Economic Reforms in Chile: From Dictatorship to Democracy

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Economic Reforms in Chile

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Economic Reforms in Chile From Dictatorship to Democracy Second edition

Ricardo Ffrench-Davis

© Ricardo Ffrench-Davis 2010 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2002 by The University of Michigan Press This edition published 2010 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978–0–230–57738–1 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Ffrench-Davis, Ricardo. Economic reforms in Chile : from dictatorship to democracy / Ricardo Ffrench-Davis. — 2nd ed. p. cm. Summary: “This book provides an depth analysis of neo-liberal and of progressive economic reforms in Chile since the Pinochet dictatorship _”— Provided by publisher. Includes bibliographical references and index. ISBN 978–0–230–57738–1 1. Chile—Economic policy. 2. Chile—Economic conditions—1970–1973. 3. Chile—Economic conditions—1973–1988. 4. Chile—Economic conditions—1988– I. Title. HC192.F443 2010 339.983—dc22 2010023772 10 9 8 7 6 5 4 3 2 1 19 18 17 16 15 14 13 12 11 10 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

Contents List of Figures

vii

List of Tables

viii

List of Boxes

xi

Preface to the Second Edition

xii

First Part: An Account of Four Decades I

Economic development in Chile since the 1970s 1 A historical perspective on development strategies 2 The neoliberal strategy, 1973–89 3 Democracy, reforming the reforms and development, 1990–2009 Annex

1 3 5 9 24 43

Second Part: The Neoliberal Experiment in Chile, 1973–1982

51

II

Import Liberalization in 1973–82 1 The import liberalization process 2 Import composition 3 Effects of trade liberalization on manufacturing 4 Towards an evaluation 5 Concluding remarks

53 54 61 64 68 75

III

Domestic Financial Liberalization and External Debt in the 1970s: Building a Major Crisis 1 Financial liberalization and foreign indebtedness 2 Financial capital flows and indebtedness: volume, sources, and uses 3 Indebtedness and macroeconomic adjustment 4 Interest-rate differentials 5 External vulnerability and the dynamics of indebtedness 6 Some lessons from this experience

Third Part: Economic Recovery and the Heritage of the Dictatorship, 1982–1989 IV

Policy Rectifications and Recovery from the Debt Crisis, 1982–9 1 The debt crisis 2 Debt management in 1982–9 3 A more pragmatic economic policy v

77 78 83 88 97 102 104 107 109 110 117 121

vi

Contents

V

4 Strong economic recovery, weak average growth 5 Macroeconomic (im)balances by 1989

124 126

Export Development during the 1980s 1 The role of exports in national development 2 Trade policy in the 1980s: a departure from orthodoxy 3 Export performance: dynamism and diversification 4 Dynamic exports and limited economic growth

130 131 133 141 144

Fourth Part: Development Challenges for Democracy

147

VI

Export Dynamism and Economic Growth since the 1990s 1 Trade policies since 1990 2 Export performance 3 Exports and foreign investment 4 Exports and economic growth 5 Concluding remarks

149 150 156 165 167 172

VII

Inequality and Poverty since the 1970s 1 Trends in income distribution and poverty 2 The role of neoliberal reforms 3 Reforms to fight poverty and income concentration 4 Concluding remarks

174 176 193 198 206

VIII Managing Capital Inflows in the 1990s and the “Encaje” 1 Capital inflows: magnitudes and composition 2 The policy counter-cyclical response 3 The effectiveness of macro-stabilizing measures 4 Savings, investment, and growth in the 1990s 5 Some policy lessons from this experience

209 211 216 226 232 234

IX

Economic Policy after the 1999 Recession 1 The origins of the break 2 The impact of the crisis, 1998–9 3 The recessive phase, 1999–2003 4 Dynamic recovery in 2004–5 5 Deceleration from 2006 6 Two relevant issues: the structural fiscal balance and the exchange rate 7 Concluding remarks

236 238 240 243 247 249

Concluding Remarks and Challenges 1 An account of sixteen years of dictatorship versus sixteen years of democracy 2 Four general conclusions 3 Ten specific challenges

268

X

255 267

268 271 274

References

278

Index

291

List of Figures I.1

Actual and potential GDP, 1960–2009 (log scale, GDP* 1996 = 100)

15

A.1

Comparison of two estimates of the Output Gap, 1960–2008 (% of GDP*)

49

II.1

Average tariff and real exchange rate, 1973–82

59

III.1

Simple conventional framework of capital markets liberalization

79

VII.1 Chile and developed countries, per capita GDP and income distribution, 2007 (PPP US$)

176

VII.2 National unemployment rate, 1960–2009 (percentage of the labor force)

183

VII.3 Income distribution in Greater Santiago, 1960–2009 (Q5/Q1 ratio, three-year moving average)

190

VIII.1 Evolution of the real exchange rate, 1986–2009 (1986 = 100)

225

IX.1

Pension fund outflows and RER, 1993–2000 (% of total funds, 1986 = 100)

241

IX.2

Real copper price, actual and trend, 1959–2009 (2009 US$/lb)

248

IX.3

Trend GDP: annual review by Committee of Experts, 2006–9 (annual growth rate, %)

262

IX.4

Panel A: evolution of exports and imports of goods and services, 2000–9 (annual real growth rates, %). Panel B: current account balances, 2000–9 (% of current GDP)

265

X.1

Per capita GDP growth, 1973–89 versus 1990–2009 (real indexes, 1973 and 1989 = 100)

271

vii

List of Tables I.1

Comparison of key macroeconomic variables, 1959–2009

8

I.2

Evolution of GDP and its composition, 1975–81 (annual average rates of growth)

17

Macroeconomic variables during dictatorship, 1974–89 (annual averages)

22

I.3 I.4

Public and private budget balances, 1990–2007 (% of GDP at current prices)

31

I.5

Gross savings ratios, 1982–2008 (% of GDP at current prices)

39

I.6

Per capita GDP growth, 1974–2009 (annual average growth rates)

41

A.1

Potential GDP growth and output gap, 1960–2007 (annual average growth rate, % of GDP*)

45

II.1

Tariff liberalization, 1973–9 (rates on cif value)

56

II.2

Cost per dollar of imports, 1973–82

58

II.3

Main imports of consumer goods and total imports, 1970, 1980, 1981 (1977 US$ millions)

62

II.4

Shares by income brackets of consumption of imported goods: main non-traditional imports in 1978 (% of total consumption)

63

Manufacturing output: Chile and the world economy, 1974–82 (1973 = 100)

65

II.5 II.6

Balance of payments, 1973–82 (1977 US$ millions)

70

III.1

Deficit on the current account and capital flows, 1970–82

84

III.2

Total foreign debt and private financial creditors, 1974–82

85

III.3

Public and private net foreign debt, 1973–82 (US$ millions)

86

III.4

Gross annual flows of loans, by debtors, 1976–82

87

III.5

Domestic and external real interest rates in pesos, 1975–82 (annual percentage rates)

98

Foreign debt and public guarantees, 1975–89 (US$ millions and percentages of total)

111

IV.1 IV.2

Production, consumption, investment, and external shocks per capita, 1980–9 (in 1977 pesos as a share of 1981 actual GDP)

114

IV.3

Net transfers of funds abroad by creditor, 1983–9 (US$ millions)

118

viii

List of Tables ix

IV.4

Indexes of stock prices in pesos and converted to US dollars, 1980–9 (1980 = 100)

121

V.1

Average tariff and real exchange rate, 1973–89

138

V.2

Growth of export volume, 1961–89 (annual averages, %)

141

V.3

Composition of goods exports, 1970–89 (%)

142

V.4

Geographic distribution of Chilean exports, according to degree of elaboration, 1970–89

143

VI.1

Growth of export volume, 1986–2009 (annual averages, %)

156

VI.2

Average tariff, collected tariff, and real exchange rate, 1984–2009

157

Indicators of export diversification, 1990–2008 (number of markets, firms, and products)

161

Geographic distribution of Chilean exports, according to technological content, 1983–2008

163

VI.5

Export participation in total output, 1961–2009 (% of GDP)

168

VI.6

Exports and economic growth, 1961–2009 (annual average rates of growth, %)

171

VI.3 VI.4

VII.1 Wages, family allowances, and social expenditure, 1970–2009 (real indices, 1989 = 100)

181

VII.2 Distribution of household expenditure in Santiago, 1969, 1978, 1988 (%)

182

VII.3 Poverty evolution in Chile, 1987–2006 (%)

186

VII.4 Poverty dynamics in Chile, 1996–2001–2006 (% of population)

187

VII.5 Distribution of household expenditure and income in Santiago, with imputed rent for homeowners, 1988 and 1997 (%)

189

VIII.1 Composition of capital flows, 1980–2008 (2008 US$ as % of GDP)

212

VIII.2 Net capital inflows and deficit on the current account, 1980–2008 (% of GDP)

225

VIII.3 Implicit cost of reserve requirement on foreign borrowing, 1991–8 (annualized rates)

227

IX.1

Investment, savings and growth, 1974–2009 (annual growth rates, % of GDP)

237

x

List of Tables

IX.2

Gross investment and depreciation, 1995–2009 (% of GDP at constant 2003 prices)

255

IX.3

Fiscal indicators, 2001–2009

258

X.1

GDP, GDP per capita and income distribution, 1974–2009 (annual growth rates, %)

270

List of Boxes III.1

The “crawling” exchange rate: a pioneer reform in 1965–70

IV.1

Debt-swaps programs

119

92

V.1

Incentives to exports by the late 1980s

137

VI.1

Molybdenum in the national economy

160

VII.1 Wages and the poverty line, 2000 and 2005 (monthly income in UF)

177

VIII.1 Regulations on capital flows by mid-1998

221

xi

Preface to the Second Edition This book reflects my research and views on crucial developments in the Chilean economy from the 1970s up to 2009. I have organized the text chronologically, in four subperiods: the first half of the Pinochet dictatorship, the second half of that regime, and then the two decades since the return to democratically elected presidents in 1990. In my view, under a restrictive definition, the four subperiods correspond to different approaches to building a market economy, progressing from an extremely orthodox neoliberalism, in the first half of the Pinochet regime (1973–82), to some significant deviations (pragmatism with a regressive bias) in the second half (1982–9), and then two variants of meaningful trials intended to achieve growth with equity (pragmatism with a progressive bias, but inconsistencies) with diverse inputs and outputs. This book is a combination of newly prepared material and previously published papers. In this second English edition, I have deleted three chapters from the first edition, abridged several sections, and added some 50,000 words, including several new sections and two new chapters. The older historical sections are built on papers written close to the times of the events, on import liberalization (Chapter II), on the building of the debt crisis of 1982 (Chapter III), and on the rectifications with recovery in the 1980s (Chapter IV). These articles were written while I was working at the Center for Economic Research on Latin America (CIEPLAN) between 1976 and 1990, no doubt the most inspiring period of my professional life. I have edited them thoroughly, but the original tone and emphasis have been retained. Happily, I continue to feel comfortable with them today. Although the knowledge informing them has improved and deepened (I hope), there is no discontinuity of approach, and I feel that the various pieces are consistent. But the reader is to be the judge. Here and there a line of thought has been expanded by incorporating paragraphs from other essays or that are newly written. Naturally, duplications among chapters have been reduced as deemed convenient, and I have deleted what I judged to be details not relevant today. Subsequently, for the first edition, I wrote the initial draft of an essay on income distribution and poverty, and a chapter on exports. For this second edition, the two chapters were carefully revised and expanded. I prepared a new chapter on reforms and policies after the contagion of the Asian crisis, as well as a chapter on exports and growth, focused on explaining the sharp variability observed in the correlation between export dynamism and GDP performance in different subperiods. A brief conclusion compares the xii

Preface to the Second Edition

xiii

overall performance during the dictatorship with that of the four democratic governments that have followed since 1990, and poses some issues and challenges for the next decade. These chapters, and several new sections, were written while I was at the Economic Commission for Latin America and the Caribbean (ECLAC); the main input of another chapter was coauthored in a highly fruitful association with Manuel Agosin and with valuable input from workshops held at ECLAC. The entire typescript has been revised and updated at the Department of Economics of the University of Chile during 2008 and 2009. I have made a serious effort to harmonize statistical series and to make use of excellent research by other colleagues on data harmonization and explanations of events. They are cited through the book. I have attempted to deal with each issue and period in a way that combines pragmatism with a solid analytical base, and to consistently take into account the objectives of growth with equity, while trying to keep my distance from fashion, myths, and extremes. In this book I stress relationships – reforms, policies, and outcomes – with other Latin American nations, on issues that I discuss at length in my book Reforming Latin America’s Economies after Market Fundamentalism, prepared during my stay at ECLAC, a period which I recall gratefully. Eight years of work at the central bank are reflected in some of the emphasis throughout the book. In the preparation of successive editions, in which statistical series were updated and harmonized, figures checked, duplications eliminated, sections of other writings incorporated, and language improved, I enjoyed the excellent collaboration and efficiency of my research assistants Heriberto Tapia and Rodrigo Heresi, both at ECLAC. In the final stage of this second edition in English, I acknowledge the support of Rodrigo Heresi, David Coble, and Felipe Labrín, at the Department of Economics of the University of Chile, and of Julia Escobedo in the checking of files. Finally, I would like to express my appreciation to CIEPLAN for its valuable support for this publication. To all those mentioned, and to the many who contributed but have been unjustly omitted here, my deepest gratitude. All responsibility for the content of this book and any errors it may contain are, of course, solely mine. Ricardo Ffrench-Davis Santiago, July 2010

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First Part An Account of Four Decades

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I Economic development in Chile since the 1970s

One main reason for the relevance of the Chilean experience for other emerging economies, with the implementation of a free market economic model, rests in the depth of transformations and the long period since this process was started. The first intense reforms were launched in 1973, under the dictatorship of general Pinochet. Usually, it has been accepted that there is “one” successful Chilean model. The fact is that the more than one-third of a century since 1973 includes several subperiods, with different approaches, diverse external environments, and notably diverse economic and social outcomes. This diversity is of great significance, since Chile teaches about successes but also deep mistakes and failures to be avoided. The first stage of the reforms (1973–81) was characterized by the implementation of a neoliberal model in its purest ideological form. Deep trade and financial liberalizations, and the adoption of “neutral” economic policies, were accompanied by massive privatizations. In general, by 1981, success was achieved in reducing the inflation rate and eliminating the fiscal deficit, but at the expense of the external balance and a low investment ratio. The consequence was an economic and social collapse in 1982, with a GDP drop of 14%, high unemployment exceeding 30% of the labor force, and a significant increase in poverty with a worsening income distribution. The second stage (1982–9) involved moves towards more pragmatic policies to overcome the effects of the deep crisis. It involved a series of foreign debt renegotiations, several policy interventions aiming to balance the external deficit – such as tariff increases and “selective” export incentives – and the direct takeover of the collapsed financial system, followed by reprivatization when balance sheets were in order thanks to heavy public subsidies to banks and debtors. At the end of this period, the economy had recovered, while income distribution had worsened even further than in the seventies. During recovery, actual GDP grew vigorously, but after due consideration of the 1982 recession, it emerges that average growth was under 3% in both halves of the Pinochet regime. 3

4 Economic Development in Chile

By 1990, in the return to democracy, the Chilean economy faced the challenges of achieving a sustained high average GDP growth and of serving the great social debt accumulated in the years of dictatorship. Thus, a third variant of the economic model began in 1990, under democracy. We have named this stage that of the reforms to the reforms, since it started from what had been inherited; the formal slogan of the Concertación Democrática, a center-left coalition of socialists and Christian democrats, was “change with stability” to achieve growth with equity in the socioeconomic dimension of the program of the new government. There were significant reforms of the market model, strengthening the social component and correcting severe failures of economic policies. These included labor reforms (which restored several labor rights) and a tax reform (which raised public revenue in order to improve social expenditure). In addition, substantive counter-cyclical changes in fiscal, monetary, capital markets, exchange rate, and regulation policies were implemented, aiming for a stable and sustainable macroeconomic environment, functional for economic development. It was in this context in which Chile expanded its productive capacity in a sustainable manner in the nineties, growing at annual rates exceeding 7%, improving at the same time the social indicators; that is, it partly achieved the elusive combination of economic growth with equity. Nevertheless, gradually, after the mid-1990s, Chile weakened its countercyclical macroeconomic approach and became, as a consequence, vulnerable to the turbulences originating in the Asian crisis: the real exchange rate appreciated significantly and the external deficit doubled. As a consequence, the economy exhibited a stagnating actual output and a drop in the growth of potential GDP in the quinquenium 1999–2003. After a partial and hesitating recovery in 2004–8, and the arrival of the contagion of the global crisis in 2009, today it should be seeking reforms to the model that would allow the resumption of sustained growth after the weak economic performance of 1999–2008. We analyze all these situations through the text. Section 1 of this chapter presents a brief summary of outstanding features of the Chilean economy since the fifties, advancing quickly up to the period on which this book focuses, which begins with the military coup of 1973. Section 2 covers the Pinochet regime. Section 3 summarizes the four democratic governments of Presidents Patricio Aylwin, Eduardo Frei Ruiz-Tagle, Ricardo Lagos, and Michelle Bachelet. Finally, a methodological annex digs into the long-run trends of Chile’s economic growth during the past halfcentury; we emphasize (i) the contrast between average figures recorded in dictatorship and in democracy, and (ii) the respective instabilities exhibited by the real economy (employment, investment, output) in diverse subperiods; finally, the annex presents alternative measurements of potential GDP or productive frontier.

Economic Development in Chile

5

1 A historical perspective on development strategies At the time of the Great Depression, the Chilean economy was one of the most developed of the region. The Great Depression affected the Chilean economy severely. The decline in the terms of trade and the collapse of exports were disastrous (see Muñoz, 1986). Following the worst years, however, the Chilean economy enjoyed a significant recovery, with a rate of industrial growth that mitigated the constraints imposed by the trade slump. Principally, this was the result of economic policies that responded actively to the crisis with new industrialization strategies. During the 1950s, however, the development model began to encounter new problems.1 On the one hand, indiscriminate protection given to import substitutes reduced its productivity and discouraged the development of new exports. The instability of traditional export prices was transmitted to the domestic economy through recurrent balance of payments shocks. One main warning signal about the intensity of failures in the Chilean economy was the accelerating inflation of 1952–5, when the annual rate of increase in the consumer price index (CPI) jumped from 12 to 86%. The government of President Carlos Ibáñez, which had been elected by a large majority in September 1952, with the support of independents and leftists, lost its popularity, encountered growing social unrest, and ended up adopting an orthodox stabilization program. Both the money supply and government spending were sharply curtailed, and the complex system of regulations introduced during the Depression and World War II was cut back. But soon, the recessionary effects of these initiatives led to widespread social rejection. In 1958 a rightist government was elected. Given the prevailing high inflation, President Jorge Alessandri focused on achieving price stabilization. In his view, that was a prerequisite for stimulating private investment. Stabilization was to be achieved by eliminating the “inflationary financing” of the fiscal deficit and pegging the nominal exchange rate. Consequently, a stabilization program anchored to a pegged exchange rate and import liberalization was designed, supported by abundant foreign loans to the government. This program enjoyed temporary success. Inflation was indeed substantially reduced in 1960–1, but the balance of payments deficits grew so large that international reserves were soon depleted. The investment ratio and output had risen, but the increase in exports was unable to offset the great expansion in imports, which exceeded the available external financing. As a result of a currency crisis, in 1962 the exchange rate was devalued, import restrictions were reinstalled, and inflation climbed back. In 1964 the Christian Democrat Eduardo Frei Montalva was elected President. The government strategy was based on a three-point platform: a 1 The next three presidential periods – 1952–8, 1958–64 and 1964–70 – are analyzed in detail in Ffrench-Davis (1973).

6 Economic Development in Chile

gradual, multi-anchored, non-recessionary stabilization program; an industrial modernization program that reactivated the role of the State as the generator of investment initiatives, introducing new, leading sectors (such as telecommunications and the petrochemical industry), and developing non-traditional exports; and a program of structural and social change that included a significant agrarian reform, the first steps in the nationalization of the nation’s large copper mines, and the development of community and labor-based grassroots organizations (Ahumada, 1966; Molina, 1972). In 1964, productive capacity was underutilized and real wages were depressed, which made it possible to reconcile a boost in output, wage increases, and a reduced inflation. This was facilitated by improved terms of trade in 1965–6. Increased fiscal expenditures in 1965 were funded by a significant tax reform, which raised revenue, diminished evasion, and improved tax equity. After strong growth of gross domestic product (GDP) in 1965–6, underutilized productive capacity gradually became exhausted, while investment continued at moderate levels. Real wages also rose much faster than planned, with a sharp surge in the organized sectors. This resulted in cost pressures on prices and had a negative impact on the government budget and on inflationary expectations. Strikes spread, and relations between the government and urban labor unions deteriorated. Inflation, which had been dampened in 1965–7, began to rekindle in the subsequent years. The macroeconomic outcome was a gradual rise in the underutilization of productive capacity after 1967. In fact, actual average growth was a vigorous 5.9% in the first two years and a modest 3.1% in the final four years of the Frei presidency. After reaching a high rate of use of labor and capital in 1966, the gradual underutilization of capacity had generated a significant output gap by late 1970.2 Nevertheless, no disequilibria as traumatic as those of 1955 and 1962 in the past, or 1975 and 1982 in the future, were recorded. A great disequilibrium that increased over the years took place in the sociopolitical arena. Political antagonisms prevented the formation of a broadbased coalition government. The scope of the new development strategy was extremely ambitious. Evidently, without a broad and solid coalition the chances of success were slim. Differences concerning the nature and degree of change prevented the formation of a large center-left majority in favor of progressive reforms. Only after the military coup would these two political sectors reach consensus for the accomplishment of sustained economic and

2 After a drop in 1967, a sharp improvement of the terms of trade in 1968 and 1969 was recorded (equivalent to 6% of GDP), followed by a partial negative shock of 3% in 1970. A significant share of the improved external balance was captured by the Chilean government and saved as international reserves in the central bank, in order to face future deterioration of copper prices. This was a pioneering approach to the implementation of a counter-cyclical copper stabilization fund, seeking to stabilize both fiscal expenditure and the foreign exchange market.

Economic Development in Chile

7

social reforms, winning all elections after 1988 and in charge of the four presidential regimes from 1990 to 2010, until defeat in the latter year. In brief, the Frei government implemented an ambitious program of progressive reforms. Productive capacity growth averaged only 4.3%, rather low compared with the 5.6% average recorded by Latin America. But currency crises were avoided and inflation was curbed (see Table I.1). A significant reform of the tax system was accomplished and 51% domestic control over the large copper mines was achieved, leading to the capture of a sizable share of the economic rent from that rich natural resource. The rural sector – with the implementation of structural reforms, most notably agrarian reform – and the industrial sector were modernized. Exports were diversified, with a steady increase in non-mining items, and there was a strengthening of Latin American regional integration, which was also instrumental in trade diversification. The State apparatus was modernized by providing it with better qualified human resources. A stable real exchange rate policy was put in place and sustained, assisted by a sort of pioneer copper stabilization fund, and strides were made in rationalizing the import regime and export promotion. In 1970, President Salvador Allende was elected by one-third of the national electorate. The Unidad Popular (UP) government sought far-reaching structural change, particularly with respect to property and without regard for macroeconomic equilibrium. It proceeded without a social and political majority. President Allende inherited idle installed capacity and large international reserves. This allowed an expansionary policy with rapidly rising wages and social expenditures. Economic activity responded positively, with an 8% rise in GDP and no significant inflationary pressures in 1971. However, the expansion was carried out with public revenue losses due to drops in real (public) utility tariffs, an appreciating real exchange rate, and a rapidly expanding money supply, which financed a rising fiscal deficit. The fiscal deficit climbed to 12% of GDP in 1972–3, financed principally by central bank money printing. The huge deficit was strongly influenced by repressing price controls on the goods and services sold by public enterprises (Larraín, 1991), while public and private investment became depressed. Meanwhile, structural changes, including completion of the nationalization of the large copper mines and the nationalization of the banking system and several other enterprises, were under way. In addition, many firms and farms were taken over arbitrarily by workers or political groups. Aggregate demand rose disproportionately with respect to the slowing creation of new productive capacity, while external, fiscal, and monetary balances worsened at an accelerating pace. This deterioration was intensified by the persistent worsening of the terms of trade from 1970 to 1972, and by the sharp cut-off of private and US government loans (see Bitar, 1979; Dornbusch and Edwards, 1991).

8

Table I.1 Comparison of key macroeconomic variables, 1959–2009a During the government of Allesandri Frei M. Allende Pinochet Concertación Aylwin Frei R.-T. Lagos Bachelet (1959–64) (1965–70) (1971–3) (1974–89) (1990–2009) (1990–3) (1994–9) (2000–5) (2006–8) GDP growth (%) Exports growth (%) Inflation rate (%)b Unemployment rate (%)c Real wages (1970 ⫽ 100) Investment (% of GDP) In 1977 pesos In 2003 pesos Government surplus (% of GDP) Structural surplus (% of GDP)d Income distribution (Q5/Q1)e Population growth (%)

3.7 6.2 26.6 5.2 62.2

4.0 2.3 26.3 5.9 84.2

1.2 –4.1 293.8 4.7 89.7

2.9 10.7 79.9 18 81.8

5.0 7.2 7.0 8.7 129.7

7.7 9.6 17.7 7.3 99.8

5.4 9.7 6.1 7.5 123.4

4.3 5.9 2.9 10.7 140.0

2.8 2.4 4.0 8.8 153.5

20.7 17.9 –4.7 n.a. 12.5 2.5

19.5 16.8 –2.5 n.a. 13.9 2.1

16.1 13.9 –11.5 n.a. 11.4 1.8

15.7 13.6 0.3 n.a. 18.5 1.6

25.0 21.5 1.9 0.7 15.3 1.3

20.7 17.9 2.0 0.4 13.1 1.8

25.1 21.6 1.2 0.8 16.8 1.5

24.2 20.8 0.7 0.7 15.0 1.1

30.2 26.0 4.3 0.4 14.0 1.0

Source: Central Bank, Budget Office (DIPRES) and National Bureau of Statistics (INE). a Annual growth rates of GDP and exports; average of annual rates of inflation and unemployment. bFrom December to December. cWith emergency employment correction; without correction it is 13.3% in 1974–89, 7.4% in 1994–9, 9.7% in 2000–5 and 8.1% in 2006–9. dOfficial estimates that use trend GDP as structural tax base, underestimating potential GDP.

Economic Development in Chile

9

A change of the head of the economic policy team in the middle of 1972 was accompanied by a serious attempt to correct the course taken. Nevertheless, the magnitude of the macroeconomic imbalances and the lack of governance frustrated this and several later attempts at rectification. During 1972–3, actual GDP declined by 4.1% because of sectoral imbalances and bottlenecks resulting from import restrictions, countless strikes, distortions in official relative prices, a growing black market, rising underutilization of potential GDP, and accelerating inflation (Bitar, 1979). Meanwhile, income distribution initially improved due to significant expansion of employment and nominal wages, but it deteriorated later with the climbing hyperinflation (an annualized 700% in the four months before the September 1973 coup) and the underutilization of potential GDP in 1972–3. In all, this period shows a distributive improvement but within a deteriorated economy: a less concentrated distribution of a smaller cake. Economic policy ended up hurting the government politically, providing ammunition to a tough opposition. The size of idle productive capacity at the outset as well as the State’s inability to enforce price controls (at levels sometimes as low as one-tenth of generalized “black” market prices) and to sustain balance of payment imbalances were highly overestimated. Macroeconomic imbalances were fully felt in the second year of the administration, and from there on the struggle for power absorbed most of the energies of both government and opposition. Economic disequilibria, black markets, hyperinflation, low governance and the growing inability to reach political agreements finally gave way to the dramatic institutional break-up and the prevalence of the coup supporters in September 11, 1973 (Bitar, 1979; Baño, 2003).

2 The neoliberal strategy, 1973–893 The period covered by the dictatorship of Augusto Pinochet is longer than that of the three democratic governments that preceded it (Alessandri, Frei Montalva, and Allende) and the three that followed it (Aylwin, Frei RuizTagle, and Lagos). This long period can be divided into two halves.4 The 3

This section is based on an abridged and revised version of “Economic and political instability in Chile: 1950–89,” co-authored with Oscar Muñoz, published in S. Teitel (ed.), Towards a New Development Strategy for Latin America: Pathways from Hirschman’s Thoughts, Inter-American Development Bank, 1992. I am indebted to Sergio Bitar, Manuel Marfán, Patricio Meller, Oscar Muñoz, Dagmar Raczynski, Joseph Ramos, John Sheahan, and Simón Teitel for their valuable comments. 4 The economic and social dimensions are examined in CIEPLAN (1982, 1983), Foxley (1983), Ramos (1986), Edwards and Cox-Edwards (1987), Larraín (1987), Fontaine (1989), Büchi (1993), Meller (1996a), and Larraín and Vergara (2000). Texts of wider coverage, with abundant references, are Moulián (1997), Hunneus (2001), and Correa et al. (2002).

10 Economic Development in Chile

first, between 1973 and 1981, is a case of orthodoxy or neoliberalism in its purest or extreme form. The second, from 1982 until March 1990, within the same general approach, introduced numerous heterodox interventions, which gave a more pragmatic, down to earth, shade. They were stimulated by the severe crisis resulting from the deep ideological policies of the first half. This second period can be identified as pragmatism (which is positive because it tries to adapt to the real economy); nevertheless, several of the interventions had a strong regressive bias (evidently negative), favoring sectors with high incomes at the expense of medium and low income sectors. That explains the significant worsening of income distribution and poverty during the 1980s. (a) Pure neoliberalism, 1973–81 One distinctive feature of neoliberalism is its “globalism”: that is, its neglect of the implications of sectoral imbalances; of the heterogeneity in productive structures and among economic agents, and in access to voice and power of different sectors; of the social and allocative implications of market segmentations, and of the difficulty of transmitting transparently information to all sorts of economic agents so that they can contribute to fulfilling the expectations of policymakers. Ultimately, neoliberalism also underestimates the frequent presence of destabilizing adjustment processes, lags, and overshooting, and the incompleteness of markets and institutions in developing nations. These elements represent severe obstacles that prevent “neutral” and indirect global economic policies from being effective, by themselves alone, in emerging economies that are in the process of deep transformation like Chile was. In parallel with the changes in the economic field, there were structural reforms in social organizations. According to the rhetoric of the dictatorship, these were part of the project to create a competitive society of “free men.” This involved reforms in the university system, in the organization and dependence of elementary schools, in health services, professional associations, and student and labor organizations.5 The initial concerns of Pinochet’s government lay with controlling the macroeconomic disequilibria and especially the hyper-inflation inherited in 1973.6 Soon, the arguments shifted into the inefficiencies of the prevailing economic system, according to the international speech that became fashionable in the following years. Increasingly, structural changes deepened, as an extreme neoliberal group extended its power until it dominated public policymaking. 5 See Campero and Valenzuela (1981), Vergara (1981), and several articles in Revista Mensaje, especially Ruiz-Tagle (1979, 1980) and Zañartu (1980). 6 Consumer prices rose by 600% in 1973; as said, in the last four months of the UP government the annualized inflation rate reached 700%.

