation within a viable balance of payments - even from the very depressed levels of 1983. xix. Chile confronts some external factors over which it has little in- fluence. One will be the speed of the world recovery. Even if OECD growth is three percent yearly, until Latin American markets improve copper consump- tion would grow quite slowly and copper prices recover equally slowly. An- other is US dollar interest rates. A one percent increase (or decrease) of these rates could cost (or save) Chile US$150 million. Because of the uncer- tainty Chile confronts, the mission prepared three alternative projections.  -v- In the base case for a yearly three percent growth of GDP, merchandise exports need to grow at ten percent yearly during 1984-90. The fastest growth must come from non-copper exports. Because of its high interest bur- den, Chile will need to maintain an increasing resource surplus for the rest of the 1980s if the current account deficit is to be filled by expected long- term capital flows of about two to three percent of GDP. The savings effort would need to be coasiderable; Gross Domestic Savings would need to rise from 11 percent of GDP in 1983 to 16 percent in 1990; an ambitious but attainable target. xx. If the OECD recovery is less strong, Chile's GDP growth will be lower - two percent - even though its current account borrowing require- ments would be larger. The compression of per capita consumption required over such a long period, and the longer net foreign borrowing -required but likely not forthcoming, makes this appear a non-viable alternative. xxi. One other option would be to attempt to reduce expected interest payments. If the interest paid by private sources could be capitalized, Chile's growth prospects would quickly improve. Foreign interest payments would be reduced by US$500 million yeariy during the crucial years of 1985- 88, permitting a 1.5 percent faster GDP growth with the same net capital flows. Chile would then be in a strong position to service its debt by the late 1980s. xxii. Finally, Chile's growth is highly sensitive to copper prices and world demand for its other exports. If OECD growth were to remain strong af- ter 1985, Chile's current account balance of payments could remain in virtual equilibrium while GDP growth averaged six percent, leading to a more rapid decline in unemployment and debt service. xxiii. Because the world environment is so uncertain, it would be prudent for the Government to quickly undertake what actions it can to improve its future export potential. The on-going development of a three-year program to allocate scarce fiscal resources as carefully and methodically as possible is an excellent step. Continuation of an open, pro-export trade regime to en- courage exports will be an essential complement, as will be continuation of an attractive real foreign exchange rate. Efforts by the Government to re- schedule debt, as well as the capitalization of private debt to firms unable to pay, will be necessary, as will be actions to improve the credibility and soundness of the financial system. Because of its high interest burden, Chile will need superb economic management with few, if any, missteDs for the remainder of the 1980s.  I. THE 1982-1983 DEPR8SSION PA. rI NT ODUCTOK 1.01 After a buoyant recovery during 1976-1979, and an economic boom during 1980-81, the Chilean economy fell into a depression in 1982-1983. The depression bottomed jout in the second half of 1983, but whether measured in terms of unemployment (25 percent), real GDP (down 15 percent from the 1981 level), financial distress (perhaps half the productive sector was technical- ly insolvent, as are the largest commercial banks), or the magnitude of the country's external debt (US$1,460 per capita in December 1983), this depres- sion may be considered as Chile's worst economic experience in the last fifty years. 1.02 The crisis was caused by a combination of major macro policy mis- takes along with an underestimation of the internal financial disarray, and by the 1979-82 world recession. What would have been a recession turned into a depression of grave consequences. When the Government ultimately devalued in June 1982, the firmness of its previous policies was replaced by a series of ad hoe measures that created uncertaiuty amongst both domestic and extern- al investors and encouraged various interest groups to seek special treat- ment, eroding not only the liberalization program put in place since 1975, but also the credibility of the Government. 1.03 As a result, in January 1983, the country was confronted by a fi- nancial crisis triggered by a banking insolvency and a massive capital out- flow, and the Government was compelled to intervene in the financial system as well as follow stern austerity measures to stabilize the economy. Extern- al equilibrium was achieved at great cost by the end of 1983, but the 1980482 events have left a legacy that will slow down the speed of any future recov- ery. First, in the wake of the ad hoc policies of 1982 and the austerity program of 1983, there are increasing demands for a protectionist-cum-expan- sionary program as a more rapid way out of the current depression. Second, interest payments on the external debt, 40 percent of exports in 1983, will not only reduce the country's growth potential, but its ability to gain ac- cess to new foreign resources for some time to come. Finally, the extent and severity of the current internal indebtedness is placing a great stress on the financial and productive sectors, and may repress domestic savings and investment until confidence is restored. B. BALAICE OF PAMETS AND EERNAL DEBT 1.04 During 1982-1983, Chile's balance of payments changed abruptly as a result of the country's external debt payments, loss of capital inflows, ex- change rate policy, and terms of trade loss. Faced with an increasing trade deficit and an acute loss of international reserves, the Government finally abandoned its fixed exchange rate policy, devaluing the peso in June 1982 from Ch$39/US$l to Ch$46/US$I and adopting a passive crawling peg strategy. As speculation continued, the Government floated the peso in August 1982. Then, in September 1982, it adopted a crawling peg after the exchange rate reached Ch$66/US$1. This time, the Central Bank accompanied the measure with restrictions on foreign exchange transactions and used the real exchange rate as an export incentive. In January 1983, the Government began a short-term stabilization program which the IMF assisted with a SDR 500 mil