Chile: The Lonely Success Story


Packing pears. Photo by Alejandro Barruel

Economic Reform in Latin America

By Juan Carlos Moreno Brid and René A. Hernández

Chile, with just 15 million people, is considered the paragon of open trade and the economic miracle of Latin America, a region where such miracles are rather scarce.

After two decades of radical macroeconomic reform, Latin America has yet to succeed in its quest to achieve high and sustained rates of economic growth. Although since the mid-1980s, it has adopted a new development strategy based on market mechanisms and trade liberalization, the region has been unable to enter a path of stable and robust economic expansion.

In fact, during 1990-2003 almost all Latin American economies grew at a slower pace than in 1960-80, when they followed the then traditional strategy of import substitution and state-led industrialization. Moreover, in the aftermath of the Asian crisis and the slowdown of the U.S. economy, Latin America’s economic recovery has lost steam in the last six years. Its GDP per person shrank in real terms. It is now 1.5% lower than its 1997 level. Such anemic economic performance arrested its progress in poverty alleviation, an urgent, still pending task in the social agenda. According to the UN Economic Commission for Latin America, 44% of Latin Americans live in conditions of poverty, with 19% enduring extreme poverty. Particularly worrying have been the series of financial crisis in Argentina, Bolivia, Ecuador, Dominican Republic, Peru and Venezuela and other countries in the region, that have plunged them in episodes of political turmoil and economic instability.

Chile is the conspicuous exception to this dissatisfying experience to date with macro reforms in Latin America. During 1980-2000 the Chilean economy expanded rapidly (See Chart 1). Its subsequent slowdown has been milder, scarcely affected by its neighbors’ deep economic troubles. Recall that in the peak of the 2002 financial crisis in Argentina and Uruguay, Chile was still able to place a bond in the international capital markets under very favorable terms and its Central Bank kept rather low domestic interest rates.

With its annual national income rapidly approaching US $5,000 per person—just below that of Mexico—Chile is poised to join the ranks of developed nations. It has a relatively high index of human development, and is currently ranked in 38th place worldwide of a total of 150 countries, a position comparable to Portugal, Poland and Hungary. Its sustained dynamic expansion was accompanied by a substantial improvement in social development. Chilean data indicate that the incidence of poverty fell from 45% in 1987, to 22% in 1998 and 21% in 2000. In turn, the proportion of its population living under extreme poverty conditions fell from 17% in 1987 to 5.6% in 1998, but rose slightly to 5.7% in 2000. It is one of only two Latin American countries that have already met the Millennium Development Goals of achieving a 50% reduction in the incidence of extreme poverty relative to its 1990 level. Social progress was also favored by the introduction of new anti-poverty programs targeted to low-income households.

Chile boasts one of the best economic performances in the region, with comparatively high investment ratios, low inflation rates, and prudent fiscal management. Moreover, international surveys systematically rank it among the top economies in the region in terms of international competitiveness, business conditions, transparency and corruption. It now regularly ranks among the top 20 most attractive business destinations in the world. What are the determinants of Chile’s economic success? What are the challenges and lessons for Chile to sustain such outstanding economic performance?

THE BENEFITS OF BEING AN EARLY REFORMER

It should be remembered that Chile was a pioneer in Latin America’s experiment with radical market reforms. Indeed, General Augusto Pinochet’s September 1973 coup against the democratically elected government of Dr. Salvador Allende and the subsequent military regime that lasted until 1989 had as a consequence the demise of the old development model based on the state’s active interventions in the economy. Instead, the dictatorship favored market mechanisms and private competition as the key agents of capital formation and production decisions. The economic rationale for such change, independently of its political motivation, was clear. The state’s intervention in the economy was perceived as a fundamental distortion in the allocation of resources, thus provoking high indebtedness and inflation.

Applying this new strategy, by the mid 1970s, Chile began to undertake key reforms: eliminating import controls, unilaterally bringing down import tariffs to a common level of 10%, opening financial markets to foreign competition, reducing the public sector and eliminating many government controls on economic activity that had become standard practice. In 1976 Chile withdrew from the Andean pact, at the time a regional organization was marked by protectionism and its adverse view of foreign direct investment (FDI). But the results of this first attempt at macroeconomic reform were far from favorable. Crucial errors in financial liberalization in the absence of adequate bank regulation coupled with a fall in the international price of copper and a sudden halt in foreign lending. The Chilean economy was pushed to an acute crisis in 1982-83, leading to the bankruptcy of the private banking sector and its nationalization.