Economic Development in Chile

11

(i) The reforms The main reforms were abolition of price controls; across-the-board import liberalization; sharp deregulation of the domestic financial market, in terms of both access by new financial institutions and interest rate and lending policies, followed at the end of the decade by a deregulation of capital inflows; reduction of the public sector and restrictions on the activities of public enterprises; privatization of the pension system and part of the national health service; the return of expropriated businesses and lands to their former owners; privatization of many traditional public enterprises; suppression of most current labor union rights; and a tax reform, which, along with eliminating some distortions (e.g. the cumulative effects of sales taxes corrected by implementing a value added tax), sharply reduced the share of direct and progressive taxes. The traditional role of the State, as entrepreneur and promoter of investment and industrialization, was to be curtailed as quickly as possible so that those functions might be fulfilled exclusively by private agents in liberalized open markets, under the “neutral” rules of a free-market economy. Privatization was not limited to transferring businesses expropriated during the regime of President Allende. It was also extended to enterprises created during successive governments after the establishment of the public Development Corporation (CORFO) in 1939. In 1970, CORFO controlled the ownership of forty-six enterprises, a number that rose to around three hundred in 1973.7 In 1980 there were only twenty-four enterprises left in the hands of this institution, half of which were in the process of being sold. There were also a dozen public enterprises dependent on other governmental departments. Among these were the Copper Corporation (CODELCO) and the National Oil Enterprise (ENAP). The sale of enterprises was largely conducted in periods of domestic recession and extremely high domestic interest rates. Hence, few agents were able to participate as buyers. This was one of the causes of the resulting acute concentration of wealth.8 It is interesting that there was weak participation by multinational corporations, in contrast with the official expectations of a vigorous flow of foreign direct investment (FDI). However, massive loans from international commercial banks provided a substantial share of the financing required by the domestic economic groups acquiring the enterprises being privatized. In the agricultural sector, the transfer of ownership had dramatic significance. The agrarian reform that had taken place during the governments of 7 This figure does not include about 220 enterprises subject to intervention in 1973. See Vergara (1981). Bitar (1979, Chapter X) examines the social property area program, its evolution, and resulting problems. 8 It is well documented that the transfers were made at prices significantly lower than normal market values. See Dahse (1979), Foxley (1983), Marcel (1989), and Devlin and Cominetti (1994).

12 Economic Development in Chile

Presidents Frei and Allende came to an abrupt end. After 1973, around onethird of the expropriated land was returned to former owners and close to another one-third was auctioned to non-rural dwellers. Barely one-third of the area was allocated to peasants. Given the curtailment of State provision of credit and technical support to peasants and cooperatives, these were some of the principal victims of the restructuring of public expenditure. It is estimated that, as early as 1979, about half of the peasants who had been assigned land had been forced to sell or rent out their farms (see Ortega, 1987).9 At the same time, a massive expulsion of peasants from the farms on which they had been living before and during the agrarian reform took place. In 1980, another major step in the process of privatization was taken in the social security system. The pension regime, hitherto financed through a pay-as-you-go system, was replaced with individual capitalization in private social security societies (AFP) created by the new system.10 Existing pensions and those of workers who would retire within five years continued to be the responsibility of the public sector; the rest of the workers could choose between remaining in the old system or transferring to an AFP. For merely making the transfer, the worker benefited from an automatic take-home increase of 11%. One enterprise of great importance that was able to evade privatization was CODELCO, the copper public firm. It underwent powerful onslaughts from the economic team but succeeded in warding them off. Even so, it suffered budgetary restrictions and systematic constraints on its expansion imposed by the Ministry of Finance, despite the substantial profits it contributed to the Treasury. It was only permitted to make investments that maintained the production level reached in 1977. Within the contradictions produced by the privatization dogma, the government encouraged, unsuccessfully hitherto, the development of other copper deposits to be operated by foreign companies.11 With regard to trade liberalization, practically all non-tariff restrictions were removed. Tariffs were rapidly reduced from the high level predominant in 1973 (a simple mean rate of 94%) to a uniform tariff of 10% for all goods from 1979. Likewise, trade reforms included the suppression of price bands, anti-dumping devices, and public purchasing mechanisms designed 9 Two financial factors that contributed to the pressure on peasants to sell or lease their allotted land were the high cost of credit in the domestic capital market and the lack of prior relations between peasants and commercial banks. On the agriculture and peasant situation see Ortega (1987). 10 The features of the pay as you go system and a comparative analysis with other options are discussed in Uthoff (2001). The health reform is analyzed in Titelman (2001). 11 The main foreign investment in the 1970s was performed by Exxon through the acquisition of a deposit in exploitation. See Vignolo (1980) and Bande and FfrenchDavis (1989).

Economic Development in Chile

13

to attenuate the transmission of external instability into the domestic economy. In line with the objective of unilateral and across-the-board opening to international trade, Chile withdrew from the Andean Pact in 1976. Further, a quite liberal statute for FDI was launched early in 1974. Chapter II covers in detail import and other trade policies. In the financial field, a drastic reform of the domestic market was introduced in 1975. The banks that had been nationalized under the President Allende regime were privatized. Interest rates were left totally free, regulations with respect to the terms and allocation of credit were eliminated, and new financial local and foreign entities were authorized with few restrictions. Finally, in relation to the capital account, there was a gradual relaxation of restrictions on financial inflows. Chapter III analyzes financial reforms, and their effective contribution to the acute recession that started in 1982. (ii) Achievements and failures Utilization rates of installed productive capacity had recovered in the first twelve months following the military coup. Labor discipline (imposed through the repression of unions and persecution of leaders), the liberalization of prices, exchange rate devaluation, increased public works investment, and high copper prices had removed bottlenecks and favored higher use of potential GDP. Rising copper prices in 1973–4 more than offset increased spending on oil imports, with a net improvement in the terms of trade equivalent to almost 5% of GDP in 1974 compared with 1972. A novel feature for Chile was the strength of the increase in the export volume. There were four causes for this outcome: (i) a very sharp real devaluation; (ii) export capacity installed in earlier years; (iii) the removal of bottlenecks in the sector and the liberalization of imports of inputs; and (iv) a sharp reduction in domestic demand (see Ffrench-Davis, 1979). The implementation of the neoliberal strategy was disturbed by two developments that negatively affected the Chilean economy during the 1970s: (i) an extremely high domestic inflation rate, which the monetarist stabilization policy had great difficulty in controlling; and (ii) the first international oil shock, which, coupled with the sharp decline of copper prices in 1975, created a severe balance of payments crisis. Until 1976, anti-inflationary action was based solely on monetary policy. From May to August of 1973, as noted above, the annualized inflation rate had skyrocketed to 700%.12 A few days after the coup, most of the controlled prices were freed within a context of high uncertainty. The foreseeable result was a dramatic upsurge of inflation (88% in October 1973). As the 12 All the inflation figures used here refer to the consumer price index as corrected in Cortázar and Marshall (1980). The official index significantly underestimated the actual rise in prices, mainly in 1973 and in 1976–8.

14 Economic Development in Chile

fiscal situation was being brought under control, monetary policy became effectively restrictive in the course of 1974. The official line was that the new price fixers, the private entrepreneurs, had to take money supply behavior into account in order to define the price of their products. The concrete fact is that the information on money supply became widely available with a lag of some months and with various divergent indicators, and given the high inflation, prices were often adjusted more frequently than once a month. Under these circumstances, the main point of reference for each economic agent became the actual behavior of entrepreneurs as a whole, measured through changes in the official monthly CPI, the most easily available and up-to-date indicator. The consequence was that annual inflation rates exceeding 300% still persisted by the third year of implementation of the model, despite monetary restrictions, a fiscal budget already under control in 1975, and a large recessive output gap (20% in 1975–6). Additionally, the price of copper dropped sharply by the second half of 1974, while the oil shock persisted, with a net negative terms of trade effect amounting to the equivalent of 6.4% of GDP in 1975 as compared to 1972. This sharp negative shock, coupled with persistent inflation, prompted the government to introduce a tougher adjustment program in 1975, based on a restriction of aggregate demand, led by fiscal and monetary contraction and significant exchange rate devaluation. The monetary restrictions, rather than influencing principally the price level, had a greater impact on economic activity: during 1975 industrial production fell by 28%, GDP declined by 17% (see Figure I.1),13 and open unemployment (including emergency programs) peaked at 20% (see Jadresic, 1986). The predominance of sharp demand-reducing policies over a weaker set of switching policies (those affecting the composition of demand and supply) explains the significant underutilization of productive capacity or output gap. This generated high unemployment, numerous bankruptcies, and depressed capital formation. The “price,” which was in fact adjusted swiftly downward, was that of labor: by 1975 wages had lost about 40% of their purchasing power owing to the drastic repression of unions, huge unemployment, and the legal readjustment based on an underestimated CPI.14 The monetarist recipe for controlling inflation multiplied, in the domestic economy, by three the depressive effects deriving from the negative external shocks and involved a notably high cost, both socially and in terms of economic activity (see Foxley, 1983; Ramos, 1986). By mid-1976, the economic 13 Naturally, the direct impact of the deterioration in the terms of trade observed in 1975 is not included in the figure of GDP decline. GDP measures real output; the terms of trade affect the real purchasing power resulting from a given GDP. 14 As Cortázar and Marshall (1980) document, in that period there was a systematic, month after month, underestimation of the CPI; the official CPI was used as reference for wage and pension readjustments. Nonetheless, even the corrected CPI shows a gradual drop in the rate of inflation.

Economic Development in Chile

15

106 Alessandri Frei Montalva Allende

Aylwin

Pinochet

Frei R.T.

Lagos

Bachelet

104 GDP growth and output gap (annual average growth rates, % of GDP)

102

1974–89 1990–2008

100

Actual GDP (%)

2.9

Potential GDP (%)

2.5

Output Gap (%)

98

5.3 5.4 5.6 2.5

10.4

96 94 92 90 Actual GDP

Potential GDP (ICOR) 2008

2004

2006

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1980

1982

1976

1978

1974

1972

1970

1968

1966

1962

1964

1960

88

Figure I.1 Actual and potential GDP, 1960–2009 (log scale, GDP* 1996 ⫽ 100). Source: Author’s calculations detailed in the annex of this chapter.

team recognized – implicitly – that monetary control was proving to be unable to restrain inflation on its own. Then the exchange rate anchor was incorporated into the anti-inflationary policy. Thus began a long process in which this rate was used to slow down inflation by reducing the cost of imported goods and attempting to influence inflationary expectations: analytically, it was a transition from closed to open monetarism. In June 1976 and March 1977, exchange rate revaluations were made (a reduction in the number of pesos per US dollar), and these were accompanied by a systematic mass media campaign.15 The measure had a significant effect, since inflation rapidly fell to levels below 100% annually after the first revaluation and below 60% after the second. There was a belated understanding that inflation was not being generated by an excess of demand and monetary expansion. The belated realization was, however, incomplete, since it implied an excessive conditioning of the exchange rate to the anti-inflationary policy, thereby sacrificing external equilibrium and the production of tradables. The severe crisis of 1982 would show that had been a wrong bet. The evolution of anti-inflationary policy ended in 1979 with the freezing of the exchange rate. As a consequence, a new stage of automatic macroeconomic policy was introduced when the government fully adopted the “monetary approach to the balance of payments” then in fashion in 15 After the publicized revaluations, daily mini-devaluations were applied. Exchange rate policy is analyzed, abridgedly, in Chapter II, and at length in Ffrench-Davis (1981).

16 Economic Development in Chile

several academic and orthodox financial circles. The new official version was that, with a fixed exchange rate, in an economy with free imports, domestic prices could not rise more rapidly than international inflation. This policy was supported by heavy foreign lending, which more than covered, until 1981, an expanding external deficit (see Chapter III). When the exchange rate was pegged, domestic annual inflation exceeded 30%, while international inflation neared 12%. Subsequently, a convergence between the two rates occurred, but only gradually; as a consequence, for a couple of years, domestic inflation was markedly higher than the external rate, so that the exchange rate lost purchasing power.16 Hence, the regime of free imports and an appreciated exchange rate caused a flood on the domestic market and an unsustainable disequilibrium in the current account during 1981. To face the external deficit, the official policy relied on an “automatic adjustment” in the style of the gold standard: it claimed that the real exchange rate would automatically adjust with the contraction of monetary liquidity associated with the current loss of international reserves in the central bank. This contraction was expected to have provoked a sharp drop in domestic prices and nominal wages. However, the fact that the exchange rate between 1979 and 1981 had accumulated, not by 2 or 3% but by 30% (besides the still lagged effect of import liberalization, as analyzed in Chapter II) was overlooked. The outcome was a drastic fall in sales, output and employment, and a progressive strangulation of business firms through increasing indebtedness at extremely high real interest rates (see Chapter III). Despite numerous tough restrictions on labor union activities and a real wage that remained below the average level of 1970, the authorities blamed salaries for their failure to achieve a fluent and rapid automatic adjustment.17 In mid-1982, they tried to establish a general reduction of nominal wages, but the economic team was unable to impose such a measure. Consequently, they turned to exchange rate devaluation, but with unsustainable disturbances in the productive and financial systems: between June and October of 1982, the nominal exchange rate was devalued by over 70% amidst a general crisis. The corresponding inflationary impact implied that the CPI increase

16 It is relevant that external inflation (IEP,measured in US dollars) also decreased due to the sharp appreciation of the US dollar with respect to the currencies of the other industrialized countries: in the twelve months before June 1982, the IEP reached an annualized average of –2%. 17 The lower limit for the adjustment in wages was determined by the official CPI of the preceding period. Various authors blame this rule for the costly recessive adjustment. Nonetheless, there were no international precedents of cases of massive deflation that had resulted from restriction of the money supply, which had operated fluently, at the required intensity, and without causing severe problems for debtors or economic activity.

Economic Development in Chile

17

in the following twelve months jumped to 32%, in contrast with the 4% recorded in the previous period. In brief, the exchange anchor was effective in curbing inflation, which by early 1982 stood at the international level, even below zero in some months.18 But once again the severity of the macroeconomic imbalances generated was underestimated. Efforts had been concentrated on bringing down inflation, while external equilibrium and investment in human and physical capital were overlooked. As said, since 1979, the real exchange rate had lost a third of its purchasing power, the external debt doubled, the export boom faltered in 1981–2, and the current account deficit had climbed to 21% of GDP in 1981.19 (iii) Vulnerability and spurious growth The weaknesses of the model are highlighted when the composition of GDP is disaggregated (see Table I.2). First, there was a rise in external indebtedness and in its cost. Around one-fifth of per capita GDP “growth” recorded between 1974 and 1981 corresponded to interest and profit payments

Table I.2 Evolution of GDP and its composition, 1975–81 (annual average rates of growth) Total 1975–80 (1) 1 GDP 2 GNP 3 Value added (a) Marketing of imports (b) Financial services 4 GNP excluding value added in 3

Per capita 1975–81 (2)

1975–80 (3)

1975–81 (4)

3.8 3.4

4.0 3.5

2.3 1.9

2.5 2.0

15.5 14.6 1.9

16.2 14.2 1.8

13.8 12.9 0.4

14.5 12.5 0.3

Source: Calculations based on official figures from National Accounts, 1960–81, in 1977 pesos. Revised figures by Marcel and Mellor (1986) give GDP growth of 2.6% for 1975–81, and not the official 4.0%; the main correction was in the industrial sector (here included in row 4). There are no disaggregated corrected figures from which to construct a revised table. 18 Several indicators of this episode in Chile are similar, in sign and size, to those in the currency crisis of Argentina that exploded in 2002: negative inflation preceding the crisis, a sharp GDP drop, huge unemployment, and a dramatic rise in poverty with the crisis. 19 Figures were calculated on the basis of the average exchange rate in 1976–8. With the very appreciated exchange rate of 1981, the deficit is 14.5% of GDP. Notice that GDP measured in current US dollars was US$15 billion in 1978, US$33 billion in 1981 and US$16 billion in 1985. Given the enormous volatility in these years, it is wise to “normalize” the exchange rate used, in order to make inter-temporal comparisons of GDP expressed in foreign currency.

18 Economic Development in Chile

accrued to foreigners, which meant that the rate of expansion of the national product was lower than that of GDP. Second, the value-added in (i) the marketing of imported products and (ii) financial services contributed a high share to GDP “dynamism”; these two sectors exhibited a dramatic cumulative expansion of 13% annually. The first sector expanded as a result of an unsustainably rapid growth of imports of consumer and intermediate goods. As discussed above, most of these imports were financed not by higher exports but by an increase in private foreign debt. This source of “dynamism” – value-added in the marketing of imports – was unsustainable in an economy that lacked vigorous real productive support and that was experiencing a notably high external deficit. The second source of “dynamism” was associated with the financial reform and responded principally to the spread between the rates of interest on deposits and loans and to the transfer of foreign credits in Chile. Thus, these two sources of “dynamism” rested on outlier values of imports and financial spreads, both of which were prejudicial to productive activity and investment. There can be no doubt that, owing to the distortion implied by both sectors in the Chilean economy, the overall performance contained a sizable share of spuriousness. Hence, it is very significant that the rest of per capita value-added, which in 1974 amounted to 91% of gross national product, remained virtually stationary, as can be seen in column 4 of Table I.2.20 Over and above this poor performance, GDP fell by 14% in 1982–3, while Latin American GDP diminished only 3.2% in the same period. The link with the future relates to national savings and investment.21 The supporters of the model claimed that it would achieve a substantial increase in savings, investment, and efficiency, all crucial sources of economic growth. The foregoing analysis has shown that the results were negative with respect to production. However, this could be consistent with a vigorous process of slow maturing investment. Unfortunately, in each of

20 As mentioned earlier, the production of exportables also grew at a significant pace. Therefore, a contraction in the rest of the economy – the non-exporting sectors – occurred. Within this subset, the industry, which accounted for the major share of economic activity, suffered the negative pulls of the recession in 1975, trade liberalization, and then exchange rate appreciation. See Chapter II and Marcel and Meller (1986). 21 By investment, is meant what in the national accounts is called gross capital formation or gross investment in fixed capital, or what I also call productive investment, in contrast to purely financial or speculative investment. Besides investment, there are many other connections to the future that are not considered here. These include: the impact that the model may have had on the capacity for technological absorption and adaptation; the degree of creativity of the technical and university education systems; national cultural development; the channels of participation and social capital that could serve for development strategies, based on a national consensus; and the dynamism and efficiency of the state as a development leader.

Economic Development in Chile

19

the years between 1974 and 1980, the gross fixed investment ratio was lower than that of each year in the 1960s; only 1981 recorded a ratio comparable with that decade. In 1974–81, the average investment ratio was 15.7%, in contrast with 20.2% in the sixties. In parallel, savings financed a lower share of investment; in 1970, around 90% was covered by national savings, whereas in 1978–81 scarcely one-half came from this source. The high rate of external borrowing, followed by a sudden stop in 1982, led the country into a new recessionary crisis as severe as the 1975 one. For the second time in a decade, the Chilean economy underwent a sharp recession, the deepeest in Latin America in 1982, with GDP declining 14%, followed by a widespread bank crisis and massive unemployment in 1983. Those disequilibria had been induced by excessive domestic spending on the part of the private sector, spurred by financial liberalization, huge capital inflows, and the so-called monetary approach to the balance of payments. Underlying these disequilibria there was a severe diagnosis error. The government assumed that, since it had achieved a fiscal surplus and external borrowing was being decided by private agents, a foreign exchange crisis would never occur. The explicit and strong support of the International Monetary Fund (IMF) (see Robichek, 1981) reassured the government in that wrong assumption. It failed to realize that an unsustainable medium-term deficit could be generated in the private sector (Marfán, 2005). With the crisis, the producers of GDP faced massive bankruptcies. Political discontent against the iron-fisted dictatorship spread, while demonstrations of opposition proliferated even among many regime supporters. National accounts, both official and corrected (Marcel and Meller, 1986), show high “growth” between 1976 and 1981. However, in the first place, the model was not initially put in motion in 1976 but (in partial form) in 1973. Second, in 1975 there was a sharp recession, which multiplied threefold the depressive effect of external shocks, with a fall of 17% in GDP. Hence, to measure economic evolution from the low 1975 point implies measuring as “growth” what in fact was simply a recovery to the 1974 level. This gave rise to the mistaken impression that Chile was growing vigorously and would continue to do so at rates in the order of 8% per year,22 irrespective of what might happen abroad. Whereas 1976–81 gives an annual per capita GDP increase of 4.7%, the period 1974–81 averages only 1.4%. It is obvious that the greater the recession of 1975, the greater could have been the subsequent recovery. Thus, the greater the loss of production as a result of the recession (a true social and private cost) the higher appears the “growth” if the measurement begins at the lowest recessed point. This is an extremely gross technical error, but it is quite frequent. This misleading implication would emerge again in the second half of the dictatorship. 22

See, for example, the illustrative statements quoted in Foxley (1983).

20 Economic Development in Chile

(b) The introduction of pragmatism, with a regressive bias in 1982–9 The impacts of the deep crisis of 1982–3 and the subsequent recovery were the dominant features of this subperiod. Renegotiations of foreign debt with bank creditors, the IMF, the World Bank and the US government played an outstanding part. As the government’s power weakened with the 1982 recession, it was compelled to revise its strategy in several respects, including the change of the head of the economic team and the “nationalization” of the private debt. The government, which by 1981 held merely one-third of total debt, by 1987 held 86% of it. The determinant of the level of economic activity, in a very explicit way, was the availability of foreign currency; thus the amount required to service the debt and the loans from international financial institutions was crucial for the speed of recovery. With respect to the policy approach, the crisis revealed the extreme vulnerability to external shocks created by neoliberal policies and the passivity of the State. The apparent economic success of the late 1970s had been based on a shaky policy of external and domestic borrowing with minimal regulations. The economic collapse and the climate of discontent made possible the reconstitution of some social movements that had been dismantled, especially labor unions and political parties of the center and left. In the economic arena, several adjustments were made by the government over the next four years, including successive devaluations, the increase of import tariffs, band prices for the main agricultural products, subsidies to non-traditional exports, stringent regulation of the financial system, implicit nationalization of private debt and massive financial aid to the private sector (see Chapter IV). All these changed policies, previously sharply dismissed by the neoliberal approach, were signals of “pragmatism,” in order to reduce the “scarcity of foreign currency” (the binding external constraint) and to recover economic activity. This implied a substantial change in fiscal policy, which after exhibiting a strong surplus until 1981 went into deficit, averaging 3.4 % of GDP in 1983–5. However, this greater pragmatism was biased in favor of upper-income sectors, including generous subsidies, while a tough position was maintained towards labor and grassroots organizations. The consequence was a further deterioration in income distribution; indeed, the year 1987 recorded the worst income distribution since statistics have been available (see Chapter VII). A strong and sustained recovery of economic activity and domestic output began in 1986. Exports were quite vigorous, encouraged by a spectacular depreciation of the real exchange rate (130% between 1982 and 1988). In 1986–7, a gradual recovery of domestic activity proceeded in a sustainable macroeconomic framework, under a binding external restriction, but generously alleviated by loans from international financial institutions (IDB, IMF and World Bank). In the next two years, the situation changed, with the disappearance of the restriction on external financing, due to a spectacular rise in the copper price. As a consequence, the expansion of aggregate demand

Economic Development in Chile

21

and economic activity accelerated, culminating in the overheating of the economy in 1989, when actual GDP increased by 10%. The jump in aggregate demand resulted from expansion of the money supply, tax reductions, and import liberalization with some exchange rate appreciation, which made imports cheaper. The installed capacity still available by 1987 and the sizable improvement in the terms of trade (copper prices) in 1988–9 made a sharp transitory jump in economic activity feasible. The last biennium of the Pinochet regime exhibited that high growth of actual GDP, in contrast with a quite moderate rise in potential GDP. Paradoxically, then, as had happened in the late 1970s, the domestic recession of 1982–7 was useful for the “marketing” of the model. The model was able to show “growth” for several years, a circumstance that attracted extensive publicity in the national and foreign mass media. The prior sharp recession was underestimated or ignored by the media under a strong dictatorial regime. In brief, the 1980s ended with the Chilean economy recording a high rate of capacity utilization and growth of actual GDP. However, average growth in the whole 1982–9 period was low, merely 2.9% annually, while per capita GDP only in 1988 reached the level it had exhibited in 1981. Additionally, the economy did show substantial disequilibria. During 1988–9, a number of macroeconomic variables exhibited inconsistent trends over the medium term. Real aggregate demand had grown swiftly – by 22% – in the biennium, and GDP had risen by 18%. Exports grew vigorously in the two-year period, but imports rose even faster. The large gap between changes in expenditure and production was compensated by an improvement in the terms of trade equivalent to 6 and 7% of GDP in 1988 and 1989, respectively, as compared to 1986. Output, in turn, rose sharply due to the progressive exhaustion of idle capacity. However, productive capacity was expanding by a total 8% in the biennium. The contrast with the 18% increase in actual GDP led to full utilization of installed capacity and overheating of the economy. This manifested itself in accelerating inflation and a deteriorating external sector. By January 1990, inflation in twelve months reached 23%, twice the 1988 rate.23 (c) A summary of outcomes Notwithstanding that some key policies were significantly different, economic growth recorded similar annual averages in both halves of Pinochet’s government: 3 and 2.9%, respectively (see Table I.3). How can these similar results be explained? The low average of both periods was associated with the severe and abrupt crises of 1975 and 1982–3, and with the gradual recovery processes, which in both cases involved high rates of underutilization of 23

This is the inflation rate for the twelve months ending in January 1990. Between August 1989 and January 1990 the annualized rate of increase in the consumer price index (CPI) was 31%.

22 Economic Development in Chile Table I.3 Macroeconomic variables during dictatorship, 1974–89a (annual averages)

GDP growth (%) Exports growth (%) Inflation rate (%)b Total unemployment rate (%)c Official unemployment rate (%) Real wages (1970 ⫽ 100) Investment (% of GDP) In 1977 pesos In 1996 pesos Government surplus (% of GDP)

1974–81

1982–9

1974–89

3.0 13.6 138.9 16.9 13.0 75.7

2.9 7.8 20.8 19.2 13.6 88.0

2.9 10.7 79.9 18.0 13.3 81.8

15.9 15.4 1.6

15.6 15.8 –1.1

15.7 15.9 0.3

Source: Same sources as Table I.1. a

Annual growth rates for GDP and exports; average annual rates for inflation and unemployment. From December to December. cWith emergency employment correction.

b

productive capacity for several years. This persistent gap between actual and potential GDP, in turn, was the main factor discouraging capital formation (Servén and Solimano, 1993; Agosin, 1998), which was under 16% of GDP in each subperiod; that is, around four points (one-third in net investment) lower than in the 1960s. The reforms had significantly different effects on the productive structure. Trade liberalization contributed to the significant expansion of exports. However, applied simultaneously with a tough monetary stabilization policy, they induced a depression that featured a 26% drop in industrial output in 1975. Nonetheless, in parallel with numerous bankruptcies, the sector achieved a rise in productivity among the surviving companies and by 1978 manufactured exports had rosen by an average of 15% (Vergara, 1980), with greatly increased heterogeneity in the sector. It must always be recalled that what is relevant for the nation as a whole is the evolution of productivity, including all people, not only those with a job! The high rate of business bankruptcies cannot necessarily be attributed to inefficiency resulting from protection under the earlier development strategy. In fact, after 1973, the long recession, real annual interest rates at an average of 38%, and the accelerated import liberalization-cum-exchange rate revaluation can be identified as the determinant factors leading to high business mortality. Manufacturing lost a significant share of GDP. Exports, on the other hand, achieved great dynamism, particularly of non-traditional goods. In fact, between 1974 and 1980, the share of non-traditional exports (including manufactures) in total sales of goods abroad rose from 9 to 19%. These exports exhibited a falling share in 1981–5 (averaging 16%), and then renewed an upward trend to 22% in 1989. In all, in 1974–89, the volume of non-copper exports averaged an annual growth of 15%, undoubtedly a significant figure (see Chapter V).

Economic Development in Chile

23

The modernized business sector featured a surge of new economic groups and managers exhibiting vigorous innovative competitiveness. This modernization went in parallel with that of the Internal Revenue Service and of the Budget Office. Together with the export drive, they contributed to, but did not determine, the economic success achieved later in the 1990s. Furthermore, many classical conditions for development arose, among them the “correction” of some prices (especially exchange rate depreciation in the 1980s and reduced costs of imported inputs), market deregulation, and guaranteed property rights. But it was also the consequence of the substantial fall in real wages and in taxes on capital, and the elimination of many labor rights, while modernization still eluded the large majority of firms. At the end, there was notable progress for some people, with the exclusion of many. An extreme neoliberal interpretation reports vigorous growth, because only the results obtained after 1986 are considered. But, it is not justified to assess a set of reforms by counting only the years with positive results and ignoring the negative ones. That leads to severe errors in diagnosis and action, and encourages other nations to repeat the experience, which happened to a large extent among Latin American economies in the 1990s (see Ffrench-Davis, 2006, Chapter I). The concrete fact is that average GDP growth was mediocre in both subperiods. Until 1982, “price corrections” had been very contradictory. In fact, the neoliberal orthodoxy did not consider that financial liberalization could lead to high outlier interest rates or that trade liberalization could be accompanied by continuous exchange rate appreciation, as was the case between 1979 and 1982. Neither was it foreseen that the private sector would be “promoted” amidst a sharp restriction of aggregate demand, as in 1975–6 and 1982–3. In turn, the debt crisis dismantled the financial system, implying that the government allocated the equivalent of 35% of annual GDP to the rescue of some affected sectors, diverting these resources from the generation of economic and social development. This combination of events helps to explain why modernization in some sectors coexisted with a mediocre economic growth averaging 2.9% between 1974 and 1989, why the average investment ratio was notoriously below the 1960s level, and why income distribution worsened so much (see Chapter VII). As on many other occasions in Chilean history, economic policy was strongly influenced by a notable transitory improvement in the copper price.24 It is undeniable that 1988–9 would have been quite different had there been a “normal” copper market in those years. Based on that abnormally high price, the Pinochet regime could finally boast an economy with impressive export values and actual GDP growth figures in 1988–9. But evident macroeconomic imbalances had to be corrected in 1990. This explains the strong policy adjustment carried out in January 1990 – in full transition 24

In fact, as was to be expected, copper prices declined from late 1989.

24 Economic Development in Chile

from dictatorship to democracy – in order to stop an overheating of the economy led by excessive aggregate demand. The adjustment was implemented, in January 1990, by the new independent central bank, launched by Pinochet a few days before the presidential election of 1989. The bank acknowledged the severity of the disequilibria and the risk in waiting until the inauguration of the democratic government in March 1990. Income inequality was notably greater than two decades earlier, as a consequence of strong worsening in the seventies and eighties. In fact, the share of the poorest quintile in total expenditure had been reduced from 7.6% in 1969, to 5.2% in 1978 and 4.4% in 1988 (see Chapter VII, table VII.2). A determining variable of that outcome was the deterioration of the labor market, with average and minimum wages that in 1989 were below those in 1981 and 1970. The major swings in distributive worsening were associated with the 1975 and 1982 crises. In political terms, a salient development was the effective organization of social movements and political parties, which were able to compel the democratization of the system, even under the rules unilaterally imposed by the dictatorship. Following the triumph of the opposition, led by a centerleft coalition, the Concertación Democrática, in the October 1988 plebiscite and the December 1989 presidential election, a democratic president, Patricio Aylwin, took office in March 1990.

3 Democracy, reforming the reforms and development, 1990–200925 From 1990 the political arena was dominated by the administration of the Concertación de Partidos por la Democracia. The Democratic Concertación, a center-left coalition of Christian democrats and social democrats, took over power with the successive elections of Patricio Aylwin (1990–4), Eduardo Frei Ruiz-Tagle (1994–2000), Ricardo Lagos (2000–6), and Michelle Bachelet (2006–10). The first two administrations gave rise to a period of the greatest prosperity in Chilean economic history, with a sustained average 7% GDP growth rate between 1990 and 1998. It marked a clear break with the historical trend (see Table I.1). High capital formation and a generalized atmosphere of stability prevailed until 1998, when the Asian crisis hit Latin American countries. The vigorous growth was led by a 10% annual expansion of exports, a figure similar to the average recorded in the seventies and eighties (see Chapters V and VI). Nevertheless, GDP growth was radically different: 7% in the nine25 Collections of studies with diverse approaches and authors can be found in Bosworth et al. (1994), Pizarro et al. (1996), Cortázar and Vial (1998), Larraín and Vergara (2000), Ffrench-Davis and Stallings (2001), Larraín (2005), Meller (2005), Muñoz (2007), and Vega (2008).