The authorities responded by implementing a conventional economic stabilization package to control inflation, relying more on a flexible exchange rate and a rise in import tariffs to face foreign sector disequilibria. The process of structural reforms lost impetus for some time. However, in 1985, structural reforms once again began to be profoundly implemented. Trade liberalization was again pushed forward, independence was awarded to the Central Bank, a new regulatory framework for the banking sector was adopted and privatization of public enterprises was accelerated.

CONTINUITY IN SOUND MACROECONOMIC MANAGEMENT CONSISTENT WITH AN OPEN ECONOMY

The Concertación—the democratic governments that have held the Presidential office in Chile since 1990—have gradually and persistently pushed to restore Chile’s historical respect for civil liberties and human rights, systematically violated during the military regime. In the economic realm, they have maintained essentially the same development model regarding the role of the market and the State as the previous regime. The macroeconomic policy’s emphasis has been placed in two areas. The first is a deepening and modernizing the structural reform process, explicitly extending it to cover health and education areas. The second emphasis is on stressing the fundamental importance of maintaining low inflation rates.

Given this overall standard orientation, Chile's macroeconomic policy has introduced key non-conventional elements in its fiscal management and treatment of international capital flows that, in our view, may help to explain its economic success in the 1990s and its resilience to the adverse effects of external shocks.

ON CAPITAL FLOWS

Capital inflows offer opportunities to finance investment and boost economic growth. However, to depend on volatile short term capital is a risk that may impose severe penalties on a developing country. Abrupt fluctuations in capital inflows may lead to a sudden sharp rationed access to foreign exchange that detonate balance of payments crisis, and push domestic activity into a severe recession. To reduce such risks, but still enjoy some of its benefits, during most of the 1990s Chile successfully imposed taxes on short term capital inflows, with the tax rate adjusted to the time-holding period. This tax was lifted in 1998 reflecting the contraction in the volume of international capital flows to the region, as a consequence of the Asian crisis and the burst of the US stock market. However, not withstanding the operation of its various FTAs, the Chilean government has retained to potential capacity to reestablish such controls in the future if it is deemed necessary.

ON FISCAL POLICY

Relative to the rest of the region, Chile's fiscal policy has been particularly prudent. According to the UN Economic Commission for Latin America (ECLAC) during 1994-2003, Chile's public sector current revenues systematically represented more than 30% of its Gross Domestic Product (GDP)—several points above those of Costa Rica, Mexico, Uruguay and most countries in the region. For more than ten years until 1997, the annual budget showed a surplus and a reduction in government debt (Economist Intelligence Unit, February 2004). And since then the deficit has not exceeded 2.5% of GDP, and has sometimes too shown a surplus. Such fiscal prudence outperforms that of most members of the European Union, not to mention the United States. An important source of public revenues comes from its high value added tax rate, (currently 19%, one of the highest in the region). It should be also pointed out that, notwithstanding Chile's commitment to privatization, the Corporación Nacional del Cobre de Chile (CODELCO), the world's leading copper producer is still state-owned, and, is a considerable source of public revenues. And, as the World Bank admits, the Copper Stabilization Fund—established by the Chilean government—has reduced the impact of external shocks on fiscal revenues.

Most important, and in sharp contrast to the rest of the developing world, since the early 1990s Chilean fiscal management has been based on a commitment to maintain on average, and in a medium term perspective, a structural fiscal balance equivalent to 1% of GDP. In other words, the policy means that, if the economy grows at its medium term potential rate (5% per year), then its fiscal results would show a surplus of 1% of GDP. In this way the government may carry out its planned expenditures in a manner relatively independent of the business cycle and its inherent fluctuations from its different fiscal revenues. So, for example, a rise in the budget deficit due to a decline in income tax revenues, associated with a downturn in the business cycle, will not necessarily lead to a cut in public spending. Indeed, the policy assumes that such tax revenues will be compensated in the upward phase of the business cycle. This approach to fiscal management ensures domestic and international markets that the government will keep fiscal prudence. At the same time, this structural approach leaves margin to implement a counter-cyclical budgetary stance to reduce the impact of adverse external shocks on domestic activity, employment and social conditions.

OTHER KEY ASPECTS

The strength of Chile's domestic savings is remarkable in a region where the absence of savings practices is the norm. Such success is usually explained in part by Chile's pioneering role in the reform of the pension system. Indeed the country enjoys a fully-funded private pension system since the 1980s. But the incentives to promote the reinvestment of profits by private business also played a relevant role in boosting domestic savings. The strength of Chile's saving capacity has now allowed local businesses to borrow long-term in pesos, something which in most developing countries can only be done in foreign currency. Finally as UN Under Secretary-General for Economic and Social Affairs José Antonio Ocampo emphasizes, Chile, the reformers' darling, did not rely exclusively on open trade to promote development. It also adopted technology and innovation policies with a selective and clear identification of "strategic visions" for certain economic sectors, as well as fostering small and medium enterprises.

CHALLENGES

Sound macroeconomic policies and trade liberalization—in addition to its orderly transition towards a more democratic political context—have been key factors in sustaining Chile's robust economic expansion and avoiding crisis. Exports have become its engine of growth, as conspicuously evidenced in the boom in external sales of forestry, fishing, wines, fruits and other agro-based products. Chile and Mexico were the only two large economies in the region whose volume of exports grew at double-digit annual rates during the 1990s. It is so far Latin America's only case of success at macroeconomic reform. However important challenges are open.

The first and crucial one is rather significant: to boost export dynamism once again. Indeed, even though the United States economy is recovering from its slowdown, it is unlikely that it will reach and sustain the extraordinary high rates of expansion experienced during the 1990s. The European Union does not appear to be poised for quick economic growth soon. In addition, the short-term outlook of Chile's neighboring countries is complicated. Argentina's problematic external debt position, if not soon resolved, may deteriorate the Southern Cone's intrarregional trade, business climate and investor expectations.

Chile urgently needs to reduce its dependence on exports of commodities as a source of foreign exchange. Copper in fact still accounts for 34% of Chile's total export revenues. Such dependence on commodities increases the Chilean economy's vulnerability to external shocks. It also constrains its growth potential, given the unfavorable long-term trends in their terms-of-trade and its effects on the allocation of investment. Indeed, in recent years, FDI to Chile appears excessively concentrated in the mining sector, and thus adversely affected by the decline in the world prices of copper.

Chile's free trade agreements (FTAs) with the European Union, the United States and Korea—that became operational in the last fourteen months—may somewhat reinvigorate exports. But by themselves, are insufficient to place them back on a high long-term growth track and to change Chilean exports' structure toward more knowledge intensive products. Recall that the FTA with the United States does not alter the subsidy scheme to American farm products. Moreover, such change in trade preferences may be insufficient to attract the foreign direct investment in the volumes required to transform Chile's productive apparatus into a modern robust export platform of manufactures and services.

The second key challenge concerns Chile's severe disparities in income and marked differences between demographic groups. Despite the advances in poverty reduction, income distribution is still dramatically uneven. As recently noted, Chile "has the largest gap on the continent between the rich and the poor" (UN Notebook, Feb 17, 2004). Moreover in 2000 income distribution was more disparate than in 1987 (EIU, 2003). Such stark inequality undermines growth potential, by concentrating saving and investment. And, more important, it may deteriorate social cohesion and the basic principles of democracy, as income inequality also means unequal access to health, education and ultimately political power. So far, the Chilean combination of economic growth and targeting of public spending towards the poor has been ineffective to reduce inequality. In particular social policies and programs need to be revised to meet the needs of especially vulnerable groups like indigenous populations, youth, female-headed households and the rural poor.

An important and—yet hard to accomplish—element in this agenda concerns Chile's structural failure to date to create sufficient jobs. The economic slowdown in 1998-2003 has pushed up the level of open unemployment to critical peaks (close to 10%). Chile's current unemployment insurance scheme partially alleviates some of the negative impacts of this phenomenon. But, the persistence of high unemployment—especially among the youth—undermines the potential production capacity, distorts incentives and, most critically, creates severe social tensions that threaten the progress made towards more democratic forms of government.

Chile has indeed come a long way, but the challenges it faces are significant and may require a deep transformation of its productive structure and a much more even distribution of its social benefits. What is the road ahead remains an open question.

Juan Carlos Moreno Brid is Regional Advisor for the United Nations’ Economic Commission for Latin America and the Caribbean. He was a DRCLAS Visiting Scholar, 1994-1997/1999-2000.

René A. Hernández is Economic Affairs Officer for the United Nations’ Economic Commission for Latin America and the Caribbean.

The opinions here expressed may not necessarily coincide with those of the United Nations.