Economic Development in Chile

25

ties and 2.9% in the two previous decades.26 Given the shared good export performance, evidently, the main factor explaining the success in the nineties was the strong expansion of the rest of GDP (non-tradables plus import substitutes), which averaged 6.5% per year in 1990–8 (see Chapter VI, Table VI.6). As in the three decades of intensive development of Korea and Taiwan (1965–95), key to success were the links between the export sector and the rest of the economy, and the persistence of a comprehensive real macroeconomic balance. The end of President Frei’s administration (1999) and the first years of President Lagos’s (2000–3) were characterized by a depressed economic environment. The sharp and sustained fall in economic activity was focused in the non-exported GDP, which represented around 70% of the whole economy. A drop in export dynamism – undoubtedly very significant – explains only 1.0 out of 4.5 points of lower growth in 1999–2003 with respect to 1990–8 (see Chapter VI). In all, GDP growth averaged 5.3% in the nineteen years between 1990 and 2008 (5% if the recession of 2009 is included). In turn, per capita GDP expanded by 4% annually in the same period, in contrast with 1.3% in 1974–89. This notable difference, which is associated with improvements in the quality of macroeconomic policies since 1990 and some efforts to “complete” factor markets, explains the substantive economic and social progress achieved. Nevertheless, the brake in 1998 is significantly associated with setbacks in the quality of macroeconomic management (see Chapter IX). (a) From the reform of the reforms to the Asian contagion, 1990–8 The new administration of Patricio Aylwin focused its efforts on achieving stronger, stabler, and more equitable GDP growth. This required stabilizing the economy after the 1988–9 overheating generated by the Pinochet regime, and, among other things, an increasing investment ratio, the implementation of macroeconomic policies achieving sustained equilibrium in financial markets and in the real economy, diminishing vulnerability to external shocks, and progress in solving the most urgent social demands by enabling larger segments of the population to benefit from the modernization of the economy. The aim was to reconcile macroeconomic and macrosocial equilibria, and implement a style of economic policy that would become legitimate within the new democratic framework. The new government had decided to avoid a radical change in existing economic policy, seeking “change-with-continuity” and thus breaking with the rehashing tradition of several previous governments. In order 26 Notice that in the three cases we “end the decades” in peak years (1981, 1989, and 1998) in order to be “fair” in the comparison. From peak to peak, actual growth reflects the creation of productive capacity better than using mechanically calendar decades.

26 Economic Development in Chile

to accomplish this goal, the government of President Aylwin had to gain the support of trade unions and incorporate their organizations into the macrosocial decision-making process. The new administration had to cope with the potential conflict between macroeconomic stability and demand for more resources to be allocated to lower income groups. On the one hand, it changed the composition of public expenditure, increasing the share of social spending in the budget, and, on the other, it rapidly presented to the parliament a tax reform to increase fiscal income. Tax reform included a reintroduction of profit taxes abolished in 1988, and an increase of 2 percentage points in value-added tax.27 Likewise, in 1990 the government proposed a reform of the labor code to Congress. It was aimed at balancing the bargaining power of employers and workers and sought to endow current labor legislation with greater legitimacy. To get this law passed, an agreement was reached between the government, labor and employer organizations, and most political parties. However, the reforms agreed (including the tax reform) were always less comprehensive than those originally proposed by the government (Cortázar, 1996; Marfán, 1998). A determining fact was the group of senators that had been appointed under the Constitution designed by Pinochet, who more than compensated for the majority achieved by candidates of the new government in the 1989 and 1993 parliamentarian elections. In 1990, a tripartite agreement was also reached between the government and the representatives of unionized workers and employers; this agreement provided for an increase of 28% in the real minimum wage between 1989 and 1993. In the early 1990s, significant progress in income distribution and poverty reduction was achieved in this constructive climate. From 1994, poverty continued to decline, although more slowly. While 45% of the population lived in poverty in 1987, by 1994 this had been reduced to 27.5%, and by 1998 to 22% (see Chapter VII). It should be pointed out that greater social effort was attained with notable fiscal responsibility. As a result of the 1990 tax reform, the expansion of economic activity and imports, a higher than expected copper price (captured by Chile thanks to the fact that the large copper mines had remained nationalized; now they were grouped under Corporación Nacional del Cobre, CODELCO), and a decline in tax evasion, the fiscal burden rose by 3% of GDP (to 18% of GDP). This allowed the government to increase public spending, in particular social expenditure, and at the same time expand

27 It can be argued that the increase in value-added taxes included in the reform would tend to impose a regressive effect as low income families consume a larger part of their income. Nevertheless, a coherent comparison also has to consider that most resources are transferred to lower income families through an increase in social spending. The net effect is evidently progressive.

Economic Development in Chile

27

non-financial public sector savings from 2% in the 1980s to nearly 5% of GDP in the 1990s (see Table I.5, below).28 Higher savings not only financed public investment but also generated an average fiscal surplus of 1.8% of GDP in 1990–7; the surplus was used to reduce the high stock of public debt accumulated during the dramatic financial crisis of 1982–3. A new political agreement in 1993 enabled the approval of several previously transitory modifications on a more permanent basis. Subsequent evidence rejected the prediction of critics of the 1990s tax reform, who claimed that it would have a negative impact on investment. After a decline of the investment ratio in 1991 – associated with the lagged effect of the 1990 adjustment – capital formation increased in 1992 and again in 1993, reaching in the next five years levels never achieved in the previous three decades (see Table I.1). This high productive investment was the main factor behind the outstanding annual GDP growth, which rose from below 3% in 1974–89 to over 7% in 1990–8. As empirical studies show robustly, private investment, given its irreversibility, is positively correlated with real macroeconomic equilibria whenever they appear to be sustainable and fulfill two key conditions. First, for real equilibrium, effective demand has to be consistent with the productive capacity being generated, and, second, key macroprices (interest and exchange rates) must be right (see Servén and Solimano, 1993; Agosin, 1998; Coeymans, 1999; Ffrench-Davis, 2006, Chapter II). This is what we call real macroeconomic balances. Given the macroeconomic disequilibria generated in 1988–9, a severe adjustment through the increase in interest rates had been carried out in order to control the expansion of aggregate demand and a new outbreak of inflation. This adjustment was considerably complicated soon after by large capital inflows, which, like other economies in the region, Chile had been receiving since the early 1990s. The gap between domestic and international interest rates had increased significantly. In the meantime, risk-rating agencies had upgraded the Chilean economy, inducing a strong inflow of shortterm “hot money” and an appreciation in the exchange rate in the second half of 1990 (with a drop from the depreciated ceiling to the appreciated floor of its 10% crawling band of the price in pesos of the US dollar). The

28 Depreciation of capital goods in public firms is included in gross private savings. Moreover, the fiscal sector generated financing to cover the deficit of the public social security system. Under the social security reform of 1981, the public sector continued paying already retired workers and financed part of the new pensions, while income was shifted to the private system. The fiscal figures do not consider the quasi-fiscal deficit of the central bank – which was initially caused by the government’s intervention to prevent a massive bankruptcy of the domestic financial system in 1983; it was enlarged, subsequently, with the operational losses in monetary sterilization in the 1990s (on this latter issue, see Chapter VIII).

28 Economic Development in Chile

central bank was forced to buy large amounts of foreign currency to defend the band’s floor. Particularly, economic authorities faced the need to differentiate between permanent appreciation pressures, resulting from Chile’s net improvement in productivity and from having surmounted the debt crisis, and transitory pressures. When the former had been identified, an attempt was made to avoid the latter in order to maintain the competitiveness of tradables. The strong external supply of both short-term and portfolio capital threatened to considerably diminish the capacity of the authorities to conduct monetary policy and to avoid excessive fluctuations in both the real exchange rate and aggregate demand. Faced with a massive capital inflow, the Chilean authorities sought to reconcile these two objectives – an interest rate suited for keeping domestic balances and an exchange rate consistent with external balances – by applying several counter-cyclical policies. Among these were active exchange rate policy and monetary sterilization; selective liberalization of capital outflows; establishing a reserve requirement (encaje) on foreign loans and liquid inflows, which increased their costs, in order to avoid what was considered an excess supply; and the extension of a tax, which had previously applied only to domestic currency loans, to include foreign currency loans. Empirical research documents that these policies were successful in reducing short-term and volatile inflows and provided space for monetary policy and avoiding destabilizing exchange rate appreciation (see Chapter VIII). But FDI – risk capital was exempted from the reserve requirement – became increasingly large. FDI was stimulated by the attractive features of the Chilean economy: rich natural resources and the almost tax free transfer of the economic rent abroad (a loophole inherited from the dictatorship that required correction),29 high quality macroeconomic policies, and the positive perception of the democratization process. Therefore, a large surplus in the capital account, with effective long-term financing, higher than the moderate deficit in the current account, was generated. The central bank responded with active purchases of foreign currency and open market monetary sterilization. The set of policies, especially those affecting short-term capital inflows, contributed to keeping the current account deficit within sustainable levels (2.3% of GDP in 1990–5) and preventing an excessive increase in more volatile external liabilities. In so doing, Chilean economic authorities contributed significantly to macroeconomic stability, to the improvement of the social indicators, to the export strategy, and to overall growth. This became evident when Chile showed nearly complete immunity during the Mexican crisis of 1994–5 (see Ffrench-Davis, 2006, Chapter IX). In 1990–5, GDP growth peaked at 7.8%. If the dynamism achieved in this period is compared with that of other episodes of high GDP growth in the 29

In 2006 it began to operate a tax that plays a similar role to a royalty.

Economic Development in Chile

29

past four decades, in contrast to previous occasions, this time a comprehensive set of positive features were fulfilled: (i) GDP growth, both actual and potential, was sustained for several rather than one or two years; (ii) growth occurred in a context of fast rising productive investment and national savings; (iii) growth occurred without significant inflationary or external account pressures; (iv) an orderly fiscal balance was maintained, and (v) no major macroeconomic disequilibria were built, thanks to several mini-adjustments, thus avoiding the common need for traumatic maxi-adjustments. After each of these years of unsustainable macroeconomics in the past four decades, an adjustment program with heavy welfare costs had to be implemented. These significant changes in the macroeconomic environment are associated, on the external front, with the instability of the terms of trade and financing. On the domestic front, they reflect the high sensitivity of aggregate demand to external shocks, especially when the economy is operating under pro-cyclical policies. The impact of the adjustment program in 1990 on other economic variables was less severe and quickly reversed. As mentioned earlier, investment ratios recovered in 1992 and reached record levels from 1993. One main merit of policies in 1990–5 rests in that they successfully resisted the temptation of achieving a faster disinflation with an increased domestic absorption of capital inflows and at the expense of exchange rate appreciation and a larger external deficit. Up to 1995 the authorities implemented an effective monitoring of the counter-cyclical regulation on capital inflows. The strength of regulations (the cost or implicit fee and the coverage of the encaje) was adjusted continuously to the strength of the external supply of funding. In the six year period 1990–5, actual and potential GDP rose at similar rates, with the economy working close to the production frontier (that is, with a minor output gap between potential and actual GDP). However, policies lost their strength after 1995, thus allowing a real appreciation of the peso and imbalances in the external accounts in 1996–7. Chile did bend, partially, to the powerful international fashion promoting the liberalization of capital accounts. That fashion was in general force, pressed by the US government, the World Bank and the IMF, the OECD, and the academic world in the most influential spheres. It had been reinforced under the belief that the management of the tequila crisis had shown that the world had learnt to control financial crisis; such overoptimism was absorbed domestically by business leaders and some public authorities. Recall that the IMF was on the road to imposing on all countries the obligation to open capital accounts. That extreme position experienced a sudden stop with the arrival of the Asian crisis in 1997. Fortunately, Chile did step back, from 1995, to a middle-of-the-road position. It did not dismantle regulations but allowed a weakening of their effects, as discussed in Chapter VIII (see also Le Fort and Lehmann, 2003) Consequently, Chile entered

30 Economic Development in Chile

“vulnerability zones” – particularly with an appreciated real exchange rate and a large external deficit – where it was caught by the Asian crisis. Additional factors, beyond the acute international fashion, can explain the policy change. First, the strength shown by the Chilean economy in the face of the Mexican crisis in 1995 created a misleading sense of invulnerability. It led policymakers to disregard the fact that immunity had been the result of a policy approach that had prevented (i) excessive exchange rate appreciation, (ii) a high current account deficit, and (iii) a significant stock of liquid external liabilities; moreover, (iv) most inflows had been directed to capital formation, thus strengthening the capacity to respond to critical situations and to absorb inflows efficiently. Second, after 1995 a change in central bank priorities could be observed, with the prevalence of an antiinflationary bias. Third, the outstanding performance of Chile transformed it into a preferred destination for foreign investors, in a context in which huge amounts of capital were being supplied to emerging economies. Despite this larger capital surge, most counter-cyclical regulations were kept unchanged instead of being strengthened. Evidently, counter-cyclical policies must be adapted to the strength of the cycle, which did not happen. Therefore, when the Asian contagion reached Chile in 1998, with a strong negative terms of trade shock, the economy had accumulated significant imbalances: the real exchange rate had appreciated by 16% between 1995 and October 1997, and the current account deficit had jumped to 4.8% of GDP in 1996–7, as compared to 2.3% in 1990–5, which worsened further with a sharp negative terms of trade shock in 1998. The fiscal policy of these two years (1996–7) deserves special consideration, since it has been an object of a misinformed debate. The fiscal policy of the nineties harmonized a significant expansion of social expenses with an increase in both public savings and investments. As said, a responsible fiscal management financed increases in expenses with the tax reform and the reduction of evasion. Real macroeconomic balances placed the economy in the productive frontier or potential GDP, with a corresponding high fiscal revenue. In the particular case of 1996–7, fiscal responsibility was kept. The actual fiscal surplus was 2.1% of GDP, even exceeding that of the previous years. Consequently, the assertion that fiscal performance was responsible for the macroeconomic imbalance of this period has no support. The external deficit was evidently located in the private sector and was financed and encouraged by the weaker regulation of the capital account (see Table I.4). It is true that fiscal expenditure registered a rise in those two years. But it must be said that it was an increase in items unanimously agreed by all political parties, related to education, health, and pensions; additionally, recall that it was financed with taxes and not with indebtedness. In the meantime, GDP and productive investment kept growing up to 1998. All evidence shows that it was necessary to act strongly on the cause of the real macroeconomic imbalance, that is, the excess of capital inflows in 1996–7.

Economic Development in Chile

31

Table I.4 Public and private budget balances, 1990–2007 (% of GDP at current prices)a Total 1990–5 1996–7 1998 1999–2003 2004–7 2008

Private sector Public sector

–2.3 –4.2 –4.9 –0.9 3.2 –1.5

–4.4 –6.4 –5.3 0.1 –2.7 –6.8

2.0 2.1 0.4 –1.0 5.8 5.3

Source: Author’s calculations based on Balance of Payments data from the central bank and DIPRES for the public sector. a

Total balance is the current account deficit or use of external saving. The public sector corresponds to central government (does not include public enterprises). The private sector is constructed by difference.

Because of that excess, the Asian crisis found the Chilean economy vulnerable, with a too cheap dollar price and a high external deficit. (b) Recessive adjustment, 1999–2003 As mentioned above, the final year of President Frei’s administration (1999) and the first four years of President Lagos’s (2000–3) were characterized by a depressed economic environment that frustrated the expectations of a spontaneous rapid recovery. The sharp and sustained fall in economic activity was focused in the non-exported GDP, which represented around 70% of the economy. A drop in the volume of exports – undoubtedly very significant – explains only 1.0 out of 4.5 points of lower growth in 1999–2003 with respect to 1990–8. Contagion from the Asian crisis arrived through two channels. On the one hand, there was a sharp deterioration of the terms of the trade (equivalent to 3% of GDP). On the other hand, a widespread reduction of capital flows towards emerging economies took place. Thus, from late 1997 there arose strong expectations of depreciation, which the central bank resisted during 1998, due to the fear of inflationary overheating and the explicit concern of allowing domestic economic groups to reduce their debt denominated in dollars. First, massive sales of foreign currency were carried out by the central bank with an artificially low market price. Then, by mid-1998, the bank drastically reduced the crawling band width, intending to give a signal of nominal exchange rate stability, in combination with a rise in the real interest rate, which reached 14.5%. In this critical context, not only was there a drop of financial inflows, but also a massive residents’ capital flight. In fact, from early 1998, there were voluminous capital outflows, principally from the private pension funds – speculating against the domestic currency, in the context of successive capital account liberalizations – totaling almost

32 Economic Development in Chile

5% of GDP in eighteen months (see Ffrench-Davis and Tapia, 2001; Zahler, 2006). It naturally had a strong contractionary impact on domestic liquidity and aggregate demand. Consequently, once again, a macroeconomic imbalance led by excessive capital inflows in 1996–7 was followed by an adjustment that was costly for both economic growth and equity. Beginning by mid-1998, aggregate demand fell sharply (with a 6% drop in 1999, while GDP decreased by 0.8%). Meanwhile, productive capacity kept rising, resting on the still high investment ratio of 1998. Consequently, with the fall in actual GDP and the increase in potential GDP, a large recessive gap between both output measures emerged. It is useful to examine in some detail the size and evolution of the output gap. It is not obsolete physical capacity. It is economically productive capacity that was in use in 1997.30 New capacity was being created at a speed of about 7% per year, which, as said, continued in 1998 and 1999, determined by the high investment ratios up to 1998. The downward adjustment in economic activity started by mid-1998, with actual GDP rising by only 3.2% in 1998 and falling 0.8% in 1999. All added, a sizable recessive gap of about 6% of potential GDP was generated in 1999 and was still persisting in 2003. That was the determinant of the sharp drop in the investment ratio in 1999–2003. As a consequence, the plateau of potential GDP growth had dropped from 7 to 4% per year, but actual growth fell even further, to 2.6%. As has been shown repeatedly, a significant gap between actual GDP and the production frontier is usually followed by a drop in productive investment. As in Mexico in 1995, Argentina in 1995 and 1999–2001, and Korea in 1998, in Chile the investment ratio diminished substantially (by 18% in 1999) and remained depressed until 2003; the output gap plus the drop in investment had a deepening impact on employment too. The presidential campaign of 1999 was marked by the target of a fast return to 6–7% growth rates. Both Concertación Democrática and the opposition based their programs on expectations that ex-post turned out to be overoptimistic. This mismatch between expectations of an imminent recovery and a depressed economy, with a stagnated aggregate demand, determined an imbalance between the resources needed to fulfill the government program and the depressed tax revenue. To face this context, the government implemented a new fiscal rule that works with the concept of fiscal structural balance (see Marcel et al., 2001; Tapia, 2003). The rule consists of sustaining a level of expenses consistent with structural fiscal income; that is, for each budget year the fiscal income is estimated as if the economy were fully using the “potential or trend GDP” and were facing the expected medium-term

30 In order to estimate that capacity, the actual GDP of 1997 was adjusted downward by an estimate of the output identified as non-sustainable in that year (see Annex).

Economic Development in Chile

33

copper price.31 Consequently, when the economy is overheated the Treasury accumulates savings; and under a recession it uses those funds (or borrow) to cover the foregone wastage of productivity and employment associated with an economic activity below potential GDP. This new public policy seems to me to show great conceptual progress in fiscal and macroeconomic management, given the volatility of international trade and financial markets. This innovative fiscal rule was accompanied by two features that are not intrinsic to the rule. One was defining as a target a structural surplus of 1%; after some time, inevitably, that goal leads to a net creditor state, a strange and undesirable situation in a developing economy.32 The other one was to define as potential GDP what had been the trend GDP of the Chilean economy, which evidently includes the intense recessions that it suffered. Obviously, trend GDP moves well below potential GDP or the productive frontier (see Annex and Chapter IX). The features of the Chilean rule implied a neutral fiscal policy with respect to the economic cycle, which involves progress with respect to the procyclical traditional norm of balancing actual fiscal budget period after period. Nevertheless, initially it did not move decidedly into a counter-cyclical rule, a shortcoming that became evident in 2001–3. Beyond the highly laudable progress achieved in facing international volatility, the evidence provided by 1999–2003 shows that there is a need for effective counter-cyclical policies to stabilize economic activity, and to become able to recover fast in recessions. As I stress throughout this book, that capacity is an essential ingredient of real macroeconomic balances. The central bank foreign exchange policy evolved from the mid-nineties, when the monetary authorities began to lose confidence in the instruments that had been so successful in the first half of that decade. In September 1999, the exchange rate was fully liberalized, leaving behind the crawling band. During 2000–1, in what was considered to be a policy consistent with the new floating regime, the majority of the remaining controls on financial flows were eliminated. One of the effects has been intense financial activity, with voluminous inflows and outflows. Associated with the recessive environment, and helping to keep it like that, in 2002–3 a net outflow of portfolio investments equivalent to 3% of GDP took place. Thus, national investors joined international markets in their pro-cyclical behavior. Notwithstanding the persistent output gap, the government continued developing social reforms. In 2001 there was a second reform enhancing 31 Two independent consulting committees, set up by the Ministry of Finance, provide each year an estimate of the trend price of copper (used to determine withdrawals and deposits to a copper stabilization fund) and inputs to estimate “trend GDP” for the next budget year. 32 By 2008 the Treasury was a heavy creditor, particularly in foreign currency. Correspondingly, in a belated decision, the surplus target was reduced to 0.5% of GDP in 2008 and to 0% in 2009.

34 Economic Development in Chile

labor rights. Also, temporary public employment programs were intensified, covering nearly 2% of jobs in 2002–3. It continued with educational reforms, all-day schooling, infrastructure improvements, and some modernization of educational programs. Public health was significantly improved with the new “AUGE” health program, which includes universal access to treatment for a progressively growing number of pathologies. The “Chile Barrio” and “Chile Solidario” programs were initiated, in order to eradicate shanty towns and to incorporate indigents into the social network supported by the State (see Galasso, 2006). In 2002, an unemployment insurance scheme was started that is financed by contributions of both private workers and employers (which go to an individual account of the worker) and government contributions (which go to a “solidarity fund”); in September 2009, after seven years in force there were 3.2 million active contributors (about 85% of AFP private employers). The high coverage in terms of number of workers affiliated has been accompanied by very modest amounts of benefits and a minimal use of the solidarity fund (see Chapter VII). In brief, this insurance was progress, but it needed great strengthening in terms of its magnitude, expeditious access, expansion of the solidarity fund, and its connection with effective labor training programs. In 2009 the parliament approved a project of the government that enhanced the extent of and access to the solidarity fund, including workers with short-term contracts, introduced counter-cyclical features in the benefits, and offered job search intermediation labor training for the unemployed. All this progress, very novel and promising, has had limited financing because of the output gap. But as significant is the regressive impact that the gap has had on the labor market. In the period between mid-1998 and 2003, the number of workers with a job (including people in special programs financed by the government) grew in total by scarcely 3.3%, while the eighteen-year-old or over population increased by around 9%. The rate of labor participation, which had been rising during the 1990s but was still low by 1998 (54%), diminished by one point, and open unemployment rose by four points (exceeding10% of the labor force). The main determinant factor of this labor market deterioration was the real macroeconomic imbalance, as we define it here: the high gap between actual and potential GDP, which implied underutilization of labor and capital, discouraging productive investment. In fact, the investment ratio (at 2003 constant prices) in 1999–2003 was three points below the average recorded in 1995–8. Chile could have implemented a vigorous domestic positive shock, taking advantage of all the strengths accumulated by the Chilean economy: large international reserves, a Treasury and a central bank with low external liabilities, outstanding fiscal discipline, among other attributes, and, a main issue, the great recessive output gap prevailing in all the period 1999–2003.

Economic Development in Chile

35

(c) Recovery led by a positive external shock in 2004–8 and the contagion in 2009 During 2003, there was a sharp rise in the international prices of commodities, which lasted until the contagion of the international crisis in 2008.33 The commodity boom implied a strong positive shock for several Latin American countries (LACs).34 In the case of Chile, the terms of trade improved by the equivalent of 10% of GDP between the recessed 1999–2003 period and 2004–5; the hike in the price of copper and other commodities exported by Chile was notably stronger than that for the imports of oil. This exogenous shock contributed to a significant jump in GDP growth, from 2.6 to 5.8% in the same subperiods. Given that potential output was rising merely about 4% annually, this implied a noticeable reduction of the output gap. Generalized improved terms of trade and volume of exports enhanced, directly, the spending capacity of the private sector, and expectations returned to broad optimism. After a usual lag, productive investment started to rise. Naturally, the outstanding merits accumulated by the Chilean economy were a factor supporting the sharp recovery. But the leading force was the positive external shock. This reveals a macroeconomic weakness, since the merits of the Chilean economy were already present in the recessive period. Thus, the conditions for a domestic reactivating shock were at hand from the moment the excessive external deficit as well as the over-appreciated exchange rate of 1998 had been corrected in 1999.35 Given a large output gap by the beginning of the positive external shock, domestic supply was able to respond with a rising GDP and low inflation pressures (within a target band of 2–4% set by the autonomous central bank). In the meantime, once again, the bank allowed the real exchange rate to appreciate by 20% between March 2003 and December 2005, contributing to anchor inflation and to further increase the purchasing power. Nevertheless, the partial recovery lost force in 2006, opening a period in which actual GDP grew below the expansion of potential GDP. In contrast with the experience of the 1990s, the Chilean economy performed below

33 Surprisingly, in 2009, amidst the intense global recession, prices relevant for the Chilean economy – such as of copper and oil – resumed comparatively high levels. A similar outcome has been recorded in stock markets: high prices in a depressed world economy could be interpreted as risky bubbles, as stressed on several occasions by the Nobel prizewinner Paul Krugman. 34 It is noteworthy that actual GDP growth also jumped in Latin America, from 1.3 to 5.4%, between those two periods. The driving force was the same one for Chile. See a discussion in Ffrench-Davis (2006, Chapters I and VII). 35 For instance, a domestic positive shock, implemented by Korea and Malaysia in 1999, was highly successful, achieving a sharp recovery in one year (see Mahani et al., 2006). In my view, that option was also available for Chile.

36 Economic Development in Chile

the average speed of Latin America, thus losing the lead that it had enjoyed in the region since the late 1980s. It is true that, by 2008 it exhibited a much better record from 1990, with an average 5.3% vis-à-vis the 3.2% of all LACs, but in the margin (2004–8) it had lost ground, with a 4.9% average, lower than the 5.3% recorded by Latin America. A mix of factors directly explains that weakening. The direct origin is located in 2006. The central bank overshot the rise of the interest rate and left the exchange rate to revalue further; moreover, the Ministry of Finance sterilized the positive impact of the copper price rise, and allowed most of the negative impact of the increasing oil price to penetrate the domestic economy. A great virtue – the copper stabilization scheme – overshot, sterilizing in excess. The moderated increase in aggregate demand was strongly biased towards imports. Again, a severe inconsistency between the current exchange rate policy and the consensus objective of fostering exports with higher value-added prevailed, while small and medium-sized enterprises (SMEs) faced external competition with reduced import tariffs and an appreciated exchange rate (see Chapter VI). In brief, there was a combination of excessive priority for inflation, a sliding of economic policy towards more neutral policies, and the belief that actual GDP was already too close to potential GDP.36 The fact is that in 2006 actual GDP grew somewhat less than the potential GDP, thus resulting in an enlarged instead of a diminished recessive output gap. That implied forgone employment, wages, and profits. Additionally, uncertainty was reintroduced in entrepreneurs’ minds, particularly in exporters and small entrepreneurs, and optimism was weakened. During the next two years, effective demand experienced several ups and downs, affecting economic activity; the significant effects of demand on the response of real supply (that is, actual GDP) reflected the fact that the Chilean economy was operating persistently below the production frontier. Exchange rate instability contributed to the weak performance. Actually, imports rose systematically nearly twice as fast as the volume of exports; high prices hided that persistent fact. Evidently, the exchange rate was an outlier, and quite unstable. That is, the exchange rate regime combined two bads for the contribution of exports, and more broadly for tradables in general, to development. The international scenario played a relevant role, naturally enhanced by the openness of the Chilean economy. There were positive features for Chile, such as the spectacular price of copper and other large exports, which allowed the Treasury, very responsibly, to accumulate sizable funds for eventual bad years (or awful years such as 2009); fiscal surpluses jumped further to an annual average of over 7% of GDP in 2006–8. Further, world 36 This belief was associated with the biased methodology that, working with a trend that includes recessive periods, leads to underestimating potential GDP.

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37

trade was dynamic up to the arrival of the international financial crisis. On the contrary, international prices of food were climbing. From mid-2007 to mid-2008, the price of food in the Chilean CPI increased by 22%, which generated significant inflationary pressures, explaining about half of the nearly 10% annual inflation recorded at the peak of the commodities boom (by the third quarter of 2008; see Ramos, 2008). It was, mainly, an imported inflation. The central bank consistently expressed its bias for the inflation target, at the expense of growth. By late 2008, when Chile was already exhibiting negative monthly inflation, the monetary policy interest rate (8.25%) exceeded by over seven points that of the USA. When the contagion of the global crisis arrived in 2008, the economy moved into open recession. In 2009 it experienced a drop in GDP of 1.5%, similar to the Latin American average. Now the government adopted a decided countercyclical approach, making use of the stabilization fund, which provided broad space for counter-cyclical fiscal policy. Notwithstanding a drop in tax revenue resulting from a depressed demand, some taxes were reduced transitorily (on fuels, loans, and SMEs). In parallel, fiscal expenditure increased by 18%, which implied a 4.5% actual deficit. The strong counter-cyclical fiscal policy was the main force compensating for the negative shocks, principally that suffered by the volume of exports. In fact, the volume of Chilean exports, which had risen 7.9% in the previous two decades, dived 5.6% in 2009. Fiscal policy softened to a significant degree the multiplication to the domestic market of the shock on exports. The domestic economy only contracted by a negligle amount (see Chapter VI, Table VI.6). For the first time since the opening of the economy, starting in 1973, the recessive adjustment, in the face of external shocks, was stronger on exports than on the domestic economy. Counter-cyclicality of fiscal policy was effective and efficient in 2009. In all, as said, growth was moderate, but low compared with the potentiality of the domestic economy and the positive shocks from abroad. In 2004–8, the average 4.9% rise of GDP was determined by a 6.6% expansion of the volume of exports and 4.2% of the rest of GDP. This latter figure contrasts sharply with the 6.5% dynamic growth of non-exports in 1990–8. Systemic competitivity was failing. The failure was associated with the second variable behind the weak economic performance: a hesitant development agenda, whose shortcomings rank from unlucky shortages in the supply of energy, to a faulty exchange rate policy, and to lags and lacks in the incomplete links of capital markets with productive sectors (particularly SMEs), labor training, and incentives to innovation. There have been relevant announcements of the design of a more powerful productive development policy focused on SMEs; but, notwithstanding some concrete progress, these are still mostly only announcements. Chile made ambitious social reforms in this period; pensions and health were substantially improved, as detailed in Chapter VII. They contributed to an improvement in income distribution, which today is notably less unequal

38 Economic Development in Chile

than in the 1980s. Nonetheless, the Chilean economy is still quite regressive. This is related to the fact that the strong social agenda was not well matched by the economic agenda. Fiscal responsibility was outstanding but derailed from a development concern. Structural reforms (as well as macroeconomic management, as shown) were weak and somewhat contradictory to the introduction of equitability in market behavior. The latter required deep reforms in the capital market, moving away from the priority on the overnight markets and decidedly towards enhancing the long-term market segment; developing segments for SMEs, and for entrepreneurs without wealth or history. Further, incentives for innovation were weak and have been taking a relevant shape only recently. Labor training for untrained workers has been improving but too mildly. The sharp increase in the number of years of education has become associated with lowered quality, which demands even more effective labor training. In brief, Chile missed, to a significant degree, what we call taking the road that leads from financierism to productivism. (d) A summary of outcomes Notwithstanding the recessive gap in 1998–2003, actual GDP rose by 5.3% in 1990–2008, in contrast with the 2.9% recorded in the 1970s and 1980s. The leading force behind that outstanding performance was the vigorous investment ratio achieved in the 1990s. The average ratio (21.4% in 1990– 2008) was seven points larger than during the neoliberal experiment (13.6% in 1974–89; all in 2003 prices). Even in the recessive period of 1999–2003, capital formation was significantly higher than that in the seventies and eighties, and sustained a potential GDP growth rate of 4%. It is important to stress that though FDI exhibited a very significant boom, 82% of the generation of productive capacity in the nineties was carried out by domestic agents (see Ffrench-Davis, 2003). After the recessive adjustment from 1998, greenfield FDI also contracted, temporarily, but the major reduction focused on private national investment, demonstrating the strong sensitivity of domestic investment ratios under a persistent output gap. On the other hand, in 1990–2008 the national savings ratio averaged 22% (at current prices), the highest in recent decades (see Table I.5). The higher savings ratio was associated with the stimulating macroeconomic environment faced by firms, with rather small gaps between actual and potential GDP, leading to greater use of installed capacity, higher profit margins, and larger reinvestment of profits (Agosin, 1998).37

37 As pointed out above, the convergence between the productive frontier and effective demand is an essential ingredient for an efficient macroeconomic policy. The absence or weakness of this fundamental macroeconomic equilibrium has been characteristic of Latin American economies since the 1980s. See Ffrench-Davis (2006, Chapter II).

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39

Table I.5 Gross savings ratios, 1982–2008 (% of GDP at current prices) Gross saving ratio External National Public sector Stabilization funds Other (1) (2) ⴝ (3) ⴙ (4) ⴙ (5) (3) (4) (5) 1982–4 1985–9 1990–5 1996–8 1999–2003 2004–8

8.4 4.9 2.5 4.7 0.9 –2.2

3.1 16.5 22.1 22.7 20.6 23.8

–1.8 3.3 4.6 4.8 2.3 5.1

– 1.6 0.8 0.0 – 0.5 3.8

4.9 11.7 16.8 17.9 18.7 14.8

Source: Author’s calculations based on National Accounts data from the central bank and DIPRES. (3) The public sector includes cash profits of public firms, principally of CODELCO (the public copper producer), collected by the Treasury, excluding stabilization funds. (4) Corresponds to the Copper Buffer Fund until 2006, and the Economic and Social Stabilization Fund and Pension Reserve Fund since then. (5) Includes net private savings plus the central bank balance, profits of public firms not transferred to the Treasury and capitalized by these firms, and depreciation reserves of all public and private firms.

The savings capacity is strongly affected by the terms of trade, which continue to be extremely unstable for Chile, as documented by the several mentions above of fluctuations of the terms of trade effect as measured by the national accounts. The main determinant of these fluctuations has been the price of copper, with a smaller influence of oil imports. For instance, in 1989 the high copper price implied additional foreign currency inflows equivalent to 3.7% of GDP into the copper buffer fund (CBF), which is one source of public and domestic savings. To the contrary, in 1999 the fund decumulated 0.8% of GDP. The change represents a net difference of 4.5 percentage points, which ought to be taken into account when analyzing the evolution of public and national gross saving figures in Table I.5; that is required in order to measure actual savings effort in each year. However, that is only part of the story. The CBF covered only the proceeds of the large public firm CODELCO. But price fluctuations of copper have an effect on the taxes paid by the private producers.38 With the replacement of the CBF with the Social and Economic Stabilization Fund in 2006, the stabilization force of the fund was enhanced by including the fluctuations of tax proceeds of private copper producers.

38 All the profits of CODELCO are transferred to the Treasury. The issue was a matter of discussion, particularly in recent years, when the fiscal budget had a huge surplus with funds provided by the profits of CODELCO, and this firm had to borrow abroad to finance its investment. In 2008 the Ministry of Finance allowed CODELCO to retain a fraction of its profits after taxes, raised to a significant US$1 billion (0.6% of GDP) for 2009.

40 Economic Development in Chile

In all, the copper stabilization fund has represented an outstanding factor of macroeconomic stabilization. In general, the authorities have operated efficiently and responsibly with it. The CBF contributed to the implementation of the structural budget, thus allowing a move from pro-cyclical to neutral fiscal policies during the recessive years. But that valuable “credibility asset” was underutilized during 1999–2003, principally, as made explicit by the authorities, because of the fear of being criticized and “punished” by financial agents if they had adopted a counter-cyclical macroeconomic policy. Exports were the driving forces behind economic growth, increasing the external links of the Chilean economy and its potential for sustainable growth. It is interesting to note that the rate of export growth was relatively similar in the past three decades, contrasting with highly volatile GDP growth. In this context, it must be underlined that GDP growth in the 1990s performed notably better than in the Pinochet regime, because the rest of GDP (non-exports) also grew dynamically, reflecting broader systemic competitiveness and the positive impact of sustainable macroeconomic equilibria. In fact, non-exports rose anually by 6.5% in 1990–8, by merely 1.7% in 1999–2003, and then recovered to 4.2% in 2004–08. The sharp swings are mostly associated with domestic macroeconomic changes. Income distribution continues to be very unequal in Chile. Nevertheless, it must be recognized, considering the diverse available data (see Chapter VII), that in 1990–8 an improvement in income distribution took place. Both the decennial Household Budget Survey and the annual employment survey of the University of Chile for Santiago show a diminishing ratio between the incomes of the richest and the poorest quintiles of population. For example, the latter survey indicates that the ratio was 13in the sixties, 15 in 1974–81, 20 in 1982–9 and 14 in 1992–5 (see Figure VII.3). The regressive impact of recessive output gaps is evidenced in subsequent years, particularly in 1999–2002. With the recovery of economic activity and strengthened social policies, distributive progress was recorded in 2004–9. Nevertheless, there is still an enormous pending debt of the economy to most Chileans. The labor situation is a main determining factor of income distribution. It is a fact that the improvement of the labor market recorded between 1990 and 1998 contributed to the distributive progress in those years, and that its worsening was a key factor explaining the partial deterioration in 1999–2002. With regard to the unemployment rate, although it was lower than one-half the average rate under the Pinochet regime, it did not recover to the level of the 1960s in a sustainable pattern. Still more, after the long recessive imbalance from mid-1998, unemployment and income inequality worsened, and labor market informality arose as one of the greater challenges to restarting the path of growth with equity. In recent years the positive features have been a significant increase in the participation of women in the labor market, with its share rising to 43%, and the gradual increase in the share of the labor force making social security contributions, which

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41

means progress towards formality and workers having the protection that contracts likely grant. The share of members of the labor force contributing to the private system had risen from 41% in 1989 to 54% in 2008. In summary, the Concertación administration compares favorably with all regimes since the 1950s in terms of (actual, potential, and per capita) GDP growth, productive investment ratio, inflation, real wages, social expenditure, and fiscal surplus (see Table I.1). This good average performance implied that, in the years of democracy, Chile shortened its distance from the developed world, as documented in Table I.6. Nevertheless, this performance was not sustained or continuous. As is known, the first half of the period (1990–8) involved vigorous growth (three times the speed of the USA’s), with a strong convergence with the developed countries and a reduction in income inequality. In the second half (1999–2008), the distance continued to be shortened, but the per capita GDP growth trend halved, and the strong development convergence exhibited in 1990–8, for example, with the United States was weakened, as were previous improvements in income distribution. What explains this remarkable change in the development trend? A mix of factors. Here, we mention four that are, naturally, interrelated. First, doubtless, the Asian crisis constituted a significant negative external shock; however, we show that its direct influence via slowing export growth only explains a minor share of the slower GDP growth (see Chapter VI). Second, there is a structural element: dynamism in exports was strongly influenced by natural resource exploitation (as in copper and forestry) and the development of public services (as in energy and telecommunications) in mega-projects that could be hardly replicated, at the same level of rising productivity, in the 2000s (Moguillansky, 1999). Consequently, a large number of smaller projects in sectors more demanding of the still pending systemic competitiveness became necessary in this new framework. Third, the strong social agenda was not well matched by the economic agenda. Evidently, there has been a lot of progress. But a rather poor economic outcome in the second decade needs an explanation. There was missing a more comprehensive effort to complete long-term capital markets; encourage Table I.6 Per capita GDP growth, 1974–2009 (annual average growth rates) Chile 1974–81 1982–9 1990–8 1999–2008 2009

1.5 1.2 5.4 2.6 –2.5

Latin America 2.0 –0.7 1.4 2.0 –2.8

Source: Central Bank of Chile, ECLAC and the IMF.

USA 1.5 2.6 1.7 1.6 –3.3

42 Economic Development in Chile

diffusion, assimilation, and adaptation of technology; broaden labor training; and open external markets for Chilean non-traditional products (all with special emphasis on SME development). All these are essential ingredients of a renewed national agenda for growth with equity. My view is that these shortcomings had a relevant influence on the defeat of Concertación Democrática in the recent presidential (January 2010) and parliamentary elections. But political analysis is beyond the reach of this book. Fourth, there is consensus that fiscal responsibility was outstanding, but some structural progressive reforms were weak and some changes were contradictory with the introduction of equitability in the market behavior. The latter required deep reforms in the capital markets, away from priority being given to overnight markets and decidedly towards enhancing the longterm market segment; developing segments for SMEs, and for entrepreneurs without wealth or history.39 Further, incentives for innovation were weak, even though they have been taking shape recently.40 Labor training for untrained workers has been improving but too mildly. The sharp increase in the number of years of education have been associated with lowered quality, demanding even more effective labor training. There appears to be a growing shortage of more trained workers and entrepreneurs, in an economy that has doubled GDP per capita, and whose requirements for growth are now more demanding. In brief, Chile missed, to a significant degree after the promising start in the early 1990s, what we call taking the road that leads from financierism to productivism. A last, but not least, factor refers to the macroeconomic environment. As detailed in Chapter IX, policies applied in the second half of the 1990s gradually lost coherence and the ability to control the vulnerability of the Chilean economy in the face of external shocks. Consequently, when the Asian crisis exploded, a climate of instability returned to Chile once again, opening a significant gap between actual and potential GDP from mid-1998. This gap, as demonstrated throughout the text, was the main cause of the sharp drop in the investment ratio in 1999–2003 and the loss of entrepreneurship pull. It is essential to find the way back to real sustainable macroeconomic equilibria, after some confusing swings between the neoliberal and growthwith-equity approaches. Thus, along with deep microeconomic developmentfriendly reforms (pro-SMEs and pro-employment) – decidedly enhanced, 39

There have been several reforms of the capital markets, which have improved the access to financing for SMEs and microcredit. However, the market is still intensive in short-term and liquid dealings and remains quite limited for SMEs (see Consejo de Trabajo y Equidad, 2008). 40 In 2008 it was decided to focus the allocation of the proceeds of a royalty recently established on mining to a selected group of clusters. It represented an encouraging deviation from allocative neutrality (see Consejo Nacional para la Innovación, 2007).

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43

located indeed as a priority of public policy – Chile can recover sustained high rates of growth of GDP and a progressive reduction of inequality. For both growth and equity it is necessary to reach sustainable real macroeconomic balances. Beyond low inflation and fiscal responsibility, foreign exchange and interest rates approaches functional for productive development are required, as well as an active management of aggregate demand at levels consistent with productive capacity.41 Recent performance has been deficient in this matter.

Annex Long-term trends and fluctuations in economic growth: estimating potential GDP This annex reports estimates of the evolution of potential GDP (GDP*) and the gaps registered between GDP* and actual GDP. Recall that output gaps have enormous effects on investment ratios, employment and the evolution of total productivity (TFP). The expansion of productive capacity – economic growth – is not a given immutable figure, but the result of public action and the behavior of social, political, and economic agents. Naturally, it also depends on the external environment and the ideas in fashion that influence the behavior of different agents; for example, the relative weight of short term “financieristic” visions focused on windfall gains versus “productivistic” visions focused on productive development. The evolution of the potential productive capacity depends on the components of the production function: gross capital formation, the labor force and its quality (human capital), technological change and productivity. As well, the actual rate of use of potential capacity is associated with sociopolitical and macroeconomic environments. I have argued that macroeconomic policies intended to ensure a high use of productive capacity are a key ingredient of an efficient public policy. They not only contribute to sustained economic growth, but also, especially, they fortify equity through its positive impact on SMEs and employment. In order to grow with equity – as shown throughout this book– the improvement of macroeconomic policies is a core requirement. For a better analysis of this issue, there is need to examine the evolution of GDP* (productive frontier (PF) or installed capacity). Counting with a credible estimate of GDP* contributes to understanding 41

It is fashionable to repeat that with the adoption of a floating exchange rate the national economy was immunized from external shocks. The truth is that exchange rate crises are eliminated, but at the expense of transferring great instability to the real economy, especially to the allocation of resources between tradables and nontradables, and to aggregate demand.

44 Economic Development in Chile

economic history and to guiding future macroeconomic policies: that is, monetary, fiscal, and exchange rate policies, and prudential counter-cyclical regulation of the capital account. There are many sophisticated methodologies to estimate potential output, but they usually do not control comprehensively in the estimates for the effects of strong recessions. Therefore, these estimates tend to take account of the trend or historical actual GDP average, including the sharp cycles experienced by the domestic economy, which implies a downward bias of potential GDP.42 The use of these estimates affects the quality of both historical analyses and macroeconomic policy, because it tends to reproduce past recessions in the future and hide the crucial variable: the sustainable economic frontier – of full utilization of capital and labor and efficiency in economic management – at which the battery of macroeconomic policies should be aimed. This annex presents the methodological options that were used to estimate GDP*, avoiding the problem mentioned above. With those estimations of GDP* the differences from actual GDP are reported; that is, the output or recessive gap. This gap reflects the evolution of aggregate demand, its relationship with effective demand (which is that located on output by domestic resources), and the match between the structures of demand and supply of goods and factors markets. That is an interaction between macro and microeconomics. GDP* expanded in a fairly stable fashion in the 1960s, with relatively high capacity utilization, compared to the large output gaps that prevailed in the 1970s and 1980s. In fact, capital formation and the growth of productive capacity were more unstable in these two decades (see Figure I.1 above, and Table A.1). The low investment ratio and slow expansion of the productive frontier are associated with the low average capacity utilization and real macroeconomic disequilibria of these two decades. The instability of economic activity has negative repercussions in two respects. First, underutilization of capacity tends to reduce the actual social and market profitability of capital; it diminishes the availability of investment funds and worsens the financial condition of enterprises. In addition to discouraging investment, it reduces actual productivity. On the other hand, this instability depresses productive employment, destroys part of capacity as a result of massive bankruptcies, and negatively affects the sustainable future income level. That is another link between macro and microeconomics. Massive bankruptcies caused by macroeconomic imbalances implied a destruction of capital (a lot of which would have been productive under 42

For example, the popular Hodrick–Prescott technique and estimations of production functions that do not duly control for cyclical changes in the rate of capital utilization or the labor supply usually give erratic estimates of total factor productivity.

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Table A.1 Potential GDP growth and output gap, 1960–2007 (annual average growth rate, % of GDP*) Potential gap

Output gap

ICOR (1)

Production function (2)

ICOR (3)

Production function (4)

1960–71 1971–3 1974–81 1982–9 1990–8 1999–2003 2004–8

4.6 1.2 1.9 3.0 7.2 4.0 4.2

3.8 3.0 2.4 3.5 6.5 4.2 4.2

1.9 5.0 8.7 12.1 –0.5 6.5 3.7

–0.5 2.4 8.7 13.2 –0.7 6.5 3.8

1974–89 1990–2008

2.5 5.6

2.9 5.3

10.4 2.5

11.0 2.3

Source: Author’s calculations detailed in this annex. Columns (1) and (2) are annual average growth rates of potential GDP or productive frontier (PF). Columns (3) and (4) report the average output gap of different subperiods, as a percentage of potential GDP. From 2002 on, the growth of potential GDP corresponds to the estimates made by the Ministry of Finance in 2009.

normal demand and right prices). Losses resulting from sharp import liberalization and large exchange rate appreciation were very significant in the 1970s (see Chapter II). The situation improved in the 1980s, partly as a result of better aligned macroprices (the exchange and interest rates), but it was restricted by the recessive effects of the binding foreign currency scarcity, and the distortion and the uncertainty generated during the debt crisis. In the 1960s, excessive protection and administrative obstacles fostered inefficiencies, but less real macroeconomic instability helped to improve the efficiency of all productive factors and to keep more enterprises afloat. It allowed the concentration of energies on creating enterprises rather than on transferring existing assets, and provided more predictable patterns of demand and stabler relative prices (which stimulated productive investment, given its irreversibility). As a consequence, development was also more inclusive or integrated, which offered greater productive opportunities for broader sectors of society. This environment, despite numerous distorting inefficiencies, explains the better performance of productivity in the 1960s vis-à-vis the 1950s and the near match with potential productivity in the 1980s (recall that actual GDP growth was 2.9% in 1982–9 and 4.8% in 1961–71). The years of great underutilization of capacity have been associated with deliberate or involuntary recessive adjustments following expansions, with fiscal, monetary, or balance of payments disequilibria. Underutilization also intensified when stabilizing policies rested on only one policy tool (generally

46 Economic Development in Chile

the exchange rate) instead of using multiple anchors. Major gaps occurred in 1954–6, 1959, 1973, 1975–9, 1982–7, and most recently 1999–2003. In the 1990s, once most idle capacity became utilized in 1989, the productive frontier started to increase vigorously at annual rates of around 7% in response to an increase in the investment ratio by 7 points of GDP between 1982–9 and 1990–8 (see table A.1). Prevailing domestic stability throughout almost the whole decade, achieved by means of prudent counter-cyclical policies like selective regulation of short-term or volatile capital inflows, determined the framework for a virtuous cycle of higher utilization of the existing capital stock, thus generating higher investment flows, and generally a more efficient use of productive resources; naturally, this reflected in significant actual productivity growth. The Asian crisis implied a sudden stop for the virtuous circle of 1990–8, enforcing a fall of the growth rate of actual GDP to below 3% in 1999–2003. The recessive gap between actual and potential GDP re-emerged, implying a significant slowdown of investment dynamism; consequently, a sharp diminution of the growth rate of potential capacity took place, from a 7% to a 4% plateau.

Estimating potential GDP or the productive frontier GDP* is the maximum aggregate supply of goods and services that can be achieved in any period, given the imperfections prevailing in the production process and factor quality. The determinant variable for achieving that maximum is an actual demand consistent with potential supply. There is a significant asymmetry in the actual performance of the economy. Actual GDP can be placed much below the PF (or GDP*), while it cannot stay above that productive capacity in a sustained way. The PF can be surpassed only temporarily, but with the exhaustion of inventories, or growing inflationary pressures, or non-financeable external deficits, or under transitory terms of trade positive shocks. In this Annex GDP* and the output gap are estimated through two methodologies, which take into account the essential issues of our interest. The first one is quite old in the literature and applied economics; it is based on the ex-ante election and correction of peaks of use of the installed capacity, then the calculation of a relation (incremental capital-output ratio, ICOR) between the increase of output and the increase of the capital stock. The second uses an aggregate production function approach. Both methods, in this specific case, report consistent results (see Table A.1). (a) ICOR methodology, with corrected peaks This is a very simple method with limitations. However, for economies with great fluctuations of economic activity it tends to give results better fitted to reality than sophisticated conventional methods that omit the control by those fluctuations or asymmetries.

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With available information, we select the peaks of use of capacity in the period studied. In this sense, there is wide consensus among economists on when peaks have been reached: in the past three decades, the Chilean economic peaks were located in 1971, 1974, 1981, 1989, and 1997. I assume that in those years potential and actual GDP were rather similar. Consequently, a first estimation of GDP* is the level of actual GDP in those years. However, for greater precision and based on complementary information, I search for the main biases in each of the annual peaks identified in getting a figure for GDP*. I have corrected for the two main sources of bias. In one the PF is underestimated by actual GDP; this happens when the peak is not achieved throughout the year (for instance, in 1974, with a recession starting in the third quarter). The other overestimates the PF, in the case of an excess of imports without sustainable external financing; the excess allows a large value-added in the marketing of imports, which implies that actual GDP overestimates GDP* (overestimates GDP* moderately in 1997; overestimates GDP* greatly in 1981, partly compensated by the underutilization in producing tradables, due to a highly appreciated exchange rate). Then the net increase in output was calculated (GDP corrected by depreciation of capital) between two peaks, and the net increase in the stock of capital (the sum of the net investment of each year lagged one year). The ratio between the two is usually called the ICOR (or reciprocal of the standard ICOR) or coefficient of gross marginal productivity of capital.43 Subsequently, this ratio and annual investment were used to estimate potential GDP between peaks.44 This estimation of GDP* is based (i) on the assumption that capital is the only (or main) exogenous factor in the production function, and (ii) on the ex-ante selection of peaks, when actual GDP is located on the production function and not “below” it. Both assumptions are reasonable as a first approach. On the one hand, in countries like Chile capital is the scarce factor and, therefore, is the binding element of the productive frontier; employment as well as the absorption of technology have a positive association with vigorous investment. On the other hand, peaks were selected by means of the revision of diverse indicators that allow a good degree of certainty on the proximity between actual GDP and GDP*. However, it is 43

The reciprocal of the ICOR was used associating increases in output with net fixed capital formation. However, apart from investment in human capital, there have been changes in the use of other factors, such as technology and natural resources (Marfán and Bosworth, 1994). In fact, the use of natural resources intensified. Numerous empirical studies examine the quantity and quality of labor and capital. 44 Estimates by Marfán (1992) for 1960–88 yield annual rates of change in GDP* similar to those obtained by the two methods used in this chapter. The similarity of results, within the time frame common to both studies, is accounted for by the choice of the peaks method and the agreement in the identification of peaks and of

48 Economic Development in Chile

relevant to ask how much estimates change when relaxing both assumptions, including labor as an independent factor in an econometric estimate of a production function. (b) A production function with labor and capital By definition, the production function represents an efficient technical relation between the output level and the factors required to produce it. Therefore, those points of underutilization of productive factors – that is, points with idle capacity and productive inefficiency – are not located on the production function. In order to deal with this relation empirically, normally the production function would be estimated using as dependent variable the actual GDP and as independent the productive factors actually used. The potential GDP would be obtained, then, when applying the parameters obtained to the factors in its “full” employment level. The problem is that, given the absence of direct data, it is difficult to get the level of capital actually used and, on the other hand, it is also difficult to establish the full employment level of labor; for that reason, the estimates available usually have significant biases using this this concept.45 An alternative approach, which I use here, makes use of valuable information by estimating the production function with a corrected sample of observations that excludes the points with evident inefficiencies (since we know that the points where actual GDP is significantly below GDP* are not on the production function). For it, first the following equation in logarithms by ordinary least squares (OLS) was estimated: ln(Yt ) ⫽ a0 ⫹ a1 ln(Kt ) ⫹ a2 ln(Lt ) ⫹ ut

(1)

where Y is actual GDP (constant prices of 1996), K is the capital stock (constant prices of 1996), L represents the labor factor (we use total hours worked corrected by education), u is a random error term.46 Then, I build a periods when the economy is placed sharply below the production frontier (that is, out of the production function). Given the huge cycles experienced by the Chilean economy, empirical studies that do not take the level of activity into account can be significantly biased in their results concerning total factor productivity. For instance, Roldós (1997) gives a change of total factor productivity (TFP) per annum of –3.8% in 1981–5 and 0.9% for 1986–90, evidently distorted by the 1982 recession. The interesting paper of Beyer and Vergara (2002) estimates –2.2 points of contribution of the TFP in 1981–85 and 2.3 points in 1986–90. Given the small output gap of 1981 and 1990, the average approximates to real structural TFP. 45 See diverse estimates for the Chilean case in Morandé and Vergara (1997), Roldós (1997), Coeymans (1999), Hofman (1999), Marcel et al. (2001), Beyer and Vergara (2002), Contreras and García (2002), and Gallego and Loayza (2002). 46 The series of capital stock and hours worked constructed by the Ministry of Finance was used.

Economic Development in Chile

49

25.0 ICOR

PF

20.0 15.0 10.0 5.0 0.0

2008

2006

2004

2000

2002

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

⫺10.0

1960

⫺5.0

Figure A.1 Comparison of two estimates of the Output Gap, 1960–2008 (% of GDP*). Source: Author’s calculations detailed in this annex: columns (3) and (4) of Table A.1.

corrected sample that does not contain the observations of years with more significant inefficiencies. In order to approximate to it I excluded the observations in which the error term is negative. With that exclusion I correct for the bias of the evidently asymmetrical fluctuations of actual GDP around GDP*. But, beyond econometrics, one must check for the consistency of the resulting selection with other data. The excluded years are 1975–8, 1982–8 and 1999–2003. This selection of years when actual GDP has deviated sizably from the PF is consistent with other empirical studies like Coeymans (1999) and Marfán (1992), among others. With the remaining observations, (1) was re-estimated. Then the new parameters obtained plus the actual value of K and estimates of “full employment” L were used (in logarithms) to forecast the dependent variable through the full sample, obtaining thereby the GDP* series. Figure A.1 compares the resulting output gap in both methods. Method 1 renders a higher estimate of the output gap because it considers only years close to the frontier, while method 2 retains years clearly below the PF, such as 1979 and 2004. Beyond this evident source of divergences, the similarity is clear, in spite of the differences in the assumptions, and the fact that the production function estimates GDP* with fixed parameters; meanwhile the ICOR methodology allows for changes in productivity from peak to peak.

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Second Part The Neoliberal Experiment in Chile, 1973–1982

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II Import Liberalization in 1973–82*

The distinctive characteristic of trade policies implemented in 1973 was the sharp unilateral import liberalization, which was undertaken to a degree then unprecedented in modern economic history in other semi-industrialized or emerging economies. By establishing a uniform tariff of 10% for nearly all imports, and deleting non-tariff restrictions, this liberalization suppressed all selective criteria for regulating them. Trade liberalization was accompanied by a reduction in restrictions on foreign exchange dealings and on capital flows. The implementation of free trade raises four questions. First, did the policy allow for a more efficient use of available resources or did it produce significant new divergences between market and social “efficiency”? Second, what degree of dynamism characterized the process, compared to its historical behavior, and how did the intensity and timing of liberalization affect employment, investment, and consumption? Third, how much competition or economic concentration did the policy reform produce? Last, how effectively “neutral” were these “non-discriminatory” economic policies? Policies, seemingly “neutral,” were applied to different segments of the economy that coexisted in a framework marked by inequalities and sharp heterogeneity in productivity among workers and among firms; the heterogeneity of productivities is an outstanding feature of developing economies, which deters economic growth and equity. It implies that “neutral” policies may produce asymmetrical effects, evidently non-neutral, among different productive and social groups. There are also different effects on the production of exportables that experience positive pulls and the production of importables that receive negative pulls. Additionally, there are * Based on “Import liberalization: the Chilean experience, 1973–82,” in Samuel and Arturo Valenzuela (eds), Military Rule in Chile: Dictatorship and Oppositions, The Johns Hopkins University Press, Baltimore, 1986. I appreciate the comments of Augusto Aninat, Vittorio Corbo, René Cortázar, Jaime Estévez, Alejandro Foxley, Dominique Hachette, and Pilar Vergara. 53

54

Import Liberalization

likely transfers of externalities to the rest of the domestic economy generated by the exposure to foreign competition (Tybout et al., 1991; Herzer and Nowak-Lehmann, 2004).1 It is evident that the effects of a deep process of reforms need a long time for completion. Nevertheless, given a positive time preference rate, it should be kept in mind that a real peso today will be worth more than twice as much as one earned ten years later. On the other hand, many other policy changes were implemented together with trade reform, making it difficult to distinguish between the effects of each of them. At the outset, it must be discarded the simplistic dilemma that the only alternative to the specific implementation of sharp import liberalization by the Pinochet government would have been to maintain the chaotic situation of 1973 must be discarded. Actually, in 1967–70 a very pragmatic policy (in my view) rationalizing trade policies was implemented (see FfrenchDavis, 1973). Why, for instance, could not that pragmatic approach to trade reform be adopted again? Its main features were gradual implementation, direct complementarity with export promotion, reduction of the variance and average effective protection to import substitutes, and an active crawling-peg exchange rate policy consistent with the tariff reform. Section 1 shows the path followed by the reduction of import restrictions, focusing on tariff liberalization and the evolution of the real exchange rate in order to determine to what degree this macroeconomic price played the compensatory role assumed by policymakers. Section 2 analyzes the behavior of the principal categories of imports, and examines some distributive effects. Section 3 studies the overall impact of import liberalization on manufacturing and employment, examining disaggregated information on the performance by industrial branches. Section 4 presents the main conclusions of this chapter.

1 The import liberalization process In late 1973, before the introduction of reforms, Chilean foreign trade was subject to a great deal of government interventionism:2 a simple tariff average of 94%, with sharp dispersion, countless non-tariff restrictions and multiple exchange rates. A remarkable reduction in the extremely high barriers that protected import substitutes constituted the core of the new trade policy. The rapid liberalization process, which began in 1973 and ended in 1 In this chapter, I focus on import policies. Export policies, their effects, and interrelationships between both dimensions are analyzed in Chapters V and VI. 2 Notice that this was the situation in 1973. As said, in the second half of the 1960s a reform was in progress that included the gradual rationalization of the import regime, the improvement of an export promotion scheme, and the systematic implementation of a crawling-peg exchange rate policy (see Ffrench-Davis, 1973, Chapters III and IV).

Import Liberalization

55

June 1979, induced a drastic change in market comparative advantages by modifying both the profile of effective protection and its average.3 During the period of liberalization, the target of the process underwent significant changes. What initially appeared to be a moderate reform, with maximum tariff rates of 60%, in the end became a drastic revamping of the tariff structure with a final uniform tariff of 10%. The first steps in the process consisted of suppressing the main non-tariff barriers and dropping to 220% all tariffs that were above that level. Most import prohibitions and deposits were eliminated. These import deposits, with a rate of 10,000%, which were charged on more than half of imports, represented a discretionary control on imports in 1973. The deposits were waived on the condition that importers fixed their volumes within the quotas recommended by the government. Since this mechanism was applied along with an undervalued exchange rate to several thousand products, it generated countless supply bottlenecks and speculative windfall gains for importers. The “normalization” of the foreign exchange market (see Chapter III), which took place in October 1973, and a significant increase in the price of copper during the second half of that year facilitated the rapid removal of quantitative restrictions and initial tariff reductions. In early 1974, the government announced a tariff liberalization scheme that would take place gradually over a three-year period and indicated that it would proceed pari passu with real exchange rate depreciation. The finance minister asserted that it would generate export-led growth and that workers would benefit, “as it would create more jobs in expanding sectors than the number of jobs that could disappear in some highly inefficient sectors.” It was argued that “greater growth perspectives are based in the opening to trade, in the development of export industries and in the intensification of Latin American integration.”4 The announcement gave no indication of the levels that tariffs were projected to reach. The first such indication came in May 1974, when the government declared that “in 1977, no tariff will be higher than 60%. This clearly defines the tariff policy that will be followed in the future, so that domestic industries can make whatever adjustments are necessary and prepare themselves so that they will be in good shape to meet foreign competition.”5 Despite these announcements, strategic differences emerged between proponents of a fully orthodox policy and other government officials with a more pragmatic bent. Towards late 1974, reserved government documents mentioned a range of 25–35%, within which the majority of tariff rates 3 In Ffrench-Davis (2006, Chapter IV) a comparative analysis is made with the trade reforms implemented by many LACs since the mid-1980s and in the 1990s. 4 See DIPRES (1978, pp. 35 and 61). 5 Comments of the finance minister, October 1974, reprinted in DIPRES (1978, p. 107). The minister reconfirmed this goal on April 24, 1975 (p. 172).

56

Import Liberalization

would fall.6 Later, in 1975, the government announced that the tariff range would be placed between 10 and 35% and that it would be reached during the first half of 1978, by gradual reductions. Although step-by-step the initial, more pragmatic, official policy gave way to the free trade approach, the policy as it was presented by 1975 contained two important heterodox elements. On one hand, it contemplated nonuniform tariff rates (from 10 to 35%) according to the degree of elaboration of different categories of products. On the other hand, it also contemplated maintaining the tariff preferences agreed under the Andean Pact, which meant that tariff reductions for several products stopped at the minimum common external tariff in place in 1972–6, according to the Cartagena Agreement. The gradual tariff reductions were made approximately once every six months, as can be seen in Table II.1. Nevertheless, the final reductions, scheduled for the first half of 1978, were anticipated in August 1977, when 99.6% of all tariffs reached the 10–35% range, with a 20% simple average. Table II.1 Tariff liberalization, 1973–9 (rates on cif value)

Date

12/31/73 3/1/74 3/27/74 6/05/74 1/16/75 8/13/75 2/09/76 6/7/76 12/23/76 1/8/77 5/2/77 8/29/77 3/12/77 6/78 6/79

Maximum tariff

Modal tariff

Rate (%)

% of all items

Rate (%)

% of all items

(1)

(2)

(3)

220 200 160 140 120 90 80 65 65 55 45 35 25 20 10

8.0 8.2 17.1 14.4 8.2 1.6 0.5 0.5 0.5 0.5 0.6 1.6 22.9 21.6 99.5

90 80 70 60 55 40 35 30 20 20 20 20 15 10 10

(4)

Simple average tariff (%) (5)

No. of items (6)

12.4 12.4 13.0 13.0 13.0 20.3 24.0 21.2 26.2 24.7 25.8 26.3 37.0 51.6 99.5

94.0 90.0 80.0 67.0 52.0 44.0 38.0 33.0 27.0 24.0 22.4 19.8 15.7 13.9 10.1

5,125 5,125 5,125 5,125 5,125 4,958 4,952 4,956 4,959 4,981 4,984 4,985 4,993 4,301 4,301

Source: Central Bank of Chile. Note: Dates refer to the official decrees on general changes of custom tariff rates between December 1973 and December 1977. On the latter date the government issued a decree of monthly adjustments that lasted until June 1979. 6 De la Cuadra and Hachette (1992) and Hachette (2000) detail the trade reforms of the 1970s.

Import Liberalization

57

Repeated official statements implied that the reduction of protection for import-substituting firms had finished in August 1977. Three months later, however, the finance minister announced a target tariff of a uniform 10% to be reached in mid-1979. The additional tariff liberalization was carried out in monthly steps between December 1977 and June 1979. By the later date, a uniform tariff of 10% was being charged on nearly all imports into Chile.7 Non-tariff restrictions, which were generally inefficient and generated capital gains, had been mostly eliminated; and several hundreds of tariff exemptions in favor of firms, regions, or individuals had been suppressed. But price bands softening the transmission of external instability (such as on wheat, oil seeds, and sugar) were also eliminated. Imports of capital goods, which had been generally exempt from tariffs, now became subject to the uniform tariff, although they could be paid in installments. Evidently, relative prices changed against imports of capital goods and in favor of consumer goods, as well as reducing the cost of exportables. Thus the process of discussion finished in the government with a clear predominance of the most orthodox approach. In fact, the 10% flat rate was unusually low for developing countries in the 1970s, and even in developed countries a uniform rate was exceptional. Some comparative information illustrates this. In a newly industrialized country such as South Korea, even after a decade of implementation of its successful economic reforms, tariffs still ranged between 0 and 150%, with many locally produced items enjoying nominal rates of protection between 30 and 60%.8 Korea as well as Taiwan and other Asian countries had carried out a profound trade reform led by export promotion rather than by import liberalization (see FfrenchDavis, 2006, Chapter IV). Developed countries, despite their position at the forefront of world industry, usually maintained selective (non-uniform) rates of protection, with levels notably higher than 10% for significant groups of items. Effective tariff protection in the United States, Japan, and the European Economic Community was relatively high for product categories such as textiles and clothing, processed food, and light manufactures. For instance, textiles and clothing enjoyed effective tariff protection of about 40% in these countries (Roningen and Yeats, 1976; Baldwin, 1981). After 1973, public officials stated repeatedly that the real exchange rate would depreciate as effective protection dropped (DIPRES, 1978, pp. 275 and 291). The government declarations implied a naive view of causal 7 With this ends the “first trade reform.” The “second,” which initially reintroduced diverse forms of protection, began in 1983; see Chapter V. 8 See Balassa (1977, pp. 148–51) and Frank et al. (1975). For other developing countries analyzed in a comprehensive project by the National Bureau of Economic Research (NBER), see Bhagwati (1978). All these authors support the use of selective moderate tariffs. See also Sachs (1987).

58

Import Liberalization

relationships in the economy, among others assuming no capital flows. In practice, however, large financial inflows implied significant deviations from this supposedly univocal causal relationship. In fact, during periods in which the most sizable tariff reductions were made, the real exchange rate appreciated in tandem. Table II.2 shows, for selected dates, the evolution of the real exchange rate (col. 1), nominal rates of protection for items subject to the maximum and average tariffs (cols 3 and 4), and the total cost per dollar of imports (col. 5). Dates were selected according to the evolution of the cost of imports and the relation between the two components that are considered here: the exchange rate and nominal tariffs.9 From this information, we can distinguish four phases in the liberalization process (see Figure II.1). The tariff reductions in phase I, which lasted until April 1975, were made when exchange rates were highly depreciated. Moreover, a significant proportion of the notably high tariffs was then redundant, which meant that the initial reductions did not have substantial effects, as they represented mostly

Table II.2 Cost per dollar of imports, 1973–82 Phase

Date Real Change of Nominal tariffs (%) exchange (1) in each rate phase (%) Maximum Average (1) 10/73

(2)

59.20

I

Average Change of total (5) in each exchange phase (%) rate

(3)

(4)

(5)

220

94

114.85

120

52

150.45

45

22

73.15

10

10

75.31

10

10

51.72

67.2 4/75

98.98

7/77

59.96

6/79

68.46

6/82a

47.02

II

31.0

–39.4

III

–51.4

14.2

IV

(6)

2.9

–31.3

–31.3

Source: Calculations based on Central Bank of Chile, Boletín Mensual, several issues, Ffrench-Davis (1984), and Table II.1. Col. (1) is the nominal exchange rate deflated by the corrected CPI (see Cortázar and Marshall, 1980) and multiplied by the index of external prices (IEP; see Ffrench-Davis, 1984), in 1986 prices. Col. (5) is obtained by multiplying col. (1) by [1 ⫹ (4)/100]. aMonthly average until the day before devaluation. 9 The selected dates are somewhat arbitrary, since the real exchange rate levels are sensitive to the price indexes used to calculate them. The average tariff can also be calculated in very different ways. I present here the simple average used by different government and independent sources. It is well known that the simple average is highly sensible to the extent of disaggregation.

Import Liberalization

59

110 Phase II

Phase III

Phase IV

RER, 1986 = 100

90 Real exchange rate

100 80

80 60

70 60

40 Average tariff

50

Average tariff, %

Phase I 100

20 40 30 1973 1974 1974 1974 1975 1975 1975 1976 1976 1976 1977 1977 1977 1978 1978 1978 1979 1979 1979 1980 1980 1980 1981 1981 1981 1982 1982 1982

0

Figure II.1 Average tariff and real exchange rate, 1973–82. Source: Tables I.1 and I.2.

“water” in nominal protection. Because of this, there were no significant increases in “non-traditional” imports during this phase. During phase I, the average cost of a dollar’s worth of imports increased by 31%.10 Hence, the reform process was principally one of “rationalization” in which the large dispersion of effective protection rates was diminished without causing a substantial impact on the manufacturing of import substitutes. However, the latter industries suffered the negative effects of the strong domestic recession then in progress. Import liberalization and exchange rate depreciation did have a positive effect on exportables; given that exports previously enjoyed customs exemptions for imported components, it was the exchange rate policy that had stronger effects on increasing exports (Ffrench-Davis, 1979). The situation faced by importables changed substantially during phase II, which lasted from April 1975 until mid-1977. During this period, reductions in nominal protection were more effective than in phase I, dropping from an average of 52 to 22%, and the maximum nominal protection decreased from 120 to 45%. The exchange rate appreciated by 39%, strongly reinforcing the effects of falling tariffs. Thus, for two years, while tariff liberalization rapidly reduced the effective protection, the real exchange rate was revalued in parallel. Consequently, the thirty-point reduction in the average

10 Obviously, the nominal tariff for several items, in particular for consumer goods, dropped notably more than the average tariff. The corresponding reduction in effective protection was even sharper. Therefore, for many of these categories the real exchange rate depreciation did not compensate for the effects of tariff liberalization. Data on effective and nominal tariffs before tariff liberalization appear in Behrman (1976, pp. 137–44).

60

Import Liberalization

nominal tariff meant a 51% fall in the average cost of each dollar of imports (Table II.2, col. 6). There was little chance for the market to gradually adjust to the strong impact of this rapid liberalization, unexpected because it contradicted repeated official statements that the exchange rate would “indissolubly” compensate for the dismantling of tariffs.11 The net result of tariff reforms in phase II was a rapid increase in non-traditional imports, particularly non-food consumer goods. In phase III, which lasted until mid-1979, when the nominal price of the dollar was frozen, the exchange rate was periodically adjusted to compensate for the newer tariff reductions. Consequently, at the end of phase III the average cost of the import dollar was about the same as at its beginning. Naturally, products that were relatively more protected at the start of phase III lost their privileged position as customs duties converged towards a uniform 10%. These changes occurred in an economy growingly more sensitive to the evolution of the international economy, including a constantly rising import coefficient. The average tariff had dropped from 94 to 10% during these three phases (and non-tariff restrictions had disappeared), while the real exchange rate at the end of the process was only 16% above the price at the outset of the reform. Exports also benefited from the broadening of the range of imported inputs, then either liberalized or subject to a uniform tariff. Substitutors, on the other hand, had to compete with imports that on average were 34% cheaper than in late 1973. Finally, in phase IV the real exchange rate was revalued steadily. This appreciation was a consequence of the fixed nominal rate and a domestic inflation that, from above, converged only gradually to the international rate during the three years in which the exchange rate remained frozen. In the end, foreign currency finished 21% cheaper than at the beginning of the reform, and the average cost per dollar of imports was 55% lower (see Table II.2). In June 1982, this phase ended with an abrupt devaluation and a deep recession in process. In summary, import policy took shape with successive official announcements, with each one of them presented as the final one. Thus, the policy evolved from a moderate opening to trade, explicitly and officially declared to be consistent with the process of Andean integration, to a sharp, acrossthe-board trade liberalization. As for the assumed compensatory role of the exchange rate, the facts show that in general this macro-variable did not behave according to the assumptions of the economic model. Therefore, an economic and social outcome that differed so much from that expected by the government is not surprising. 11 In this phase, Chile left the Andean Pact. As a result, producers of importables faced less Andean competition, while exporters lost their significant inroads in that market.

Import Liberalization

61

2 Import composition The drastic changes in the structure and level of protection had a significant impact on the composition of imports. As could be foreseen, imports of consumer goods (particularly non-food), which had previously been the most restricted category, were the most favored by across-the-board liberalization. Many variables other than trade policies affected the behavior of imports. Among the most significant variables were the sharp contraction in aggregate demand in 1975–6 and the recovery in 1977–81, the low investment ratio during nearly the entire liberalization period, and the rise in oil prices. Between 1970 and 1981, total imports increased by 127% in real terms (104% excluding oil and lubricants), as shown in Table II.3.12 We must recall two factors. First, until 1980 imports of equipment and machinery, as a share of GDP, were significantly below the level of 1970 and insufficient to raise productive investment and recover the 1960s growth rates. Second, per capita GDP barely increased by 10% in 1970–81, while per capita imports other than equipment and machinery grew by 115%; that is a gross income elasticity of 11. Evidently, increased imports were not associated with an income effect, but were predominantly due to import liberalization and exogenous changes in the supply and demand of importables (e.g. oil prices and changes in income distribution). Different import categories behaved heterogeneously. The influence of liberalization can be observed mainly in non-food consumer goods, where the greatest number of “new” non-traditional imports is concentrated. Purchases of non-food consumer goods increased by 534% between 1970 and 1981. The share of machinery and equipment in total imports dropped from 21 to 11%, and their participation in GDP fell by one-tenth between 1970 and 1981, with an even more noticeably lower share in the intermediate years. This drop reflects a depressed productive investment ratio in the period. Due to a reversal of the import substitution of final products, a reduction of demand for intermediate goods took place. Consequently, net expenditure in foreign currency involved in these “new” imports was less than their gross value. Additionally, relaxed or dismantled national integration requirements for manufactures caused an increase in the share of imported components in consumer goods in which substitution survived. This occurred in the car industry, for instance. Likewise, gross industrial output figures tended to overestimate the level of domestic activity due to the falling integration of domestic inputs.13 12

Given that 1973 presents significant distortions, in Table III.3 I used figures for 1970, which was considered a relatively “normal” year. Real figures are nominal dollars deflated by the index of external inflation faced by Chile. 13 This was the main source of overestimation of GDP, in the national accounts calculated with fixed coefficient matrices. See Marcel and Meller (1986).

62

Import Liberalization

Table II.3 Main imports of consumer goods and total imports, 1970, 1980, 1981 (1977 US$ millions) 1970

1980

1981

Change 1970–81 (%)

0.2 1.3 1.1 24.8

8.2 9.0 22.8 171.9

10.5 17.5 27.5 271.6

5,150 1,246 2,400 995

Confectionery items Leather and fur manufactures Alcoholic beverages and cigarettes Carpets, clothing, knitwear and fabrics Photographic and cinematographic products Footwear, hats, and umbrellas Musical and optical instruments Toys and recreational goods Processed foods Perfumery and cosmetics Television sets Radios Cars and motorcycles

8.0

17.4

25.2

215

2.1 4.4 3.5 5.3 0.1 0.7 4.7 19.5

24.0 18.1 32.0 34.6 13.7 49.0 46.0 144.4

43.3 28.7 42.4 41.3 19.6 66.2 45.8 263.9

1,962 552 1,111 679 9,500 9,357 874 1,249

I

75.7

591.1

902.6

1,093

309.9 262.1 666.9 689.5 1,561.2 1,714.3

757 484 48

II III IV V VI

Total main non-traditional consumer imports Wheat, maize, and sugar Fuels and lubricants Other consumer and intermediate goods Transport equipment Other capital goods

Total imports

43.6 118.0 1,155.5 157.4 408.6

317.5 376.6

395.8 480.6

152 18

1,959

3,823

4,445

127

Source: Calculations based on National Customs Authority for 1970 and import applications of the Central Bank of Chile for categories II, III, V, and VI in 1980 and 1981. Current dollars were deflated by the IEP.

Table II.3 shows the groups of consumer items (food and non-food) that increased most between 1970 and 1981. The thirteen groups disaggregated in this table cover 50% of all consumer goods imports in 1981. During the eleven-year period they grew by 1,093% (i.e. twice the increase in fuels), while all other imports expanded by 62%. As can be seen, most of these non-traditional imports were items that had traditionally been considered “luxury” goods. In several cases, these new imported items were not locally produced, even though they did replace similar domestically produced items. There was, then, a significant diversification in the composition of consumption. The consumption of goods whose imports grew most significantly was concentrated among high-income groups. Naturally, this phenomenon was related to the worsening of income distribution, although this effect

Import Liberalization

63

was magnified by the fact that the distribution of consumption is more concentrated for these importables than for total consumption. Undoubtedly, the low-income sectors were able to buy new varieties of consumer products, but these purchases were bound by their limited and declining earnings. According to household budget surveys conducted in Santiago by the National Bureau of Statistics, families in the upper quintile increased their share of total consumption from 44.5 to 51% between 1969 and 1978, while families in the lowest quintile decreased their share from 7.6 to 5.2% (see Chapter VII, Table VII.2). The 1978 survey also reflects the concentration of consumption of non-traditional imports that year (see Table II.4). In eleven of the thirteen groups of importables included in Table II.4, the richer quintile consumed a higher percentage than its share in total expenditure (as said, 51% in 1978). The two groups in which this richer bracket purchased proportionally less than its average include “inferior goods” (negative income elasticity) for the higher-income levels. For example, as income rose purchases of black-and-white television sets were replaced with purchases of color televisions, and transistor radios were passed over in favor of stereo sets and tabletop radios. Table II.4 Shares by income brackets of consumption of imported goods: main non-traditional imports in 1978 (% of total consumption) Item Color television sets Automobiles Imported whisky Imported cigarettes Cassettes Tennis racquets Electric blenders, mixers, and food processors Motorcycles Watches Toys Stereo equipment, record players, and tape recorders Transistor radios Black-and-white television sets Share of each bracket in total consumption

Highest 20% of households

Middle 60% of households

Lowest 20% of households

100.0 98.6 94.0 92.0 72.8 71.8 71.8

0.0 1.4 6.0 8.0 26.8 28.2 28.2

0.0 0.0 0.0 0.0 0.4 0.0 0.0

65.3 59.7 56.1 51.3

34.7 34.7 41.4 48.5

0.0 5.6 2.5 0.2

32.9 18.8

57.8 71.2

9.3 10.0

51.0

43.8

5.2

Source: Instituto Nacional de Estadísticas, III Encuesta de Presupuestos Familiares, vol. 3, Santiago, May 1979. Note: Only includes those products that could be identified in the survey as “non-traditional” imports. Unless otherwise specified, includes consumption of domestic and imported goods.

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3 Effects of trade liberalization on manufacturing Evaluating the effects of import liberalization is a complex task. First, the effects were significantly different in each phase. Second, many other important changes took place simultaneously. On the one hand, there was a drop in aggregate demand, wages, and investment, and a rise in unemployment; these factors strongly influenced the nature of the adjustment process. On the other hand, export expansion, which began before the impact of liberalization was substantial (especially in 1974), contributed to the recovery of economic activity and offered opportunities for investment in the production of exportables. In this section, first, I examine the global changes in the industrial sector. In the second part, I try to progress to a disaggregated analysis by sectoral branches. (a) Macroeconomic effects Manufacturing production was drastically affected by the economic recession of 1975. That year, industrial output dropped by 26%, while GDP fell by 17%. As could be predicted, this meant that there was room for a subsequent intensive recovery. Actually, subsequently, the manufacturing sector exhibited high rates of “growth” from 1977 to 1979. Still, this was only a partial recovery. Moreover, it lost velocity in 1980 and fell off in 1981. Evidently, the invasion of imported consumer goods in 1980–1 played a crucial role in this outcome. By 1981, eight years after the neoliberal economic policy started to be implemented, industrial value-added per capita was 18.5% lower than in 1973. Table II.5 depicts the contrast between the evolution of the manufacturing sector in Chile and in developed and developing countries. This performance resulted in a notorious drop in the share of manufacturing in GDP, from 26% in 1970 to 20% in 1981. Finally, this deterioration was also revealed in industrial employment: since 1975 it remained markedly below that in 1970.14 This was caused, partly, by the diminished importance of labor-intensive industrial activities such as textiles and garments. There was also a drop in employment in areas where output increased but where value-added per unit of gross output decreased, which naturally resulted in a reduction in labor demand. Finally, without even having

14 Several studies assert that manufacturing was not affected negatively by trade liberalization. The causes of that contradictory conclusion, in sharp contrast with evidence, are: (i) the comparison is made with 1975, after the great fall of that year or (ii) the comparison centers on the eighties, disregarding that liberalization took place in the seventies and that tariff and exchange rate protection were reintroduced (though mildly) in the eighties.

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Table II.5 Manufacturing output: Chile and the world economy, 1974–82 (1973 ⫽ 100) Total value-added (VA) Year

1974 1975 1976 1977 1978 1979 1980 1981 1982

Chile

Industrialized countries (1)

Developing countries (2)

Chile (3)

Value-added per capita (4)

Industrial employment (5)

100.1 91.8 100.1 103.7 107.9 113.3 112.3 112.8 108.5

106.3 108.1 116.7 125.3 133.6 139.7 146.8 147.0 149.6

99.1 73.0 74.9 79.9 85.0 91.0 93.3 92.1 72.8

97.5 70.6 71.4 75.1 78.8 83.1 83.9 81.5 63.4

97.5 88.8 86.1 87.1 88.8 88.2 88.8 87.3 71.0

Source: For Chile, calculations based on central bank data, Jadresic (1986), and Marcel and Meller (1986). For developing and industrialized countries, United Nations, Monthly Bulletin of Statistics, May 1983.

recovered its 1973 or 1974 levels, the sector suffered another spectacular drop of 21% in 1982. Let us return to 1974.15 The actual level of industrial production in 1974 underestimates the actual productive capacity: a sharp contraction of aggregate demand had already begun in the second half of 1974 and was negatively affecting the annual level of output.16 The effect can be partially seen by observing that between October 1973 and September 1974, that is, during the first twelve-month period of the new government, industrial output was 3.4% higher than during the 1974 calendar year. From mid-1974 until 1981, the sector operated below its productive capacity and significantly below its historical trend. The gaps between actual and trend supply were caused by a series of events. Output losses in 1975 were due primarily to the contraction of aggregate demand, led by

15 The manufacturing value-added had expanded by 5.9% per year in the sixties. Nevertheless, the assertion that the industry had been “destroyed” by 1973 is disproved by the output performance immediately after the military coup. In general, there was not “destruction,” but growth did stop in 1971–3. The latter is one of the costs of macroeconomic imbalances and lack of discipline in those years. 16 There was a large drop in real wages in 1973 and 1974; the surveys conducted in January, April, and July 1974 by INE show that the average decrease was 16% compared to the same months in 1973. The decrease strongly influenced sectors that produced goods intensively demanded by middle- and low-income consumers. An outstanding example was that of the textile and clothing sectors.

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recessive external shocks.17 During the 1977–81 period, however, production responded principally to the changes in demand patterns induced by the across-the-board import liberalization with exchange rate appreciation, the concentration of income, and the drop in domestic investment as a result of a recessive and unstable macroeconomic environment and high outlier interest rates (Mizala, 1992; Agosin, 1998). In fact, negative pulls for imports de-substitution were significantly stronger than the positive pulls for specialization in some importables and export dynamism. It is undeniable that the specific way in which import liberalization was implemented contributed strongly to the overall poor performance of the industrial sector and of the entire Chilean economy between 1973 and 1981. The productive capacity of the sector was seriously damaged, and many firms needlessly went bankrupt; survivors, naturally, tended to be strong. Altogether, despite the evident need to reduce the average level and dispersion of effective import protection in 1973, the net balance appears to be overwhelmingly negative for manufacturing. Disaggregated data presented in the next subsection provide additional support for this assertion. (b) Effects on the structure of manufactured output The structure of industrial output changed significantly during the 1970s. To identify the impact of import liberalization more precisely, I now examine the behavior of the different production branches. The close relationship between the domestic industrial sector and foreign trade can be seen first in the global evolution of exports and imports of manufactured goods. Exports grew significantly from 1974 until they totaled 10% of the gross value of the sectoral output in 1981, while imports rose to 35%. The respective figures for 1969–70 were 3 and 17%. It is well known that in the real world the behavior of exports is not univocally tied in a unique way to import policy (see Bhagwati, 1978); in fact, export promotion can be fully consistent with a policy of selective import substitution, as the East Asian countries have demonstrated beyond any doubt. Consequently, the effects of import and export policies on domestic production can be analyzed separately. Information broken down into twenty-nine groups (ISIC, rev. 2, three digits) compares the 1969–70 average to 1978; that is, a year before the freezing of the exchange rate in 1979. The composition of consumption, 17 The contraction of aggregate demand was associated in part with a significant worsening of terms of trade beginning in the second half of 1974 (see Chapter V). The negative terms of trade shock was equivalent to 6.4% of GDP in 1975 compared to 1972. It must not be forgotten that this worsening followed a strong 5% improvement in 1973–4. In fact, during the first year in which the new economic policy was put to work, the copper price was extremely high. Nevertheless, the transitory high revenues were not saved but disbursed as they were received.

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output, and trade changed substantially during the decade (see Vergara, 1980). First, trade was dynamic in the sense that exports increased in sixteen groups while imports rose in eighteen; both imports and exports grew in ten of these groups, implying that, at three-digit information, there was intraindustrial specialization. There were drops in both output and consumption in seventeen branches. This suggests that domestic demand decisively influenced output in this period. At this level of disaggregation, many of the groups include goods whose production processes and marketing channels are quite diverse. Notwithstanding this heterogeneity, the data allow us to advance some conclusions (Vergara, 1980; Foxley, 1983, Chapter 3). First, only two groups show output growth that is associated with exports (wood and paper); in two other groups, exports play a significant role (food and industrial chemicals), even though their role is not as dominant as in the preceding groups.18 When the data are broken down still further, it can be shown that a large share of export expansion was concentrated in only five sectors: pulp and paper, wood, molybdenum oxide, fish meal, and semimanufactured copper. After a sizable diversification in the period 1974–6, the share of these products fell in 1976 to 58% of industrial exports, but in 1978 it rose to 64% and in 1981 to 66%. For imports, diversification was greater, as shown in section 2. This diversification is also reflected in the large number of groups for which imports became significant. Three branches were strongly affected by imports: electrical machinery, transport equipment, and professional equipment. In the first two groups, the rise in domestic demand ameliorated the negative impact of imports on output, while in the third group a receding domestic demand exacerbated the negative impact. In six groups, opening to trade together with a significant reduction in domestic demand led to a decline in output (textiles, clothing, leather, oil derivatives, pottery and china, and non-electrical machinery). In four other groups (footwear, printing and publishing, non-metallic minerals, and iron and steel), the determinant variable in declining output prior to 1978 seems to have been the decrease in domestic demand. Data on the other groups are more difficult to interpret, as the results depend largely on which years are compared and the methodology used to estimate the real change of each variable. As shown, the behavior of domestic demand had a determinant effect on the level of output. This effect makes it difficult to evaluate the impact of import liberalization, while depressed domestic demand contributed to increased exports of items in excess supply in the local market. Naturally, to the extent that domestic demand recovered subsequently, the relative weight of different variables changed; thus, after 1978 the effects of import 18 The main food products exported are fish meal and frozen seafood. The most important exported chemical substance is molybdenum oxide.

68

liberalization gained importance vis-à-vis aggregate demand as an explanatory factor of the poor performance of manufacturing. It was clear that by 1978 the effects of import liberalization had not yet been fully felt. At that stage, the growth of export quantum was losing speed, while imports, particularly of consumer goods, were rising quickly. This trend was at work in 1978 and 1979, before the nominal exchange rate was fixed. Subsequently, the sharp real appreciation of the peso that followed reinforced the lagged effects of import liberalization. The negative impact of non-traditional imports increased as compared to changes in domestic demand and the positive effects of exports. Aggregate demand became more import-intensive, the quantum of non-resource-based exports ceased growing in 1980, and imports (especially of consumer durables, as shown in Table II.3) rose in 1980–1 notably faster than in the previous two years. The sector had adjusted to foreign competition in three ways. Some went into bankruptcy or closed down plants. In other cases, firms began to specialize within the industry in two ways: merging with other firms and suspending lines of production within a firm. Finally, some firms also began to import goods that they marketed in place of those they had previously produced. Marketing imported products enabled firms affected by import liberalization to capitalize on the relative advantage they had because of their sales outlets and knowledge of demand. This adjustment mechanism had several interesting effects. First, in this case producing and importing were not independent functions but were managed by the same decision unit; thus, for a while foreign competition would be operating in a more limited fashion than is assumed by orthodox theory. Second, a larger share of firms leaned towards commercial and financial activities rather than producing goods. The extent of this bias is shown by changes in the composition of GDP recorded in the national accounts (see Chapter I, Table I.2). Third, the resulting growing current account deficit, which was created by the asymmetrical response of producers in sectors hurt by new trade policies and in sectors favored by them, was financed by an unsustainable increase in foreign debt. Fourth, although some producers defended themselves by switching to marketing imports, this change negatively influenced employment; in fact, productive employment decreased per unit of sales and even per unit of output.19

4 Towards an evaluation In these concluding remarks, I look first, briefly, at the global effects of trade policy on the balance of payments. Next some points are raised about the 19 This is a microeconomic increase in productivity. However, it has negative social and economic consequences (i) when it implies a greater reduction in employment than in production, instead of a greater increase in production than in employment, and (ii) when it takes place within a framework of widespread unemployment and worsened income distribution, as was the case.

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effects on the efficiency, dynamism, and competitiveness of the Chilean economy. (a) Balance of payments and the current account Practically all components of foreign trade expanded during the period under study, especially non-traditional imports and exports. The export quantum recorded a most dynamic behavior. After an abrupt jump and diversification in 1974–6, exports moderated their increase until 1980. Undoubtedly, exports became the dynamic productive sector of the Chilean economy. Actually, they recorded a remarkable 13.6% annual expansion in 1974–81. Exports even provided some dynamism to the highly depressed agricultural sector. But the net effect was limited since, after “enforcing discipline” in the rural sector in 1974, growth reached merely 2% between 1974 and 1981. The dynamic agricultural exports, consisting mainly of fruit and forestry products, shared the sector with traditional agriculture, which decreased spectacularly (especially in grains, sugar beet, and oil seeds). The expansion of imports was much larger than that of exports, leading to a growing trade deficit that increased markedly between 1976 and 1981. A component that deviated most from “normal” values was imports of equipment and machinery, whose share of total imports lost ten percentage points; they fell to merely 11% of imports, notwithstanding that the Chilean GDP growth was highly dependent on imported capital goods. The trade deficit was affected by the copper price,20 which recorded a level one-fifth lower than the “normal” or trend price.21 Nevertheless, foreign exchange proceeds from copper exports increased as a result of two factors. On the one hand, large investments made between 1967 and 1970, with long maturing lags, made it possible for copper output to increase by 50% immediately after “discipline” was imposed in 1973. On the other hand, the 1971 nationalization of the large mines allowed the government to capture a greater share of the economic rent derived from the rich Chilean copper deposits. These two positive effects were “permanent,” while the low price could be assumed to be “transitory.” A huge current account deficit in 1981 was covered with extraordinarily and unsustainably large capital inflows. These inflows, which were primarily directed to the private sector, not only financed the current account deficit but allowed a balance of payments surplus and the respective accumulation of international reserves (Table II.6). In the meantime, external debt was 20 A component that showed a notable change in the opposite direction was the price of molybdenum, a copper byproduct whose real price increased sixfold during the 1970s. The higher value of this export was equivalent to 46% of the increased expenditure on oil imports in the same period. See in Chapter VI, Box VI.1 for the role of molybdenum in the external accounts. 21 See an early methodological discussion on the “normal” or trend copper price in Ffrench-Davis (1973, Chapter IV).

70

Table II.6 Balance of payments, 1973–82 (1977 US$ millions)

I

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

Current account –441 1 Trade balance 32 Exports (fob) 1,968 Copper 1,577 Non-copper 391 Imports (fob) 1,936 2 Non-financial services –328 3 Financial services –165 4 Unrequited transfers 20

–256 434 2,612 1,971 641 2,179 –478 –225 13

–536 76 1,734 947 787 1,657 –313 –310 11

159 693 2,282 1,330 952 1,588 –212 –352 30

–551 34 2,185 1,161 1,024 2,151 –295 –365 75

–960 –376 2,171 1,076 1,096 2,547 –214 –432 62

–925 –276 2,984 1,469 1,515 3,260 –186 –525 62

–1,361 –527 3,250 1,467 1,782 3,777 –269 –642 78

–3,213 –1,817 2,605 1,180 1,425 4,422 –476 –994 74

–1,600 43 2,573 1,170 1,403 2,529 –385 –1,334 76

94 –163

305 –230

143 303

669 118

1,589 628

1,740 815

2,220 859

3,259 45

791 –809

II Net capital inflowsa III Balance of payments

507 65

Source: Calculations based on data from the Central Bank of Chile, Balanza de Pagos. Note: The figures were deflated by the IEP (see Ffrench-Davis, 1984). aIncludes errors and omissions.

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climbing fast, mostly devoted to finance consumption of imports (see Chapter III). Given the evolution of the sector, the authorities held on to two valid assertions, although with a faulty interpretation of their implications. It was stated that if the exchange rate were to be liberalized by the Central Bank the rate would strongly appreciate. This evidently would have happened, confirming that foreign exchange flexibility under a capital surge tends to exacerbate imbalances (see Chapter IX and Harberger, 1985). A lesser evil had been the fixing of the exchange rate at $39, but the most efficient policy would have been to moderate capital inflows and to manage a real devaluation in order to enhance a positive restructuring of production. The other weak point was the assumption that the excess of imports would slow down spontaneously. Slowing did tend to occur but with a significant lag. Additionally, since the exchange rate continued to appreciate until 1982, it stimulated a fast-rising expenditure increasingly intensive on imports, which crowded out domestic output and savings. These effects left indelible footprints on the Chilean economy over a prolonged time span. As underlined in Chapter III, the deficit on the current account of 21% of GDP in 1981 revealed an impressive and absolutely non-sustainable disequilibrium. (b) Efficiency, dynamism, and competition The theoretical foundation of import liberalization asserted that the market, free of government interference, would allocate resources according to a sort of unmistakably identifiable “comparative advantage.” Actually, market comparative advantages depend on the level and stability of the exchange rate, on the degree of activity in domestic and world markets, on international price fluctuations, and on many other factors (such as the availability of long-term funding, infrastructure, and trained labor). Additionally, market comparative advantages tend to diverge from social comparative advantages because of the disequilibria and distortions characteristic of developing economies; particularly relevant are the presence of severe unemployment and the obstacles to acquiring dynamic competitivity. The differences between the two can be striking, and highly costly, in a country facing a radical change in several economic policies, with high capital and labor unemployment, and inconsistencies among reforms, such as import liberalization and real exchange rate appreciation. (i) The macroeconomic framework and efficiency The efficiency of any economic policy depends on the context in which it is applied. The generally recessive domestic economic situation of this period was relatively conducive to export promotion, but on the other hand it increased the transition costs of import liberalization. Consequently, that macroeconomic and reforming environment would have required a trade opening led by export promotion, as East Asia had done, instead of the

72

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approach led by import liberalization, as Chile did in the 1970s and Latin America did in the 1990s (see Ffrench-Davis, 2006, Chapter IV). The expansion and diversification of exports provided an outlet for excess production that otherwise would not have had a market. In fact, the sharp contraction of domestic demand (in particular, during the period from mid1974 to 1976) left a significant share of industry with underutilized installed capacity. The prevailing depreciated exchange rate, the access to the Andean market, and the efforts of PROCHILE (the government export promotion agency) supplied a market abroad for many firms with excess capacity. Later, productive capacities were expanded, and non-traditional and traditional natural resources were exploited, enhanced by prior investment during the 1960s that developed the bases for the forestry, fruit, and fishing industries, and the accelerated liberalization of imported inputs. Dynamism was reversed in the early 1980s, when an overwhelming exchange rate appreciation induced a generalized drop of exports. In general, the expansion of non-copper exports promoted efficiency in the allocation of resources, principally through an increase in the rate of utilization of capital and labor, the exploitation of natural or acquired comparative advantages, and the generation of externalities. For imports, the situation was the opposite. In fact, if a trade liberalization process goes too far, is too rapid, or is undertaken at the wrong juncture, it will provoke premature and unnecessary plant shutdowns, the underutilization of capital and labor, and a decrease in investment. Therefore, to evaluate the effects on the Chilean economy we must distinguish between the different stages of the liberalization process and take into account the macroeconomic context in which it was implemented. In phase I, clearly redundant levels of protection were eliminated. But the first tariff reductions served to limit national producers’ capacity to set monopolistic prices. In a second stage (phases II and III), the additional tariff reductions, which lowered the maximum nominal protection from 120 to 10%, had a much greater effect. The most painful part of import liberalization was carried out rapidly, with misleading announcements, and its negative effects were reinforced by exchange rate revaluations. This policy was implemented during a time in which wages were deteriorated, domestic demand was very depressed, and open unemployment was remarkably high. First, wage repression acted as an artificial protection mechanism that, although it was obviously regressive, compensated for reduced tariffs on imports. In fact, in 1976 the ratio of indexes of wages/exchange rate was less than half that of 1970, and in 1979 it had recovered to only two-thirds (see Ffrench-Davis, 1981). Second, given the depth of recession, recovery rates for demand and production were bound to be high. Since tariff liberalization took place during recovery, a naive examination of the data may lead to the wrong conclusion that the liberalization process encouraged an output increase. As was

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73

demonstrated earlier, however, the opposite occurred. The implementation of free imports contributed to maintaining the recovery of domestic production at a level notably lower than that of the recovery of aggregate demand; output and aggregate demand became increasingly import intensive. The recession itself negatively affected the efficiency of the process. The underutilization of productive capacity and the extremely high real interest rates (averaging 38% between 1975 and 1982; see Chapter III) tended to raise the average cost of output to domestic producers, making it more difficult for them to face foreign competition. Third, high unemployment created a significant gap between market and social comparative advantage. Thus, the opportunity cost of resources freed by the sectors negatively affected by reform was lower than their market price. (ii) Dynamism and efficiency Here, the discussion will be confined to two interrelated points, concerning the investment ratio and asymmetry of adjustments, and “dynamic comparative advantages.” A remarkably low level of gross domestic investment contributed to an asymmetrical adjustment: strong negative pulls and weaker positive pulls. The widespread underutilization of installed capacity discouraged domestic investment (see Solimano, 1990; Agosin, 1998; Ffrench-Davis, 2006, Chapter III); the low investment ratio was also associated with the remarkably high real interest rates. It is obvious that resource reallocation is easier in an economy with a high rate of capacity utilization and dynamic growth. The stagnation exhibited by the domestic economy during this period made it necessary for many of the hurt sectors to reduce absolute output in order for the relative adjustment to take place. Limited sectoral and regional mobility of resources and the reduced rate of investment were obstacles to the effective reallocation of freed resources: it was predominantly the expansion achieved in the export sector that compensated, but quite partially, for the resulting lack of dynamism in the economy. As stated in Ffrench-Davis (1979), a growing share of the scarce domestic investment was channeled to the export sector. Investment was mainly concentrated in activities intensive in natural resources. It was less significant in products intensive in value-added and in “acquirable” comparative advantage. A reliable hypothesis is that it became easier to identify comparative advantages exhibiting a defined base of natural resources or already acquired. The countless changes taking place in the Chilean economy – depressed domestic demand, unstable and outlier interest and exchange rates, and incomplete strategic markets – made it difficult to identify the whereabouts of potentially acquirable comparative advantages. The diffuseness of comparative advantages was, presumably, one additional factor explaining the low actual investment ratio.

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(iii) Competition and efficiency One result the government expected from import liberalization was increased “competitiveness” in the domestic market. This would be achieved by means of the effective or virtual presence of foreign importables, which would put an upper limit on domestic prices. It is undeniable that this did happen to a significant degree. What also happened, however, was that there were important deviations from the types of relationships that were supposed to characterize a “competitive” economy. First, a significant proportion of non-traditional imports belonged to categories in which product differentiation played a decisive role. Consequently, competition among suppliers of these products was based on product differentiation to a larger degree than on pricing. The segmentation of the capital market (one example is the persistent gap between domestic and foreign interest rates) also introduced competition based on the terms of suppliers’ credit. These factors provoked effects quite distinct from those that “competition” should have generated according to orthodox theory. Second, marketing channels were not completely open to every competitor; for instance, in a number of cases the producer of import substitutes became an importer of “competitive” goods. Third, the abrupt-cum-appreciation trade opening promoted greater concentration in the ownership of domestic productive activities. This phenomenon was reinforced by the depression in aggregate demand and by the manner in which the capital market operated. These factors gave a significant advantage to economic groups that were linked to financial activities and had access to foreign credit. A crucial argument for free trade policy refers to the benefits that competition allegedly brings to consumers, with the availability of a wider variety of goods and lower prices. Within the framework of orthodox consumer theory, the opening to foreign trade is seen as positive because it allows demanders to equalize their marginal utility with the marginal cost of importing (which is assumed to be the same as the international price for a “small country”). The diversification of consumption is seen as welfare increasing, as it would increase the freedom of choice of consumers. Ceteris paribus this is perfectly true. However, it is relevant to add two comments, concerning the indirect effects on consumers in their role as producers and on equity. First, the “de-substitution” of imports during the adjustment process generated unemployment and delayed the recovery of overall economic activity. These discouraged investment, which in turn had a negative impact on the creation of new job opportunities. Therefore, low-income consumers (who suffered the highest levels of unemployment), in their roles as producers (workers), bore much higher costs than the contingent benefits derived from the diversification of the basket now available in the market to those with purchasing power. Depressed producers cannot perform as dynamic consumers.

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Second, the diversification of consumption enabled a small, high-income sector to rapidly adopt the consumption patterns of the well-off in the richest economies. The notorious increase in inequality that took place during these years (see Chapter VII) manifested itself in a noticeable differentiation of lifestyles rather than in higher savings rates and productive investment. The collapse in national savings supports this hypothesis (it dropped to 9.6% of GDP in 1981 and to 3.4% in 1982, in current prices).

5 Concluding remarks The Chilean experience left heterodox lessons. The national economy in 1973 had excessive effective protection for numerous import categories; therefore, a significant trade liberalization was required. However, trade liberalization was excessive and ill-timed; it was not coordinated with exchange rate and capital account policies, and disregarded the challenge of completing underdeveloped factor markets. A gradual procedure should have been adopted and a deliberate search for dynamic complementation between import substitution and export promotion should have been undertaken in the East Asian style. Positive export expansion would have been essentially consistent with a more pragmatic tariff policy than the one adopted. It could have involved a greater conversion of import substitutes into exportables, and a more diversified export basket that would have been more intensive in value-added. Consequently, a drastic dismantling of tariff protection, instead of a gradual and more comprehensive reform, including all ingredients for productive development, should not have been undertaken in a macroeconomic environment such as the one predominant in the Chilean economy. Supporters of the policy being implemented argued that if the policy had not been implemented so rapidly it would have been impossible to carry it out at all. The answer to this argument is threefold. First, it would have been better not to undertake tariff reductions as drastic as those performed from 1975 (covering phases II and III) rather than attempting to impose them amidst a depression, with high unemployment and low investment. As a consequence, the corresponding de-substitution of imports, predictably, was higher than naturally necessary, and therefore was inefficient in many cases. Neither excessive protection nor extreme liberalization was the appropriate solution. It is evident that “corner” solutions were not the optimal choice. Second, foreign exchange appreciation should not have been allowed during tariff liberalization. This misstep flagrantly contradicted the government’s repeated assertions. Third, developed or complete domestic markets for long-term financing, labor training and innovation were missing. These generated a real environment that differed substantially from the theoretical framework on which the arguments in favor of free trade were built.

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Finally, the conventional hypothesis that an unrestricted opening to imports would promote the expansion of labor-intensive tradables and result in a contraction of capital-intensive activities was contradicted by the characteristics of changes that occurred in the productive structure. This performance was directly linked to the richness and characteristics of natural resources, but also to the macroeconomic framework in which trade was liberalized, to the excessive intensity and lack of selectivity of the reform, and to the absence of a comprehensive development strategy.

III Domestic Financial Liberalization and External Debt in the 1970s: Building a Major Crisis*

The Chilean economy recorded great fluctuations in its economic activity during the period 1974–81 (see Foxley, 1983; Ramos, 1986; Edwards and Cox-Edwards, 1987). In all, GDP growth averaged 3% per year; a figure notably lower than the 5.6% recorded by Latin America in the 1970s. Note that in the year after the end of that period, 1982, the debt crisis brought a generalized recession in the region; it was particularly acute in Chile. It is extremely informative that the deepest recession in the entire region took place in a Chilean economy that had eliminated the fiscal deficit, privatized many public firms, sharply liberalized imports and the domestic capital markets, and was praised by international financial markets and institutions as a highly “successful” economy. The Chilean outcome shares causes and results with those of Mexico in the “tequila” crisis of 1995, and with the currency and debt crisis of Argentina in 1998–2002.1 The poor outcome had six relevant causes: (i) the rapid and indiscriminate import liberalization (especially of consumer goods); (ii) the exchange rate appreciation in combination with sharp reductions in effective protection; (iii) the persistence of high real interest rates on the domestic capital market; (iv) the overwhelming permissiveness resulting from the lack of regulation of financial institutions and capital flows; (v) the composition of inflows, with a minor share directly linked to productive investment, while the increase in debt was principally directed to consumer imported goods; and (vi) the difficulty of identifying comparative advantages in a macroeconomic environment with a large output gap and “wrong” macro-prices. * Partially based on “The external debt, financial liberalization, and crisis in Chile,” in M. Wionczek (ed.), Politics and Economics of External Debt Crisis: The Latin American Experience, Westview Press, Boulder and London, 1985. I gratefully acknowledge the comments of researchers at CIEPLAN, and those of Robert Devlin, Rudi Dornbusch, Jorge Marshall Silva, and Carlos Massad. I appreciate the assistance of José de Gregorio. 1 In Ffrench-Davis (2006, Chapter VII) an analysis of the crises of several LACs since the implementation of the “Washington Consensus” is made. 77

78 Building a Major Crisis

Finally, great vulnerability in the national economy was generated, which resulted in the severe crisis of 1982. In fact, in view of the passive and neutral domestic policies pursued, the authorities were left with weakened policy tools to deal with external stocks. Furthermore, growing indebtedness and the magnitude of the current account deficit obviously could not have been sustained, even had the international financial crisis not taken place. Consequently, the external sector was placed on a course that would inevitably call for a traumatic adjustment process. The seriousness of this situation was exacerbated, of course, by the fact that during the 1970s the domestic productive base had been weakened given extremely low investment ratios. In fact, the average gross investment ratio fell by almost one-fifth compared to the 1960s and the GDP growth rate diminished proportionally more. Section 1 starts with the official conceptual framework, then presents the main features of the financial liberalization process and the policies adopted. Section 2 presents the evolution of capital flows and external debt; special attention is given to bank loans and the behavior of capital flows received by private debtors. In section 3, the macroeconomic impact of external indebtedness is examined, especially the effects on liquidity and on exchange-rate policy, and the disequilibrating adjustment processes to which it gave rise. Section 4 analyzes the evolution of interest rates, stressing the persistent gap between domestic and foreign rates. In section 5, a discussion of the various sources of external vulnerability to which Chile was exposed as a result of its financial openness is made. I argue, contradicting the neoliberal approach, that the problems were concentrated in the private sector segment of the debt. I also attempt to explain why the massive financial inflows were accompanied by a drop in national savings and a decline in the average investment ratio. Finally, section 6 summarizes the lessons provided by the 1970s neoliberal experiment for capital account and financial markets management. All are quite relevant for the early twentyfirst century.

1 Financial liberalization and foreign indebtedness2 A full liberalization of the domestic financial market and a rather broad opening of the capital account were the official policy in Chile. This section presents the conceptual framework on which the financial opening was based and then examines the way in which the principles were implemented. Finally, the volume and composition of capital flows and external indebtedness are analyzed. 2 For more detailed analyses of domestic financial reforms in Chile, see Arellano (1983), Eyzaguirre (1988), Zahler (1988), and Fontaine (1989). A comparative analysis of Latin American cases in the 1970s and early 1980s is presented in Ffrench-Davis (1983a).

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(a) The analytical framework of the experiment There are of course some very sophisticated neoliberal versions of how the liberalization of capital markets should work and of its effects compared to those of so-called financial repression. The essential aspects of the official version can be conveyed by means of a very simple scheme, however. The liberalization of the domestic financial market and the opening up to capital flows sought to increase overall investment and to improve the allocation of resources. It was expected that there would be an increase in the volume of investment and its efficiency, which would provide the basis for vigorous and sustained economic growth. In simple terms, the conceptual framework may be described in Figure III.1. Curves O and D represent the supply of and demand for funds in the domestic market, which are identified with savings and investment, respectively. To begin with, there prevails a situation of “financial repression” in the sense that there are restrictions regarding the organization of new banks and the operations they can carry out, and there is extensive rationing of demand. Against this background, the authorities fix an interest rate (rc ) lower than the equilibrium rate for a closed economy (re ). This determines a volume of savings, Vc, and demand is rationed at the same level (for the sake of simplicity, it is assumed that initially there are no net capital inflows). The volume of savings and investment (Vc ) is less than that in a closed market situation with a free interest rate (Ve ). At the same time, some unprofitable investments are made, since rationing means that not all of

Interest rate r D

O

O1 re rf

Of

rc

Vc

Ve

Vf

Volume V

Figure III.1 Simple conventional framework of capital markets liberalization.

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the most efficient investments take place. Thus, some investments would have returns equal to rc, whereas others, with a higher yield, would remain without financing (in some of them, the return would exceed re, since total investment would be Vc ). Domestic financial liberalization would allow a rise of r to its local equilibrium, and savers would face more options for investing their funds. Given the broader variety of options, there would be a larger supply of national savings (O1, to the right of O) replacing the investment in nonproductive assets. On the other hand, the financial opening would allow capital inflows, which would complement the local funding for investment.3 A small economy, like Chile, would face a horizontal supply of external funding (Of).4 With free capital inflows, an investment volume of Vf > Ve and an equalization of the interest rate at rf would be reached. The national savings rate would rise, despite the lower interest rate, if the shift of supply were sufficiently strong, as in Figure III.1. This is a common assumption, explicit or implicit, in the neoliberal reforms of financial markets. The exchange rate policy is a determining factor in the final outcome. To reach an equalization of interest rates, there must be no expectations of variation in the real exchange rate (deflated by net inflation). Initially, this was sought through a crawling-peg policy of mini-devaluations. Subsequently, a fixed nominal rate was adopted in 1979. Official policy assumed that – in a free trade regime, such as was already at work in 1979, with a fiscal surplus and, supposedly, an exchange rate close to the “equilibrium level” – freezing the nominal exchange rate would rapidly prevent domestic inflation from exceeding external inflation. Consequently, the exchange rate would become the anchor for stabilizing the level of domestic prices. The authorities thus formally adopted the “monetary approach to the balance of payments,” with its neutral monetary policy. The official approach assumed that financial liberalization would work efficiently since capital flows were managed by private agents and mostly without official guarantees. Thus, capital inflows would take place only if the borrower expected a net return for its use that would exceed interest payments. It was said that the fast growth in the external debt that took place reflected a healthy economy (De la Cuadra, 1981, p. 1025) and private debt would not present any threat of insolvency. This problem would only arise in the case of public debt (Robichek, 1981, p. 172). 3 The relevant figure for the contribution of foreign capital to domestic capital formation refers to the net transfer of funds (NTF) – that is, the net capital inflow minus the rent of foreign capital. Domestic savings plus NTF ⫽ national savings plus net capital inflows ⫽ gross domestic investment. 4 See Harberger (1985) for the case of an upward sloping supply, associated with the “negative externality” resulting from rising liabilities of a small economy.

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A naive vision of the working of private institutions prevailed. Statements by the authorities that users knew how to distinguish between good and bad financial institutions were frequent. The evident fact is that prudential supervision was extremely lax in Chile.5 In all, the discrepancies between the official approach and the real world were very marked. The economic team expected that liberalization of the domestic financial market, in association with the gradual opening of the capital account, would lead to an increase in national savings. In parallel, the quality of investment would improve in response to the suppression of former subsidies, free interest rates, and the removal of discrimination among different borrowers. The volume of national savings and capital formation was less than Vc ; that is, instead of growing, ratios decreased sharply. As documented below, the domestic interest rate stood at unexpectedly high real levels, was quite unstable, and its average was spectacularly higher than international rates; terms were extremely short, mostly of thirty-days loans, with a negligible share of mid-term lending. Fixing the nominal exchange rate in 1979 led to a significant loss of purchasing power of the dollar price and to a growing external deficit. Private external indebtedness grew notably, encouraged by the risky assumption that its real cost would remain low and that there would continue to be easy access to loans in the future. Finally, the excessive indebtedness, with the correspondingly rising service, by financing competitive imports, weakened the productive system and the payments capacity instead of strengthening them. (b) The new institutional framework In this period, three subperiods may be distinguished with regard to the implementation of financial policies. The first ran from 1973 to 1975, when there were no substantial changes in the domestic financial system; banks nationalized under the previous regime remained under state control. On the other hand, varied measures undertaken in order to encourage foreign investment and foreign loans carried negligible net inflows. The second period began in 1975 with the drastic reform of the domestic financial system and the privatization of almost all commercial banks.6 In addition to freeing the interest rate, in 1975 the government eliminated the norms relating to quantitative controls of credit in domestic currency and the selectivity of bank reserve regulations, which were largely intended to channel funds into production rather than consumption. Moreover, 5 Interestingly, something similar occurred in industrial countries with a deregulation of loans to developing countries. See Valdés-Prieto (1989) on the relaxation of norms to facilitate the recycling of oil surpluses. 6 The largest commercial bank, the Banco del Estado, founded in 1953, remained public, but its market share fell from about half of the system by the early 1970s to 14% of outstanding loans in 1981.

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restrictions relating to maturity terms were removed (except for a general restriction of thirty days minimum). Next, a gradual uniformity was imposed on the different financing institutions for both the operations permitted and their relaxed regulations. The tendency towards uniform treatment also included foreign banks. Their activities had been restricted during the governments of presidents Frei and Allende. In December 1974, restrictions on their operation in Chile were lifted; in the same year, a permissive statute for foreign investment (Decree 600) was enacted. By 1982, there were nineteen foreign banks, though only covering 10% of outstanding loans. In respect of the capital account, liberalization was slower. This gradualism contrasted with the rather abrupt trade and domestic financial reforms. The gradual nature of the liberalization of controls on the size and terms of capital flows was meant to ensure control over money supply, which for several years played the principal role in anti-inflation policy. It was considered that, in view of the sizable difference between domestic and foreign interest rates, abrupt liberalization of the capital account would attract inflows in such a volume that it would endanger price stabilization. To control the size of inflows, several tools were applied: quotas on borrowing and guarantees that banks could grant were established, as well as quotas on the volume of foreign loans that could be sold monthly in the domestic foreign exchange market, and a reserve requirement on financial inflows (to inflows via article 14). Indeed, with the passage of time, the capital account was liberalized through releasing quantitative restrictions or replacing them with more flexible controls. In 1981, when the net use of foreign savings jumped to 21% of GDP,7 financial inflows (under article 14 of the law on foreign exchange operations) were subject to a minimum stay in the country of twenty-four months and the compulsory deposit of a percentage of the credit (10 or 15%, depending on the term) in the case of financial operations for less than sixty-six months. There were no special restrictions on the volume of credit that the banks could borrow abroad and lend in foreign currency in Chile, but there was still a limit on the guarantees they could grant. In all, there were heavy capital inflows, which grew rapidly between 1977 and 1981. The determining factors were the abundant international supply of funds, the low initial bank debt of Chile, the image of creditworthiness that Chile had been achieving, and the weakness of prudential regulations. The poor effectiveness of capital controls was due to numerous leakages or insufficiencies, including: (i) a climbing share of financial flows was dealt 7

Current account deficit in 1977 constant prices, with GDP converted to US dollars with the real RER of 1976–8. In current US dollars, the net use of foreign capital was 14.5% of GHDP, due to the abnormally increased value of GDP expressed in US dollars as a result of an extremely appreciated (outlier) exchange rate in 1981.

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away from banks (37% in 1976–81); (ii) only loans with terms under sixtysix months were subject to the reserve requirement, in an international environment in which the standard international financial loan exceeded that term; (iii) in loans under sixty-six months, the cost of the reserve requirement represented a negligible fraction of the huge spread between the domestic interest rate and the cost of external loans (see Table III.5); (iv) short-term trade credit was free to expand vigorously, duplicating their participation in a total debt that grew rapidly towards 1981. Finally, from late 1981 onward, despite the further liberalization of capital inflows, the supply shrank drastically, as a result of both the emergence of the international financial crisis and the late recognition by bank creditors of the excessive indebtedness of Chile. When the Mexican debt crisis officially exploded in August 1982, Chile already found itself amid a deep crisis. In fact, from the second half of 1981 on, GDP had been decreasing persistently (see Marcel and Meller, 1983). During 1982, the minimum term of twenty-four months was eliminated, the compulsory deposit was set at 5% of the foreign loan, which was a rate similar to the reserve requirement for domestic bank deposits, and capital outflows were liberalized.

2 Financial capital flows and indebtedness: volume, sources, and uses Capital flows grew rapidly from 1977 onward. Even though Chile recorded a large and growing current account deficit in the following years, net capital inflows were sufficient to allow a significant accumulation of international reserves until during 1981. This capital surge took place in a context of dynamic expansion of the external sector, especially of imports of consumer goods. Inflows were overwhelmingly concentrated in lending to the private sector with no state guarantee. FDI and loans to the public sector accounted for less than one-fifth of inflows. The government expected a vigorous inflow of FDI in response to the “economic and political system” that the dictatorship offered and to the new statute for foreign investment (Decree 600, of 1974). It was hoped that FDI would arrive to exploit the “comparative advantages” previously repressed, which the model was liberating. However, the response of FDI was disappointing for the expectations of the economic team. Actual inflows were rather low and concentrated in the last part of the period (see Lahera, 1981). On the other hand, a significant share of inflows corresponded to two components not involving direct creation of productive capacity. One corresponds to risk capital contributed by transnational banking branches and the other to the acquisition of firms or of packages of equity shares. Table III.1 shows several indicators of annual capital flows, expressed in constant prices. They increased significantly in the second half of the 1970s

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(col. 2). Columns 3 and 4 show that capital flows rose sharply as a share of gross domestic investment and GDP. This was partly a result of the relative stagnation of the latter two variables during the 1970s. Foreign savings (deficit on the current account) and the capital service also grew, with some ups and downs, in relation to exports (cols 5 and 6), in spite of the dynamic growth of the latter in the early years of the neoliberal experiment. The total debt service in 1982 amounted to 88% of exports of goods and services, that is, three times the average coefficient recorded in 1970–4. In short, the data show that from 1977 capital inflows captured a growing relative weight in the Chilean economy. The coefficients reflecting their incidence exhibit a debt-servicing burden substantially greater than for Latin America as a whole in the 1970s and early 1980s (Bacha and DíazAlejandro, 1983; Ffrench-Davis, 1983a).

Table III.1 Deficit on the current account and capital flows, 1970–82 Year

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

Balance on current account (1977 US$ millions) (1)

Gross inflow of loans (1977 US$ millions) (2)

External financing of investment (%) (3)

(4)

(5)

–166 –367 –690 –441 –256 –536 159 –551 –960 –925 –1,361 –3,214 –1,600

941 772 1,302 1,106 1,064 1,109 1,086 1,390 2,559 2,691 3,270 4,640 2,238

6.8 15.5 36.4 24.7 12.0 32.5 –11.4 34.1 50.9 42.2 51.2 108.1 87.2

1.4 2.8 5.4 3.6 2.1 5.0 –1.4 4.6 7.4 6.6 9.0 20.7 12.2

6.5 16.9 40.0 20.7 8.9 29.3 –6.5 22.5 38.5 27.3 36.8 103.2 53.4

External Export Debt-service financing deficit (%) coefficient to GDP (%) (%)

(6) 27.0 38.4 27.9 25.4 35.1 55.6 52.7 52.8 58.7 50.8 47.7 70.8 88.5

Source: Calculations based on Central Bank of Chile, Balanza de Pagos, Deuda Externa de Chile, and Cuentas Nacionales in 1977 pesos. Note: All nominal figures were deflated by the Index of External Prices (IEP; see Ffrench-Davis, 1984), in order to convert them into figures at 1977 prices. Column (3) measures the ratio between the deficit on the current account and gross fixed capital formation. Column (4) is the deficit on the current account as a share of GDP. Column (5) is the ratio between the deficit on current account and exports of goods and services. Column (6) entries are amortizations plus net interest payments as a share of exports of goods and services. For the conversion into US dollars of the figures for GDP and investment, which were originally in 1977 pesos, the average real exchange rate for the three-year period 1976–8 was used, expressed in 1977 pesos per US dollar of that year.

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Debt activity (as reflected by the volume of gross inflows and amortization payments) increased faster than net capital flows since the terms of the loans became shorter. This was a direct consequence of the increased share of private creditors in total debt and their shorter maturity terms. The magnitude reached by capital movements is reflected by the fact that, in the two-year period 1980–1, average gross inflows were equivalent to 24% of GDP. During the period under analysis, significant changes took place with regard to the agents (creditors and debtors) participating in capital flows. Among creditors, 84% of the external debt in 1981 was with banks and financial institutions, which had accounted for only 19% by 1974 (see Table III.2); in parallel, the nominal amount of debt with official institutions declined. This “privatization of creditors” was partly the result of greater use of the supply of foreign banks, which before 1977 had been scarcely used by Chile compared to other emerging economies. From then on, however, it rapidly grew-up. By 1982, Chile’s per capita bank debt exceeded US$1,000, compared to a regional average of US$600 and only about US$500 in the case of Brazil. On the other hand, Chile’s bank debt increased by 57% per year between 1977 and 1981, compared to an average of 28% for developing countries. With regard to debtors, after 1975 the growing net inflows were received mostly by the private sector, while the government moved towards a budget surplus and amortized its external debt. This situation was in line with a deliberate policy of reducing state participation. This was facilitated by the Table III.2 Total foreign debt and private financial creditors, 1974–82 Financial institutions Year

1974 1975 1976 1977 1978 1979 1980 1981 1982

Total debt (US$ millions) (1)

US$ millions (2)

Share in total (%) (3)

4,776 5,453 5,392 5,763 7,153 8,790 11,325 15,700 17,263

923 1,352 1,506 2,144 3,723 5,885 8,579 13,169 14,986

19.3 24.8 27.9 37.2 52.0 67.0 75.8 83.8 86.8

Source: Central Bank of Chile, Deuda Externa de Chile, 1982, August 1983, Tables 1, 3, and 11. Note: Total debt refers to the disbursed outstanding stock at year-end. In addition to the traditional foreign debt, it includes liabilities in national currency, liabilities with the IMF, and short-term debt contracted by sectors other than the monetary system, with the exception of direct foreign-trade operations.

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change that took place in international markets: the loss of weight on the part of official financial institutions, which operated mostly with governments; and the vigorous emergence of private international capital markets, which offered access to both public and private debtors. Table III.3 shows the composition of total outstanding foreign debt of public and private borrowers. Since international reserves grew steadily until 1981, part of the debt was not absorbed in the economy. I distinguish between total “gross debt” and “net debt” (the share used to finance the deficit on the current account). This has implications for determining the sectoral origin of the macroeconomic disequilibrium that Chile experienced and the effects of external debt on domestic purchasing power. An estimate of the net impact of capital flows is shown in columns 3 and 4 of Table III.3, which present the total debt minus the international reserves of the respective sectors. As the accumulation of assets was concentrated in the public sector (central bank), from 1975 up to 1981 this was reflected in a substantial reduction in its net liabilities. In the case of the private sector, in contrast, net indebtedness grew very rapidly, multiplying by thirteen between 1974 and 1981. It should be noted that most of the private debt was contracted without state guarantee. Thus, in 1981 almost two-thirds of Chile’s total debt lacked an official guarantee (see Chapter IV, Table IV.1). That high share could have constituted a decisive bargaining factor in the renegotiations of the external debt. Table III.3 Public and private net foreign debt, 1973–82 (US$ millions) Gross debt Year

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

Net debt

Public sector (1)

Private sector (2)

Public sector (3)

Private sector (4)

3,276 3,896 4,426 4,252 4,319 4,858 5,018 4,905 5,145 5,892

786 879 1,027 1,140 1,444 2,295 3,772 6,426 10,561 11,371

3,063 3,709 4,252 3,718 3,763 3,648 2,882 1,569 1,878 3,866

716 773 931 1,016 1,339 2,147 3,053 5,986 9,761 10,586

Private sector share in net debt (%) (5) 18.9 7.2 18.0 21.5 26.2 37.0 54.9 79.2 83.9 73.2

Sources: Calculations based on IMF, International Financial Statistics Yearbook, 1982; Central Bank of Chile, Boletín Mensual, and Deuda Externa de Chile. Note: Column (1) excludes state-guaranteed private debt and debt contracted by the Banco del Estado. Column (2) includes private debt, state-guaranteed debt, and debt contracted by the Banco del Estado. Columns (3) and (4) represent the gross debt minus the international reserves of the central bank and the financial system, respectively. For measuring reserves, holdings of gold were valued at a constant real price of US$42,222 per ounce of fine gold, base 1977.

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With regard to the intermediaries, up to 1977 a significant share of the private sector debt had been borrowed directly abroad, because of quantitative restrictions faced by domestic banks. Two qualifications should be posed, however. On the one hand, the segment of the non-financial private sector with most access to inflows was that with the closest connections to national and foreign banking institutions. On the other hand, a substantial share of these loans had bank guarantees. From 1978 onward, the domestic financial sector gained greater importance in the direct intermediation of external private financing. Table III.4 provides details on liabilities under the main channel of financial inflows (the so-called article 14). Private borrowers captured 97% of gross inflows in 1976–81. The official figures for the real net outstanding debt showed a reduction over the five-year period 1976–80: it decreased from US$5.3 billion in 1975 to US$4.3 billion in 1980 (in 1977 dollars). Two external factors explained this decline in contrast with high annual inflows in current dollars. The main factor was the rate of international inflation, which eroded the real value of the debt stock; second, net debt also decreased in response to the rise in the value of international reserves maintained in gold. These two factors explain a drop of US$2.7 billion in real net debt during the five years (see Ffrench-Davis and Arellano, 1981). Thus, instead of having decreased by 18% in real terms, the debt would have grown by one-third and would have shown a sharp acceleration toward the end of that period in the absence of these two factors. Actually, in 1981 there was an additional increase in debt that was spectacular in both nominal and real terms. It was therefore clear Table III.4 Gross annual flows of loans, by debtors, 1976–82 Breakdown (%) Private non-financial sector Year

Total flows Public (US$ millions) sector (1) (2)

1976 1977 1978 1979 1980 1981 1982

263 336 780 1,245 2,504 4,517 1,771

13.3 13.2 4.2 1.8 3.1 1.9 24.4

1976–81

9,645

3.1

Nonguaranteed (3)

31.0 34.7 14.5 20.6 24.7

Guaranteed (4) 86.3 80.1 57.0 56.3 32.1 25.2 30.8 37.2

26.0 21.6 17.6 4.6 6.1

Domestic financial institutions (5) 0.4 6.7 38.8 41.9 64.8 72.9 44.8 59.8

Source: Based on data from Central Bank of Chile, “Créditos Liquidados Artículo 14,” December 1980; and Boletín Mensual, No. 662, April 1983. Note: Column (1) shows the gross annual flow of disbursed loans minus compulsory deposits. The breakdown over cols (2) through (5) was estimated on the basis of that for Santiago.

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that the rapid growth of external indebtedness was generating macroeconomic vulnerability as well as was being harmful to national development, as is shown later (see also Chapter II). Nevertheless, the government insisted right up to the end that “borrowing abroad was good business” because the real interest rate was very low or negative; furthermore, debtors were in the private sector, which was subject to “free market laws” so that, in the official view, there could be no doubt that borrowing was efficient. A major share of foreign loans was used to finance consumption by the private sector. In fact, about three-fourths of the net debt rise in 1977–82 was used to increase the import/GDP coefficient of the Chilean economy (see Ffrench-Davis and De Gregorio, 1987). The massive net inflows, also, encouraged the excessive exchange rate appreciation and contributed to sustain it for several years. In fact, if the supply of inflows had been weaker, the government would have been forced to moderate the tariff liberalization and/or the exchange rate appreciation. Indeed, the loans available to Chile were larger than could be absorbed productively. In contrast to other countries, which channeled external financing into investment, Chile, instead of having a “debt-led economic growth” (as in Brazil), incurred a “debt-led deficit on current account,” with a crowding-out of savings and domestic output (particularly manufactures and investment in tradables) by climbing imports of consumer goods. The growing and unsustainable external gap made a future downward adjustment unavoidable. It is interesting to highlight two contrasts, one positive and one negative, between Chile and other LACs. On the one hand, capital flight was rather minor in Chile (Arellano and Ramos, 1987), while in Argentina and Venezuela it was notably high (Frenkel, 1983); in fact, in these two countries, in parallel with inflows, substantial outflows were recorded. On the other hand, the investment ratio was low in Chile, while Brazil and Colombia exhibited significant productive capital formation as a consequence of more efficient absorption of foreign resources (see Bacha and Díaz-Alejandro, 1983; Perry and Junguito, 1983).

3 Indebtedness and macroeconomic adjustment The massive process of external indebtedness between 1977 and 1981 had significant effects in many areas of the national economy. The process profoundly affected aggregate demand and its composition, contributed to the spectacular concentration of wealth (see Chapter VII), considerably altered the functioning of the savings/investment process, and conditioned to a crucial extent the management of monetary and exchange rate policies. The initial impact of external indebtedness involved an increase in the availability of foreign exchange. This gave rise to two possibilities. One was an increase in international reserves, which is usually accompanied by a rise in the money supply; the other consisted of an expansion of the

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current account deficit. In practice, up to 1981, the growing indebtedness manifested itself in both ways, since net capital inflows were larger than the capacity to absorb them, notwithstanding that the current account deficit steadily increased by considerable amounts. In 1980, net use of foreign capital was the equivalent of 9% of GDP, in contrast with an average of 5% for Latin America. The difference between inflows received and those used gave rise to the increase in international reserves registered, which in 1980 represented 68% of annual imports of goods. Additionally, in 1981, both the debt stock and the deficit on current account experienced sharp jumps, with a drop in the reserves/imports ratio. The rapid building-up of reserves until 1980 had substantial effects on monetary and foreign exchange policies. They contributed, evidently, to the recovery of economic activity, thus reducing the large recessive output gap that emerged in the crisis of 1975; however, in parallel, other macroeconomic disequilibria were being built. Furthermore, the huge capital inflows meant that a large share of the total credit available in the domestic economy had originated from foreign sources. (a) Monetary policy, inflows, and the crowding-out of domestic credit From 1975 onward, net purchases of foreign exchange by the central bank represented the main source of expansion of the money supply: in the threeyear period 1978–80, these operations represented more than 100% of the total high-powered money issued (Ffrench-Davis and Arellano, 1981, Table 13). As noted, the overwhelming share of net purchases of foreign exchange by the central bank came from the private sector. Indeed, in some years foreign exchange operations with the public sector even had a contractive effect. This situation continued until 1981, when the severe macroeconomic imbalances that had been building in the Chilean economy started to emerge openly and the loss of international reserves began. Correspondingly, the monetary effect of foreign exchange operations became markedly restrictive in 1981. As indicated in section 1, during certain periods direct restrictions on capital inflows were imposed as an instrument of monetary control. This limitation was enforced – with successive modifications in the maximum amounts of foreign exchange operations authorized – in September 1977 and was held up to April 1980. These restrictions were not sufficient to keep inflows to the private sector down to a volume consistent with the monetary expansion desired by the economic authorities. Consequently, the latter took action on the other sources of money issue and on the exchange rate. In both cases, there was a crowding-out of the domestic economy by the sectors associated with foreign financing. In fact, domestic credit to banks was restricted in the face of the increase in high-powered money. The exchange rate, for its part, was revalued (see point (b) of this section) in response to

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the accumulation of reserves, and concerned with the stubbornness of inflationary pressures. As a consequence, there was a significant crowding-out of domestic producers of tradables. Quotas in the expansion of liquidity remained in force as long as the closed economy monetary approach predominated. Subsequently, with the adoption of the open economy monetary approach, the nominal exchange rate was frozen, and a “neutral” monetary policy was explicitly adopted. Thus, changes in the international reserves were to be the determining factor of liquidity of the domestic economy against the background of a balanced fiscal budget (actually, a surplus) and stable low bank reserve requirements. Interest rates fluctuated freely according to financial market forces. The monetary approach to the balance of payments survived until mid1982. During the last year in which it was in force, a contractive “automatic adjustment” did operate, with disastrous effects on employment and output (see Chapter IV). (b) Foreign exchange policy: instability and appreciation8 In October 1973, a second experience with a crawling-peg regime was adopted (the first experience in 1965–70 is briefly described in Box III.1). Both experiences involved frequent small adjustments of the nominal price of the dollar, lasted more than five years, and were established during periods of acute balance of payments difficulties and sizable inflation rates. However, they differed with respect to the political environment in which they were implemented and the role assigned to the exchange rate, the stability of the policy, and the criteria used to determine modifications of the real exchange rate (RER). In this second experience, initially, the authorities sought to return the ER to the purchasing power parity of 1970, and to compensate for significant import liberalization. But subsequently they were strongly influenced by changes in gross reserves, and the ER became more a monetary policy tool than a resource allocator. Finally, the ER was used as the main instrument regulating inflationary expectations and as anchor for tradable prices, rather than as a signal for resource allocation and determinant of sustainable current account balances. The changing role of the ER – the changes in policy priorities and in the analytical approach – meant large fluctuations in the RER.9 8

A detailed analysis of foreign exchange policies between 1965 and 1982 can be found in Ffrench-Davis (1981). 9 By RER, I mean the nominal exchange rate divided by an index of domestic prices and multiplied by one of external inflation. Since Chilean trade was diversifying and price relations and exchange rates among the country’s main trading partners had changed notoriously, we built a weighted index of external inflation faced by Chile that reflects these phenomena (see Ffrench-Davis, 1973, Appendix I; Ffrench-Davis, 1984).

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In a first stage, between October 1973 and 1976, the main rate, of the then multiple rates, experienced a 38% real depreciation between the average of 1974 and January 1976. The devaluation was directly associated with a depressed copper price and a worsened current account. Real devaluation compensated approximately for the average fall in nominal restrictions on imports during those years, and both factors combined to enhance the competitiveness of exports. By early 1976, a growing balance of payments surplus (owing to the external credit boom experienced by Chile since 1976) and a rising monthly rate of inflation (to levels between 11 and 15% per month) invited a change in the trend of the RER. Thus, it began a second stage, with a substantial modification in the role of the exchange rate, associated with its impact over inflation. The main features of this second phase, which covered the period up to February 1978, were the daily frequency of mini-devaluations, according to schedules (tablas) announced monthly, and a series of abrupt exchange rate revaluations. Immediately, the real rate started to appreciate rapidly, losing 14% in five months up to June. In this same period, import liberalization became more effective because tariff reductions already faced a clearly fading redundancy. Now liberalization came together with RER appreciation, rather than the reverse as the authorities had repeatedly announced. Then an abrupt revaluation of 10% took place in June 1976, when the policy change was made official. This was a notorious change in the policy, and caught public attention not so much because of its intrinsic economic effects but because of the conditions and arguments that surrounded it. The minister argued that: (i) in 1975 the ER had increased faster than domestic prices, producing an “unrealistic” ER that was not sustainable in the long run; (ii) the new parity would be adjusted systematically because its new level was realistic; (iii) the new system would allow the exporter to work with certainty; (iv) the revaluation would reduce industrial costs and inflation from July onward, thus, he asserted, increasing real wages; (v) imports and economic activity would be fostered by revaluation; and (vi) money expansion originating in net reserve purchases by the central bank would be reduced.10 The decision to revalue can be traced to a combination of factors. First, the monthly rate of inflation had been rising, complicated by a slow recovery from the downswing in economic activity in 1975, and open unemployment was at a very high level. It appeared that a spectacular event was needed to ensure the survival of the drastic orthodox policies being enforced, since economic policy was under heavy attack from government supporters; criticism from the opposition was not allowed by the dictatorship. Second, the purely 10

Speech of the Minister of Finance, in DIPRES (1978, pp. 261–2). About 80% of the changes in high-powered money had been originating in the net purchase of reserves.

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Box III.1 The “crawling” exchange rate: a pioneer reform in 1965–70* Chile was a pioneer in implementing an exchange rate (ER) policy belonging to the family of crawling peg approaches. It happened between April 1965 and July 1970, making Chile the first country to implement a policy of this nature systematically. After Chile, Colombia and Brazil implemented similar policies in 1967 and 1968, respectively (see Williamson, 1981). The policy was conducted by the central bank in coordination with the Treasury. The policy selection was influenced by several factors. First, it was believed that both the nominal peg and totally free rates – the two corner solutions that were then in fashion in the literature – had a negative impact on macroeconomic stability and on resource allocation. The purpose was to have a reasonably stable real exchange rate (RER), without large jumps, in order to provide better allocative signals and avoid speculative capital gains and sharp shocks to the domestic economy. Second, the authority intended to limit the transmission of copper price instability to the domestic economy. It was necessary to ensure that government expenditure was guided by a “normal” copper price. This was done through annual agreements between the central bank and the Treasury on the use of the tax revenue from large copper producers; by using an account in dollars in the Central Bank where the “excess” revenues were deposited and sterilized abroad. This was the “informal” birth of the Copper Buffer Fund, created two decades later. In spite of facing intense appreciation pressures, the economic authority resisted them successfully. In fact, in the period 1965–70, a persistent stability of the RER was achieved, with some real devaluation associated with a gradual program of rationalization in import restrictions. The Frei Montalva government wanted to pursue in a more efficient fashion the substitution of imports and to expand and diversify exports, with stable incentives. The main variable guiding the nominal ER adjustments was the expected rate of domestic inflation. It was the purpose of the authorities to achieve a real devaluation: first, because there was a desire to reduce the upward trend of the previous decade in foreign indebtedness; and, second, because the average level of protection for import substitutes was to be reduced gradually, thus requiring a compensatory adjustment in the ER. The real rate was devalued by about 25% during the more than five years that the policy lasted. Two episodes illustrate the quality of the exchange rate reform. In 1967, the authorities foresaw early a balance of payments imbalance, to

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which they responded with a reduction in fiscal expenditure and a faster devaluation (with more frequent adjustments). This conjuncture had removed the ER from its former role as a main expectations destabilizer during critical situations. Second, because of a higher price for the main export of Chile (copper, which represented about two-thirds of total exports) and an increase in the share of the economic rent accruing to the government, the balance of payments showed sizable surpluses from 1968 onward. This also induced an increase in short-term capital inflows into a “successful” emerging economy. The inflows were fostered by the larger reserves, and relatively tight domestic credit. Obviously, strong pressures were exerted on the government in order to freeze the ER. But the economic authorities managed to retain the real devaluation achieved in 1967–8 and to enlarge it by continuing to crawl nearly pari passu with the rate of domestic inflation; thus external inflation provided a positive differential. In summary, given available policy tools, in 1965–70 public policy searched for stability in the RER rather than in reserves, (i) because of its direct allocative effect, particularly with regard to exports; (ii) because of the fear of ratchet price effects if the ER started following transitory changes in the terms of trade or capital flows; and (iii) because of the belief that the actual price of copper was above its “normal” level and would fall drastically at some time in the future, as it did by mid-1970.

*Based on R. Ffrench-Davis, “Exchange rate policies in Chile: the experience with the crawling peg”, in J. Williamson (ed.), The Crawling Peg: Past Performance and Future Prospects, Macmillan, London, 1981. monetarist approach to stabilization (à la Friedman) had been weakened by the negative experience with the dynamics of inflation in previous months (Foxley, 1983). Thus, the emphasis was placed on the anti-inflationary effect that a widely announced revaluation could exert via expectations.11 The fact is that all the weight of the government-controlled mass media was put into promoting the newly announced policy. The revaluation 11 The orthodox closed economy monetarist approach to inflation that had prevailed until mid-1976 was questioned by the emergence of an open economy monetarist approach, to which most official economists seemed to have been converted rapidly. Nonetheless, the latter approach took the lead only in 1979 when the nominal ER was pegged. It is curious that economists who in the previous period had stated that if the money supply was held constant the ER would have no effect on the price level later argued that the ER determines the price level. Trade liberalization did not justify such an extreme change of approach. Thus, we witness, once again, the role of fashion in economics at the expense of pragmatism.

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actually did change expectations, reducing the monthly rate of inflation to 6% in August and September; but it stagnated at that level for two quarters. The minister of finance announced in March 1977 a new revaluation of 10%, with the set of mini-devaluations fixed at 4 and 3% per month, for March and April, respectively. This was to be followed, again, by adjustments according to the rate of inflation in the preceding month. Most of the arguments provided by the government were the same as those given for the first revaluation, though with more emphasis on the assertion that exports (except for “marginal” ones) would hardly be affected because the ER “was 20% above October 1973.”12 The rate of inflation was indeed reduced to 3 or 4% a month, but it again stagnated at the new level. The drop of inflation, led by revaluations, implied a sharp real appreciation. Most of the real devaluation recorded in 1973–5 was reverted in this period, notwithstanding the deep tariff liberalization. The phase ended in February 1978 when the monthly schedule was replaced with a daily schedule for the rest of the year. The formula used in the previous biennium, based on a nominal ER dependent on previous inflation, was replaced with a schedule, determined by the annual inflation target. The policy change considered decreasing devaluation adjustments, starting with 2.5% (roughly the official rate of inflation in the previous three months) and ending with 0.75% for December. The Minister declared that “given the excellent balance of payments situation, the opening to foreign trade and the announcement of the exchange rate for 1978, competitive imports would rapidly enter if prices of domestic products were increased excessively,” and that “the government is providing the foundations, so that 1979 will mark the start of a period of unprecedented price stability.”13 On this occasion, the content of the official announcement, and of conferences and interviews of several government representatives, gave the impression that, more than the regulation of expectations, the crucial factor was the belief that the economy was already so open that the law of one price would apply.14 Domestic inflation, measured by the official CPI, fell from 64% in 1977 to 30% in 1978 (from 84 to 37%, according to the corrected CPI). This apparent success led to the adoption of the same approach for the following year. In December 1978, a schedule of daily adjustments was announced for 1979. 12 Speech of the Minister of Finance, March 1977, in DIPRES (1978, pp. 308–9). The official figure clearly overestimated the RER. See Table II.2. Recall that the official CPI systematically underestimated actual inflation. 13 Speech of the Minister of Finance, February 1978, in DIPRES (1978, pp. 369–71). 14 This law implies that domestic and external prices of tradables, corrected by tariffs and ER, are equal. As a result, it is argued that in a small country domestic prices cannot change except through tariffs or ER changes. According to the extreme view, prices of non-tradables similarly have no autonomy because they are determined by their interrelation with tradables through goods and factors markets.

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The compound annual rate of devaluation to be implemented was 14.7%, similar to the rate of inflation that had been announced informally as the rate expected for 1979. No account was taken of either external inflation (which was over 14% per annum in 1978–9) or the declining gap between effective and potential GDP. If it was to be true that the law of one price applied, exchange rate policy would clearly lead to inflation above 15%. It is possible that the economic authorities were still in transition from an expectations theory to a law of one price approach. The fact is that during the first half of 1979, instead of decreasing, inflation began to rise. In the twelve-month period ending in June, inflation reached 35%. This last phase ended abruptly in June 1979 with the freezing of the ER at a level 5.7% above the price prevailing then; the new level anticipated the schedule for the end of the year. By mid-1979, after almost six years of several policy variants and oscillations of the RER, the rate was at a level close to that established at the outset. However, during the process import restrictions had been drastically reduced: most non-tariff obstacles disappeared, and tariffs were reduced from an (unweighted) average of 94% to a flat 10%. Additionally, the nominal ER was fixed in the context of a 35% inflation trend. The ER remained pegged at 39 pesos per US dollar up to mid-1982. Annual domestic inflation decreased from 35% to close to zero, but during the transition between both dates the RER had appreciated by one-third. As a result, given the pegged nominal rate, in order to return to the June 1979 level of RER, apparently estimated as one of equilibrium by authorities (McKinnon, 1981, p. 34), a domestic inflation 30 points lower than the external one was required. That was evidently out of touch, given the severe problems that a large deflation poses for financial markets.15 An initiative to accelerate the adjustment process, through a legal reduction of nominal wages, could not be imposed by the economic team. In fact, after some months of the so-called automatic adjustment, the outcome was disastrous. Unemployment increased sharply and a rapid fall in manufacturing output occurred.16 The end of the fixed exchange rate came when an abrupt devaluation of 18% was applied in June 1982, followed by a series of successive policy changes. In short, since the mid-1970s, huge financial inflows were crucial to allow diverse exchange rate approaches other than those of efficient resource

15 The wholesale price index fell by 8% between May 1981 and May 1982, while the CPI declined by 1% between February and May 1982. On the other hand, international markets exhibited negative inflation as well: the external price index fell by 4% in the first half of 1982 as a result of a US dollar revaluation. 16 Open unemployment (excluding public emergency programs) grew from 11 to 23% of the labor force between September 1981 and June 1982. The value-added by manufacturing fell by 21% in 1982.

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allocation; in the process, rising inflows over-financed a climbing deficit on current account. The use of the exchange rate to guide expectations (in 1976–9) and/or to anchor domestic prices (1979–82) did indeed result in lower inflation. Nevertheless, inflation persistently decreased more slowly than expected by the government. The exchange rate was used as a variable to repress inflation, appreciating the peso during the process. This, together with import liberalization and the recovery in economic activity recorded between 1977 and 1981, led to an unsustainable current account deficit.17 At the same time, the gradual real exchange rate appreciation reduced the cost of external indebtedness vis-à-vis domestic loans. Consequently, the flows were encouraged by the evolution of the real exchange rate, enhancing the growing current account deficit and the surplus on the capital account, in a pro-cyclical behavior. (c) Worsening of portfolios and prudential supervision External indebtedness contributed to a domestic credit boom. Total availability of funding was expanded by non-guaranteed (col. 3 in Table III.4, above) and guaranteed (col. 4) direct foreign loans, and external loans intermediated by local banks (col. 5). The rest of lending by domestic banks was based on the liquidity generated by foreign exchange operations with the corresponding accumulation of international reserves by the central bank. The credit expansion took place in an environment of lax prudential regulation and supervision.18 As said, loans to related parties grew at an accelerated pace; most of them without effective guarantees. To avoid the prevailing regulations, debtors made use of cross credits and turned to dummy firms as well as operating from offshore institutions. In the face of high domestic interest rates, banks renewed the principal and granted new loans with the objective

17 The increase in the deficit was also associated with the rise in interest rates and the deterioration of the copper price. With regard to this latter item, the smaller fiscal income from this source in 1981, compared to the average for 1960–70, was equivalent to 0.7% of the 1981 GDP. The current figures on fiscal income contributed by the large copper mining industry have been deflated by the external price index. The deterioration in the copper price was partly compensated for by the improvement in the price of molybdenum, a rise in copper output, and the capture of the economic rent of the copper deposits for Chile due to the nationalization of these activities in 1966, 1969, and 1971 (see Ffrench-Davis and Tironi, 1974). 18 The permissiveness of banking regulation and supervision, and the absence of public guarantees to deposits, rested on the assumption that self-regulation would work together with the capacity of bank depositors to distinguish between the quality of different banks; irresponsible and risky banks would be rejected by the public. Consistently with this view, the authorities repeated systematically that no private loses would be financed by the state. However, after the intervention of a bankrupt bank, in 1977, a guarantee was established on deposits in domestic currency up to the equivalent of nearly US$3,000 (Held and Jimenez, 2001).

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of being paid interest commitments (or the capitalization of interest); between 1976 and 1981, the outstanding stock of bank lending rose 38% annually in real terms. Non-performing loans seemed to be low, and the banking system exhibited high real profitability on capital and reserves, on the order of 17% in 1978–80. Seemingly, for the government and diverse analysts, the market was working fluently and without menacing risks. Meanwhile, provisioning for risky portfolios, both total and individual, was low. In 1979, total provisioning was reduced from 2% of loans to 0.75%, and it was stated that priority would be given to individual provisions but without implementing the latter. When the banking crisis exploded in January 1983, it appeared that 19% of outstanding loans in 1982 had been made to related parties and represented 249% of the capital and reserves of domestic private banks. The deep weaknesses of the financial system as a result of the neoliberal reforms became evident in the following year, with enormous economic and fiscal costs mounting to nearly one-third of an annual GDP (Sanhueza, 1999; Held and Jiménez, 2001).

4 Interest-rate differentials Policymakers expected that the market, once freed from public intervention, would achieve equalization of domestic and external interest rates, an integrated financial market, and increased investment and its efficiency. As shown in Table III.5, despite the huge volume of inflows, the outcome was different: (i) there were persistent gaps between domestic and external rates of up to over twenty percentage points annually, even in 1980–1 when huge capital inflows were recorded; (ii) in the domestic market, the spread between lending interest rates and passive rates (deposits) was around fifteen points; (iii) the nominal and real rates were extremely unstable, as were the mentioned spreads; (iv) consumer loans expanded, predominantly for imported consumer goods; and (v) the high cost of credit, its instability, and the short maturities (mainly thirty days) discouraged productive investment. What non-speculative investment could pay real interest rates with annual averages of 38%? It may be noted that the ex-post gap between the domestic and external rates for loans never dropped below eighteen percentage points per year. In this respect, the traditional explanation that the differential was due to expectations of a higher devaluation than the effective evolution of the official exchange rate does not appear to have been valid. For example, between 1977 and 1982 the parallel or black market rate was very similar to the official rate. The easy access to the foreign exchange market that existed at that time and the spot nature of the parallel rate do not make it a precise indicator with regard to expectations of devaluation over twentyfour months, which was the minimum term for the entry of capital under article 14, but they do reflect the prevailing atmosphere of a relaxed foreign

98 Building a Major Crisis Table III.5 Domestic and external real interest rates in pesos, 1975–82 (annual percentage rates) Year

Domestic (1)

External (2)

Differential (3)

1975a 1976 1977 1978 1979 1980 1981 1982

121.0 51.2 39.4 35.1 16.9 12.2 38.8 35.2

– –21.1 0.2 3.8 –0.9 –8.0 12.4 45.0

– 72.3 39.2 31.3 17.8 20.2 26.4 –9.8

Source: Calculations based on data from the Central Bank of Chile, Instituto Nacional de Estadísticas, Cortázar and Marshall (1980), and Ffrench-Davis and Arellano (1981). Note: In 1982, the “preferential” exchange rate fixed by the government for debtors was used in calculating the external interest rate. This rate reflects the dominant segment of the market, of loans between 30 and 89 days. The international rates paid correspond to the interest rate for bank credits through Article 14 plus the cost of compulsory deposits and the financial spread, all converted into their peso equivalent. a Second semester, after the interest rate liberalization.

exchange market in which there were continuing sales of foreign exchange by the public over bank counters. It is quite possible that the market was not aware, then, of the need to make an adjustment for external inflation when measuring the real exchange rate. It is therefore probable that the expected “foreign interest rate,” comparable to the real domestic rate, would be closer to its nominal level in dollars than to the ex-post rate given in column 2 of Table III.5. This nominal rate fluctuated between 14 and 23% in 1976–82. Consequently, even using this hypothesis, there would still be a substantial gap with the domestic lending rate. In addition to the domestic–external gap, there were substantial differentials between the domestic rates for deposits and loans. There were various reasons for these high spreads, and their significance was changing over time. This issue has been dealt with elsewhere.19 Here I summarize the aspects that have the greatest implications for the focus of this chapter. Traditional explanations are as follows: (i) high bank reserve requirements are a determining factor in the gap between domestic interest rates on deposits and loans (the financial spread); (ii) the fiscal deficit and the inelastic

19 See Ffrench-Davis and Arellano (1981), Arellano (1983), Harberger (1985), and Ramos (1986, Chapter 8).

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demand for credit by public enterprises are responsible for the high interest rates on loans; and (iii) the restrictions on capital flows are responsible for the differential between rf and re (Figure III.1). None of these possible causes was of significant importance during the whole period, however. The first one was of some importance only in 1975–6 because of the high requirements for noninterest-bearing bank reserves and over 300% inflation per year. Nevertheless, very large financial spreads, net of the costs of reserves, persisted during most of the period from 1975 to 1982. Second, the fiscal deficit fell rapidly (reaching equilibrium in 1975) and turned into a solid surplus from 1976 onward (Larraín, 1991, Table 4.4). Finally, in spite of the persistence of restrictions on capital movements, such flows were huge, as was shown in section 2. Consequently, orthodox analysis is not able to explain why, with net capital inflows equivalent to an average of 8% of GDP in 1978–80, the gap between domestic and external interest rates stood at an average of twenty-three percentage points per year (see Table III.5). In this period, as noted, it was evident that there were still no expectations of a massive devaluation. Therefore, there are other significant factors that explain the behavior of domestic interest rates and the financial spreads. First, diverse data suggest that the banking system was subject to rising operational costs after the reform. One of the reasons for this, prior to 1977, was the underutilization of installed capacity. Furthermore, the fact that the system operated with such short terms for both deposits and loans tended to increase costs. This contributed to explain why in 1978 the operating cost of the system averaged 8% of total loans, an abnormal figure in comparison with international standards. Nevertheless, even after discounting the operating costs, the spread still remained at abnormal levels. In all, as documented, bank profitability was very high. Second, the short maturities of financing facilitated the prevalence of high interest rates.20 Those who had no access to external credit faced a severe domestic recession simultaneously with interest rate liberalization. Against the background of heavy propaganda to the effect that the recession would be brief, many businesses and individuals resorted to expensive short-term credit instead of closing down their operations, expecting a rapid reactivation of domestic demand and employment. Under these circumstances, debtors did not view themselves as borrowing, for instance, at a real interest rate of 40% per year but rather at 2.5 or 3% for thirty days, with the expectation of renewing the loan for a few months with a decreasing cost. Effective demand, however, remained generally depressed until 1981 (and lagged behind aggregate demand), and interest rates continued to be high and unstable. Remember that only in 1981 did effective GDP reached a level close to the productive frontier (see Chapter I). Given the continuing delay 20 On various occasions, the cause of the rise was the falling rate of inflation and the lagging adjustment of the nominal interest rate.

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of the expected reactivation, a devaluation for producers of exportables, and a reversal of the trade reform hoped for by producers of importables, entrepreneurs engaged in successive renewals of their bank loans, with the increasing riskiness involved. Third, some opportunities for highly profitable “investments” did arise. Numerous public enterprises were sold at prices significantly below normal market prices (see Foxley, 1982; Marcel, 1989). Similar opportunities were offered by investment in real estate and financial assets, whose prices rose notably in real terms: For instance, the stock exchange price index multiplied by in constant prices between 1975 and 1979 and almost doubled in 1980. The elimination of regulations on the use of credit made its rapid redistribution towards these uses possible, creating extremely profitable investments from the private point of view but no new productive capacity. Fourth, a spectacular increase in consumer credit, especially for imported durables, was observed. Here, too, the suppression of previous restrictions on bank lending for consumers facilitated the switch in the composition of expenditure. Furthermore, import liberalization promoted an expansion of the demand for credit, to be used for marketing imported consumer goods. Thus, on its transit through the financial system, the savings of some nationals leaked towards the consumption of imported goods. This is one explanation for the drop observed in the rate of national savings in contrast to the sharp increase in financial savings, which multiplied by six between 1976 and 1981.21 In the four-year period 1979–82, which was the period of alleged great success of the economic model, the national savings ratio (measured as gross capital formation minus the utilization of foreign capital, as a share of GDP), reached barely 9% of GDP. Fifth, the gradual recovery of domestic economic activity and wages, from the very depressed levels of 1975, together with massive official publicity within the prevailing authoritarian framework, helped to create an image of a dynamic and rapidly growing real economy.22 And as economic recovery on the basis of the utilization of installed capacity come to an end, aggregate demand was fed with the very large inflows that allowed exchange rate appreciation and sustained the consumption boom until far into 1981. The atmosphere of success thus created, together with the biased expectations of a growing permanent income, induced consumers and firms to continue increasing their indebtedness, while it prompted the banks to 21 The stock of loans of the banking system in domestic and foreign currencies rose from 9% of GDP in 1976 to 55% in 1981. Figures that include assets of the central bank are 33 and 62%, respectively. See Arellano (1983). 22 Schmidt-Hebbel (1988, p. 178) argues that “the explosive rise in consumption of tradables between 1976 and 1981 … can be explained, in one half by diminished restrictions on credit or consumer liquidity, and the other half by expectations of higher permanent income and personal wealth, to a large degree stimulated by official euphoria and propaganda.”

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renew and rapidly expand their loans: it was an inter-temporal destabilizing adjustment generated by an over-optimistic euphoria. It was not an enhanced appetite for risk, but an assuming away of risk. For instance, by 1981 many borrowers were moving from debt in pesos to debt in dollars, because of the lower interest rate they faced. What an enormous capital loss they suffered in 1982. Within this over-optimistic framework, the banking institutions competed with each other, partly, by reducing the guarantees requested from their borrowers. Pari passu, there was a huge crowding-out of domestic savings by foreign savings; dropping domestic savings contributed to increased real interest rates. Sixth, banks allotted a significant share of funds to related companies and individuals. Thus, for example, in 1982 the main private bank, which was controlled by the largest economic group in Chile, had 42% of its portfolio lent to firms that were directly related to the same group (Harberger, 1985; Held and Jiménez, 2001). Consequently, financial transactions became mere internal group operations, weakening appraisal criteria and procedures for recovering loans. Seventh, in a framework of frequent renewals of short-term lending and borrowing to pay interest, the high cost of loans in the domestic capital market implied an increase in the volume demanded rather than reducing it: The latter effect predominated over the pure price effect. The magnitude of the effect of financial costs is illustrated by the fact that between 1976 and 1982 an average debtor paid “excess” interest, over a real “normal” rate of 8% per year, amounting to the equivalent of 300% of the initial loan. In other words, a borrower who effectively disbursed the 8% each year, renewed the principal, and capitalized the interest commitments in excess of 8% would be liable by the end of 1982 for a debt four times the original amount in constant purchasing power.23 It should be noted that, in contrast, a debtor in foreign currency, also disbursing the 8% annually, in 1982, just before the devaluation, would be liable for a real debt 44% below that contracted in 1976. Consequently, even after a massive real devaluation of 80%, the debtor would have ended up with a debt just equal to the original amount (and equivalent to only a quarter of the liabilities of a person with a debt denominated in pesos). This calculation is, of course, sensitive to the rate assumed as “normal” and the period taken as a starting point. Thus, for example, “late” debtors who borrowed in foreign currency only in 1981 suffered a huge loss, taking into account the real devaluations recorded in 1982. This is in sharp contrast to the case of “early” debtors.

23 These calculations were made using the corrected consumer price index. If the official consumer price index had been used, the amount of the outstanding “real” debt would have been 5.3 times.

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Finally, capital inflows played a role different from the one traditionally assumed. It is usually supposed that these funds enter into an integrated market characterized by great substitutability between domestic and external funding, so that the two types of interest rate would tend to equalize. It is true that the external credit did relax liquidity constraints and, evidently, there were some borrowers who had simultaneous access to domestic and external sources of funds in diverse proportions.24 External financing became available on a very large scale, representing as much as 40% of total loans available in the Chilean financial system (including foreign loans) in 1981. The interest rate differentials, therefore, had substantial effects for both resource allocation and income distribution (see Zahler, 1980). Small and medium-sized producers were mostly relegated, at best, to the segment where high interest rates prevailed. In contrast, borrowers related to financial institutions and the main economic groups had easy access to external credit, either directly or through the intermediation of domestic banks. This noteworthy and persistent market segmentation helped to explain the spectacular concentration of income and wealth in these years. In all, the eight points summarized above, therefore, pushed up the lending domestic interest rate. This was the result of persistent market segmentation. In fact, only some debtors could borrow directly abroad or gain access to credit through the intermediation of local banking. As a result, the difference between the domestic and external interest rates reached notably high levels. As already stated, the explanation for this does not lie in the expectations of devaluation, since until far into 1981 these were absent, but is to be found in the significant segmentation and incompleteness that prevailed in the financial market.

5 External vulnerability and the dynamics of indebtedness The growing indebtedness generated great vulnerability for the Chilean external sector and for macroeconomic sustainability. In fact, the form assumed by the transfer of foreign resources and the incentives provided by the economic model led to a crowding-out of domestic savings and a decline in productive investment (see Tables I.1 and III.1). Paradoxically, it also crowded out the production of tradables, which experienced a drop in their share in GDP (the production of exportables increased less than the reduction in the production of importables). The ease with which new loans could be obtained by “credible debtors” and the low real international interest rates led many countries to take a 24 There was also significant heterogeneity within the domestic market itself. For example, the average publicly offered lending interest rates exceeded the weighted annual average rate calculated by the central bank by five and ten percentage points in 1979 and 1980, respectively (Mizala, 1992).

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complacent attitude during the 1970s.25 This was backed up by the belief, in domestic official circles and international financial institutions (IFIs), that since indebtedness was predominantly private its use would naturally be efficient (see Robichek, 1981, pp. 171–2). The growing indebtedness made gradual exchange rate appreciation feasible. This, in turn, made it still more attractive to resort to external loans; thanks to the appreciation, the real cost of foreign loans was negative during most of the period. At the same time, domestic asset prices rose vigorously. The process was thus self-encouraging, exacerbating capital inflows, which increased domestic demand and allowed the continued exchange rate appreciation. This led to the rising accommodation of the national economy to massive financial inflows. In the productive sector, however, the opposite of what was expected by neoliberal reformers was taking place. The savings and investment ratios were notably below the levels reached in the 1960s: the rate of gross fixed capital formation barely reached an average of 15.5% of GDP in 1974–82, and in its best year (1981) it did not exceed the average of 20.2% of the 1960s. An increasing share of inflows was directed towards the consumption of imported goods, crowding out spending on national products and domestic savings. The most obvious “comparative advantages” were located in the purchase in the domestic market of underpriced equity from deeply indebted firms. Except for some sectors making intensive use of natural resources – such as fresh fruit, forestry, and fisheries (which indeed expanded vigorously), and luxury construction – investors ran into the difficulty of identifying comparative advantage: exchange rate appreciation, high interest rates, the cutback of public support for productive development, the reduction of public investment, the sharp trade liberalization, and a significant recessive gap, all combined to provide a discouraging environment for productive investment (see several articles in CIEPLAN, 1983). Consequently, in spite of the climate of euphoria and the close linkages between the government and economic groups, productive investment languished. The “financieristic” bias imposed on the domestic economy prevailed; recall that the two “dynamic sectors” in the generation of GDP, between 1974 and 1981, corresponded to value-added by the financial sector and by the marketing of imports (see Chapter I, Table I.2). Apart from the poor performance of the productive system, it was obvious that the dynamics of the external sector could not be sustained for long, even if there were no changes in the international environment. Nevertheless, the official view was that the process would be self-regulated. It was believed that since (i) there was no fiscal deficit, (ii) money supply 25 Interestingly, while Chilean liabilities and the external deficit were increasing rapidly, the spreads it faced (which supposedly should reflect a growing risk) were diminishing.

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was less than the value of international reserves, and (iii) monetary policy was “neutral,” a currency crisis could not arise. Several authorities even asserted that there were economic arguments in favor of a revaluation (De la Cuadra, 1981, p. 1024). It was thought that imports of consumer goods would rapidly reach saturation and that the adjustment capacity of the economy had been strengthened by the reforms imposed since 1973. In contrast to these beliefs, when the international financial problems were about to emerge, in 1981, the trade deficit amounted to 12% of GDP and the current account deficit stood at 21%. For a long time, there had been an evident need to reduce the external imbalance and to devalue the outlier exchange rate. The Chilean difficulties in capturing large external financing by late 1981 coincided with a situation in which there was a pressing need for fresh foreign currency in order to cover increasing interest and amortization payments and finance the huge trade deficit. Regarding the first two items, the composition of external debt showed three strongly negative features. First, the prevalence of flexible interest rates amid significant rate increases in the international markets, together with a climbing outstanding debt led, between 1978 and 1982, to interest payments being multiplied by four (to 7% of GDP). Second, short-term indebtedness rose from a “normal,” sustainable amount of trade credit to 13% of GDP. Third, amortization commitments of private debt increased at an accelerated pace and were projected to triple between 1981 and 1985. Furthermore, the government had dismantled most economic regulations, productive capacity had been weakened, and firms were heavily indebted. Thus, the effects of external shocks were multiplied in the domestic economy, with a decline in GDP of 14% in 1982, concentrated in the manufacturing and building sectors. In short, the external shock found Chile in a highly vulnerable position, and this multiplied its negative effects on the domestic economy. As documented in Chapter I, if the value added in financial activities and the trading of imported goods (both based on shaky grounds) is deducted, the per capita national product in 1981, before the effects of the shock, stood only at a level similar to 1974 (see Chapter I, Table I.2). Despite emerging modern sectors in the domestic economy, this was an unmistakable sign of stagnation compared to the growth of the region in the 1970s.

6 Some lessons from this experience I would like to underline three lessons from this financial opening process. Financial liberalization is not neutral concerning the allocation of resources, especially during the transition from a closed to an open economy, because of the pressures generated on variables such as the stability of aggregate demand, the composition of money supply, and the level and stability of

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the exchange rate; they all have allocative affects and have an incidence on the supply of factors of production. The key questions that emerge are how to ensure that inflows are effectively channeled towards investment, and whether access to and costs of the supply of external financing will be stable in the future. Financial markets work with very short-term horizons and naturally do not take into account the effects on productive activity. Consequently, it is essential that the opening process be regulated in a manner consistent with macroeconomic sustainability (see Ffrench-Davis, 2006, Chapter VI). First, access to external credit is not homogeneous for different economic agents. In practice, this type of funding is usually available mainly to large firms and economic groups. The cost differential observed among agents during the expansive stage affected not only allocative efficiency but income distribution as well. In particular, the opening of the capital account in Chile provided substantial profits for those who were able to obtain foreign loans (see Zahler, 1980). Also, during the recessive stage, the outcome is regressive since SMEs and informal segments tend to be affected more intensively by drops in domestic demand and the emergence of liquidity constraints. A second lesson is connected with the destabilizing macroeconomic effects of capital flows. In developing countries, where domestic markets are not fluid and integrated, the instability in the supply of funding can be quite disturbing for domestic economic activity. A feature of great practical significance is that international financial markets experience sharp fluctuations, which are promptly transmitted to domestic markets unless there is some form of counter-cyclical regulation, principally during the expanding part of the cycle (e.g. in 1977–81). Particularly, the supply of funds is subject to abrupt changes in response to fluctuations in the lenders’ expectations of short-term profitability. In critical situations, the latter tends to affect part of the total stock of the debt rather than solely the new inflows. Specific taxes can reduce short-term speculative flows by making them more expensive compared to longer term flows (see Chapter IX). Beyond these, the existence of external instability in the supply of funds requires more complex counter-cyclical macroeconomic mechanisms, geared to stabilize the volume of net flows recorded in each period. This can be done, for instance, through the introduction of borrowing limits for national banks or currency mismatch regulations (mechanisms in widespread use in developed economies), the auction of external debt quotas, ad valorem taxes that fluctuate according to the intensity of the supply of external funds, and non-remunerated compulsory deposits like the encaje implemented by Chile in the 1990s (see Chapter VIII). Third, except in the case of compensatory flows, the regulation of capital flows should consider their being channeled towards complementing national savings and investment. That happens automatically with greenfield FDI.

106 Building a Major Crisis

Insofar as inflows are directed towards the domestic financial market and to real estate and stock market bubbles, they can easily filter through to consumption. The experience of various developing countries suggests that the final use of funds is determined to a significant extent by the source of funding and the way in which capital inflows are regulated and channeled. Consequently, in incomplete capital markets such as in emerging economies like Chile, there is a need to push the market explicitly towards a term structure consistent with productive investment; the effective channeling of external funds towards productive investment represents a necessary condition if external savings are to contribute to capital formation and domestic development.

Third Part Economic Recovery and the Heritage of the Dictatorship, 1982–1989

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IV Policy Rectifications and Recovery from the Debt Crisis, 1982–9*

During the 1980s, most Latin American countries were facing a dramatic foreign debt crisis. The sharp deterioration in international markets recorded from 1981affected the emerging developing nations with unusual severity; the drop in export prices and worsening access to the markets of industrialized countries, the rise in international interest rates, and the sharp reduction in capital inflows all contributed to the strongest negative external shocks in the past half century. In 1982, the external shocks that struck Chile – the cutoff of bank loans, the rise of international interest rates, and falling terms of trade – and the “automatic domestic adjustment” carried out implied a 14% plunge in GDP, the largest drop among LACs in that year. The Chilean economy began to recover in 1984. However, only during 1988, after seven years of recessive adjustment, did GDP per capita surpass its pre-crisis peak, recorded in 1981. In the early stages, even after the explosion of the crisis in August 1982, the adjustment followed a rigorous orthodox approach in continuity with previous years. Domestic demand was curtailed sharply through an automatic adjustment associated with losses of international reserves; most public policies were kept “neutral.” In 1982, domestic demand fell by 25%, diminishing sharply imports, but also domestic output and employment. It is interesting to underline that a widely privatized economy, with free trade and a fiscal surplus, suffered that huge 14% drop in GDP, notably more severe than in the rest of the “non-reformed” LACs. Indeed, there was a causal relation between the nature of reforms and the severity of the crisis. Subsequently, the severity of the crisis led the authorities to introduce deviations from the extreme market fundamentalism of the neoliberal * Partially based on “Debt and growth in Chile: trends and prospects,” in David Felix (ed.), Debt and Transfiguration? Prospects for Latin America’s Economic Revival, M.E. Sharpe, New York, 1990. I appreciate the comments of José Pablo Arellano, Sebastián Edwards, David Felix, Stephany Griffith-Jones, Manuel Marfán, and Carlos Massad, and the research support of Andrés Gómez-Lobo. 109

110 Policy Rectifications and Recovery from Debt

approach. Public policy moved towards more pragmatic, active and selective policies. Among other important changes, (i) export subsidies were established; (ii) import tariffs were raised, (iii) in combination with a strong real exchange rate depreciation; (iv) private debt was – directly or indirectly – “nationalized,” with the public sector assuming the responsibility for a significant part of private debt, with its share rising from one-third in 1981 to 86% of total external debt in 1987. In 1987–8, Chile experienced three positive external shocks – a sharp rise of the copper price, an agreement with creditor banks to postpone half of interest payments from 1988 to 1991–3, and other foreign exchange savings resulting from debt swaps. As a consequence, the economy benefited from the full relaxation of the acute binding external restrictions (scarcity of foreign currency) faced since 1982. The elimination of liquidity constraints allowed a significant expansion of aggregate demand in 1988–9. The supply of output was able to respond vigorously, but essentially through the use of idle capacity. Therefore, actual GDP growth between the previous peak, in 1981, and the new peak in 1989 averaged only 2.9% per year. Section 1 briefly summarizes the situation just before the explosion of the crisis. Then it focuses on the large negative net transfers taking place in 1982–9. Then the macroeconomic adjustments in 1982–9 are analyzed, assessing the evolution through the decade of (i) external shocks, (ii) demand-reducing policies, and (iii) supply- and demand-switching policies. In section 2 a discussion of debt management after the crisis follows. Section 3 reports several of the more pragmatic changes in policy design forced by the economic crisis. Section 4 focuses on the recovery of GDP growth, investment, and its sustainability; the performance of investment is stressed, arguing that the macroeconomic environment was determinant of a low average investment ratio as well the low economic growth recorded between the peaks of 1981 and 1989. Section 5 analyzes the macroeconomic (im)balances by the late eighties.

1 The debt crisis1 (a) Accumulation of imbalances by 1981 As documented in Chapter III, Chile accumulated a large foreign debt in 1977–81. Borrowing was principally by private Chilean firms from foreign private banks, without any guarantee from the Chilean government; in parallel, the public sector exhibited a surplus balance, which relieved the Treasury of the need to borrow. Thus, there was a major privatization of the sources and uses of debt (see Table IV.1). Until late 1981, net capital inflows exceeded the absorptive capacity of the domestic economy. Therefore, international reserves accumulated and 1 The 1980s performance of Latin America is examined in Feinberg and Ffrench-Davis (1988), Devlin (1989), Griffith-Jones and Rodríguez (1992), and reports by ECLAC, IDB, IMF, and World Bank.

Table IV.1 Foreign debt and public guarantees, 1975–89 (US$ millions and percentages of total) Year

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Total

Private with guarantee

Public and publicly guaranteed

Private without guarantee

(1)

(2)

Amount (3)

Amount (5)

% (6)

5,453 5,392 5,763 7,153 8,790 11,325 15,700 17,263 18,133 19,746 20,607 20,898 20,722 19,012 17,569

21 30 46 48 76 72 69 62 1,815 2,130 2,348 3,408 3,276 2,829 2,120

4,667 4,434 4,479 5,198 5,369 5,304 5,623 6,770 10,497 13,212 15,242 17,160 17,894 16,083 13,568

786 958 1,284 1,955 3,421 6,021 10,077 10,493 7,636 6,534 5,365 3,738 2,828 2,929 4,001

14.4 17.8 22.3 27.3 38.9 53.2 64.2 60.8 42.1 33.1 26.0 17.9 13.6 15.4 22.8

% (4) 85.6 82.2 77.7 72.7 61.1 46.8 35.8 39.2 57.9 66.9 74.0 82.1 86.4 84.6 77.2

Capitalized debt (7)

11 85 355 1,187 2,112 3,436

Total including capitalized debt (1) + (7) (8) 5,453 5,392 5,763 7,153 8,790 11,325 15,700 17,263 18,133 19,757 20,690 21,236 21,844 20,965 20,629

Source: Central Bank of Chile, External Debt of Chile, 1990. Figures refer to end-of-year disbursed outstanding debt. Note: (1) Total including IMF and debt payable in domestic currency and excluding short-term trade credit to non-bank debtors; the latter amounted to US$800 million in 1985 and US$1.1 billion in 1989. (2) Chilean private debt publicly guaranteed. (4) and (6) are percentages of col. (1). (7) Face value of debt capitalized through D.L. 600 and debt-equity operations through Chapter XIX. (8) Column (1) plus 100% of debt capitalized through D.L. 600, plus the redenomination value of capitalized debt through Chapter XIX: averages of 93% in 1985–7, 89% in 1988, and 84% in 1989.

111

112 Policy Rectifications and Recovery from Debt

exerted pressure for real exchange rate appreciation and import expansion. Since the growth of imports outran that of exports, the deficit in the trade balance underwent persistent and substantial increases. The external deficit was led by the huge financial inflows; most inflows were financial, with a low share of greenfield FDI. Undoubtedly, the lack of prudential regulation and supervision facilitated the excess of external indebtedness and then the depth of the bank crisis in 1983. The Chilean economy had become particularly vulnerable to eventual negative external shocks because the government had done away with most of the regulatory mechanisms that coped with external instability (instead relying on the automatism of the dollar standard or currency board) and because the private sector (consumers and firms) was overleveraged (Arellano, 1983; Eyzaguirre, 1988). (b) The shocks leading recession and recovery in the 1980s Chile suffered three severe negative external shocks in the early 1980s, which had an unusually large multiplier effect on the domestic economy. GDP fell by 14% in 1982, with manufacturing output declining by 21%. Expenditurereducing policies dominated over expenditure-switching policies. The strongest shock was related to gross capital flows; rather than a sharp rise in outflows, the larger shock was the drop with respect to the voluminous inflows (and huge external deficit) recorded in 1981. After climbing to 19% of GDP in 1981, the use of foreign savings fell to one-half of that figure in 1982 and to one-fourth in 1983 (see Table V.2).2 Clearly the figure recorded in 1981 reflected a domestic policy, which allowed excessive indebtedness for several years. Since 1977, the Chilean economy had been adjusting (in both the productive sector and expenditures) to an unsustainable level of capital inflows. Consequently, aggregate demand was exceeding domestic output by unsustainable amounts, and even without an international debt crisis a major readjustment would have been needed in the near future. The fact that in the second half of 1981 – long before the Mexican crisis of August 1982 – GDP and employment had begun to fall (Marcel and Meller, 1983, Table 1) is robust evidence. Adjustment was unavoidable, no matter how well Chile might have managed relations with creditor banks after 1982: the deep economic problems had been sown during the previous boom years. Given the vulnerabilities already accumulated and the international scenario, the best bargaining 2 The figures used in this chapter are based on official national accounts, calculated in 1977 relative prices. Naturally, the external sector weight (and its associated shocks) depends on the year base. For example, in 1981 prices, it decreases; in 1976–8 and in 1986 prices, it increases. In general, in this book, in order to compare peso figures of GDP with dollar figures of the current account, I use the average RER of 1976–8. That gives an external deficit of 21% of GDP.

Policy Rectifications and Recovery from Debt 113

outcome certainly would have been a zero net transfer of financing, and even that would have implied a huge decline in the net capital inflows compared to 1980–1. A second shock was the increase of interest payments that had been associated with growing indebtedness and an impressive jump in the financial cost of foreign debt since late 1979. The third shock was the decline in the terms of trade, which was led by the copper price drop. Subsequently, an “automatic adjustment,” set in motion by the monetary effects of the corresponding loss of international reserves, exacerbated the reduction in domestic liquidity and aggregate demand. This resulted in a 17.2% drop in GDP per capita in 1982–3. As a consequence, there soon arose a large gap between potential and actual GDP, and a decrease in investment. The expansion of the production frontier, in turn, lost speed because of the lower investment ratio. The ideal adjustment in a perfectly flexible economy would eliminate excess aggregate demand without generating a gap between actual and potential GDP. In an economy with initial underutilization of capacity in the production of tradables, adjustment with an appropriate dose of switching policies could even achieve an increase in resource utilization and output. But in an economy with price inflexibility, imperfect factor mobility, and limited or confusing information, neutral demand-reducing policies (i.e. policies that are intended to affect uniformly all expenditure components) can cause a significant drop in output because the demand for both tradables and nontradables diminishes. In the real world, adjustment processes usually involve a drop in output. This causes a lower rate of utilization of installed capacity and, subsequently, a fall in gross capital formation. Selective policies that facilitate switches in the composition of output and expenditure can dampen output-reducing effects. A good combination of expenditure-reducing and switching policies would tend to allow an outcome closer to a constant rate of utilization of potential GDP (see FfrenchDavis and Marfán, 1989). In fact, if an excess of expenditure prevails, as in 1981, then aggregate demand needs to be reduced urgently. However, this can be done in combination with switching policies that are geared towards reducing the demand for tradables and encouraging domestic investment and the supply of exports (Ffrench-Davis, 2006, Chapter II). There now follows a brief account of estimates of the external shocks and the paths taken by GDP, aggregate demand, exports, and imports during 1980–9. The purpose is to provide rough estimates of two components of the economic costs of recessive adjustment: underutilization of installed capacity and slackened creation of new capacity. All variables fluctuated widely in this period, as is shown in Table IV.2. Economic activity peaked in 1981 (row 1a). The actual GDP of 1981 is taken as a good indicator of productive capacity as of that year. However, there was some idle installed capacity, principally in the agricultural and manufacturing sectors, as a consequence of the sharp trade liberalization with a strong

Production, consumption, investment, and external shocks per capita, 1980–9 (in 1977 pesos as a share of 1981 actual Average 1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1983–7

1988–9

1 (a) Actual GDP 96.2 (b) Potential GDP 97.0 2 Domestic 102.7 expenditure 3 Consumption 79.7 4 Gross fixed 17.0 investment 5 National savings 13.1 6 Non-financial –6.5 current account (a) Exports 22.8 (b) Imports 29.2 7 Terms of trade 1.9 effect 8 Net interest and –3.4 profits paid 8.2 9 Current account deficit0ab (a) Capital flowsab 13.1 4.9 (b) Change in reservesb

100.0 99.0 112.9

84.6 102.3 84.4

82.6 103.0 79.2

86.5 101.5 84.5

87.1 103.0 81.6

90.5 103.9 84.5

94.1 103.9 89.2

99.3 105.6 95.5

107.4 107.4 105.3

88.2 103.0 83.8

103.4 106.5 100.4

85.3 19.5

75.0 12.7

71.6 10.6

71.3 11.4

69.5 12.9

70.9 13.6

72.4 15.5

77.6 16.9

81.9 20.0

71.1 12.8

79.7 18.4

9.6 –12.9

2.9 0.2

4.6 3.4

7.8 1.9

10.5 5.5

12.4 6.0

15.7 4.9

15.4 3.8

19.4 2.1

10.2 4.4

17.4 3.0

20.4 33.3 0.0

21.1 20.9 –2.1

20.9 17.4 –1.1

21.9 20.0 –2.8

23.0 17.5 –3.3

24.9 18.9 –3.0

26.6 21.7 –1.6

27.8 23.9 1.5

31.6 29.5 0.9

23.5 19.1 –2.3

29.7 26.7 1.2

–5.1

–6.7

–6.5

–7.3

–7.2

–7.2

–6.0

–6.4

–6.1

–6.8

–6.3

18.5

9.3

4.6

8.5

6.0

4.4

2.7

1.1

2.4

5.2

1.8

18.7 0.3

4.8 –4.5

2.6 –2.1

8.5 0.1

5.6 –0.4

3.6 –0.8

2.8 0.1

3.2 2.0

3.5 1.1

4.6 –0.6

3.3 1.6

Source: Author’s calculations based on official figures of the Central Bank of Chile and Chapter I. a

Unrequited transfers included. bFigures based on balance of payments data, which can differ from those of the national accounts.

114

Table IV.2 GDP)

Policy Rectifications and Recovery from Debt 115

exchange rate appreciation in preceding years. We have estimated that this underutilization was more than compensated by “overuse” in the nontradable sector, especially by the value-added in the domestic marketing of imports (see Chapter I, section 2 and Table I.2). Consequently, principally based on the “value-added on an estimate of non-sustainable volume of imports”, I consider the 1981 actual GDP as a 1% overestimation of potential GDP in that year (rows 1a and 1b). In Table IV.2, all figures are adjusted by population growth and as percentages of per capita GDP in 1981. Comparing any figure in a given row to its value in 1981 indicates the change with respect to a situation of both constant GDP per capita and constant shares of all other variables in the table. For instance, the 1987 figure for fixed capital formation indicates a fall from 19.5 in 1981 to 15.5. As a share of the absolute level of GDP in 1987, the decline was from 19.5 to 16.4% (15.5/94.1). Actual GDP per capita, in 1983–7, averaged 88.2% of the 1981 GDP. Because in the meantime potential output was growing somewhat (Chapter I), the gap between actual and potential GDP was even wider: 14.8 points per annum (rows 1a and 1b). Only in 1989 did actual and potential GDP converge. The significant underutilization shows that demand-reducing policies had strong negative effects on output, while switching policies (exchange rate and trade policies, the selective fiscal policy, etc.) were weak. This shortcoming was reinforced by the inflexibility in the composition of aggregate demand and supply. The three external shocks are measured in rows 7, 8, and 9. Row 9 shows the net use of foreign capital (current account deficit). Initially, after the supply became dry, Chile could use its international reserves. That explains why the financial shock does not appear as intense in 1982 as the cutoff in external financing. The central bank lost reserves of 5% of GDP to compensate for the foreign capital shortage. The reserve losses, with a fixed exchange rate and passive monetary policy at the outset of the crisis, gave rise to the sharp reduction in domestic expenditure (row 2) on both consumption and investment. They were transmitted to the external sector (row 6), reducing imports (sharply) and increasing exports (slightly). The 11.8% drop in actual GDP in the years 1983–7 with respect to 1981 is the “static” output-reducing effect of the combination of external shocks and weak switching policies. In the “dynamic” dimension, by 1983 investment per capita had diminished by 45% with respect to 1981 (row 4), reducing both potential GDP growth and the capacity to restructure the composition of supply and demand, which is directly associated with the level of new capital formation. Empirical work shows that the drop in capital formation was significantly associated with the large gap between potential and actual GDP (Agosin, 1998; Ffrench-Davis, 2006, Chapter III). Meanwhile, the drop in capital formation weakened the capacity to restructure the composition of supply and demand, which is a positive function of output expansion.

116 Policy Rectifications and Recovery from Debt

As a consequence, the low investment made a constructive adjustment of the economy more unlikely, which became a determinant factor of the poor behavior of real wages in that period (see Chapter VII). An “automatic adjustment” mechanism, as was used in 1982, relies heavily on the shock effects of demand-reducing policies. After any one-shot endogenous downward adjustment of domestic expenditure, as time goes by, some switching in demand and supply composition gradually takes place spontaneously. That reallocation was assisted additionally (after several months) by an increase in tariffs, the introduction of export subsidies, and a series of sizable exchange rate devaluations with a return to a crawling-peg scheme (see Chapter V). Subsequently, there was a gradual recovery of output and expenditure. This was greatly accelerated by a sharp positive shock in the international price of copper; in 1988–9, after half a decade of severe recession, the sizable improvement in the terms of trade allowed a strong recovery of economic activity. However, by 1988, GDP per capita was merely reaching the level achieved in 1981, while investment per capita still was 13% lower.3 This was, in addition, the end of a cycle, because a macroeconomic overheating in 1989 demanded a significant new adjustment in late 1989 and 1990. In the external sector, the automatic adjustment of 1982 was stronger and came sooner on imports, which are highly responsive to drops in domestic expenditure. Again, subsequently, time allowed a change in the behavior of these two variables. Encouraged by large exchange rate depreciations, exports grew faster in the latter part of the period. It is interesting to measure the changes in exports and GDP between the peaks of economic activity in 1981 and 1989. Cumulative export growth per capita was significant: 55% and nine points as a share of GDP (six points if compared to 1980). However, the cumulative GDP growth scarcely averaged 2.9% per year. This implies that the rest of GDP (non-exported GDP) growth was quite weak (as shown in Chapter V). The behavior of imports is also interesting. Their strong recovery ensued following the spectacular drop recorded between 1981 and 1983 and the swings in 1984–6, which were linked to a mini-recession experienced in 1985. Per capita imports grew by 56% between 1986 and 1989, a twofold increase over the per capita export growth in those years (see Table IV.2, row 6a). In the recovery following an adjustment such as the one carried out in 1982, it is normal for imports to grow faster than exports. Nevertheless, 3 Figures in 1977 pesos. Later national account figures, in 1986 pesos, give 1988 as the year in which the GDP per capita of 1981 was reached again. Weights of different components of GDP change with relative prices. For instance, between 1986 and 1989, the terms of trade improve by the equivalent of 4% of GDP in 1977 pesos accounts, and 7% in 1986 pesos; the main explanation is that trade is weighted in 1986 with a RER nearly two-thirds more depreciated.

Policy Rectifications and Recovery from Debt 117

the difference in the rate of growth between both variables was quite large, as shown below. The disequilibrium was not evident in the trade balance at current prices due to a remarkable improvement in the terms of trade – led by the copper price – between 1986 and 1989.

2 Debt management in 1982–9 In 1982, external debt was four times the value of exports; debt service captured 89% of export proceeds. In the following years, there were five negotiation rounds with creditor banks framed by agreements with the IMF and the World Bank (three Structural Adjustment Loans (SAL) agreements).4 Liabilities with international commercial banks represented, as shown earlier, more than four-fifths of the country’s total debt. The negotiations with banks were geared towards rescheduling maturities, maintaining short-term trade credit, and obtaining new loans to finance part of interest payments. Since Chile fully paid its interest commitments, the remaining interest payments were financed with a trade surplus and net transfers from public creditors. Net transfers to bank creditors implied a negative flow of approximately 5% of GDP per annum in 1985–7.5 On the other hand, official creditors played a crucial role as net suppliers of funds. Multilateral institutions were the largest lenders, the World Bank and IDB provided positive net transfers of US$300 million per annum (Table IV.3). This was a relatively large figure, as the net transfers of funding from these two institutions to all Latin America averaged only US$1 billion annually in 1985–7 and turned negative in 1987 (World Bank, 1989).6 As a consequence, private creditor banks reduced their participation to 65% of the total debt of Chile, while official creditors increased their share from 3% in 1982 to 30% in 1989. The small outstanding debt with IFIs climbed, with an average growth rate of 32% per annum. With regard to disaggregation by debtors, after 1982 the state assumed responsibility for an overwhelming share of total debt. In 1987, the public sector share peaked at 86%, if the publicly guaranteed debt is included. This figure was 36% in 1981 (Table IV.1). The debt “nationalization” was carried out in three ways. The main one was the growing indebtedness incurred by 4 The five rounds – of 1983, 1984, 1985, 1987, and 1988 – are discussed in FfrenchDavis (1992). An analysis of the Latin American rounds is provided in Devlin and Ffrench-Davis (1995). 5 Additionally, creditor banks received prepayments through debt swaps, either in cash or in shares of Chilean firms. See below. 6 The “preferential” treatment for Chile is discussed in Felix and Caskey (1990) and in Ffrench-Davis (1992). In 1985–7, Chile received 30% of the net new loans of the IDB and the World Bank to Latin America, whereas it produced only 3% of the regional GDP (at 1986 exchange rates). It must be recalled that the multilateral Chilean debt was negligible in 1982.

118 Policy Rectifications and Recovery from Debt Table IV.3 Net transfers of funds abroad by creditor, 1983–9 (US$ millions)

Direct foreign investmenta Multilateral institutionsb Bilateral officialb Suppliersb Banks MLTb Other MLTc Short termd Total

1983

1984

1985

1986

1987

1988

1989

51

–51

–56

–139

–57

–102

–5

167

248

349

266

253

109

33

–57

–101

–69

–60

–38

213

82

–241 –178 –21 –834

–154 –589 –69 906

–140 –718 –24 0

–7 –990 –86 198

131 –988 –100 –64

–30 –442 –119 –423

–19 –791 –104 405

–1,113

190

–658

–818

–863

–399

–399

Source: Calculations based on data from the Central Bank of Chile. a

Net flows of foreign investment are disbursements minus net profits remitted after taxes; they exclude debt swaps, capitalization of credits, and reinvested profits. bNet transfers from multilateral banks of medium- and long-term foreign net loans minus actual interest payments. cIncludes net interest payments to the IMF and medium- and long-term flows other than foreign debt. d Includes credit lines, trade credit, interest receipts, and errors and omissions. It excludes the counterpart of debt swaps.

the central bank and other public organizations in order to provide foreign currency to cover interest commitments, for both public and private agents. This took place in an environment in which voluntary loans to LDCs had disappeared. Second, the state granted ex post the public guarantee to the foreign debt of domestic banks, under pressure from creditors and some governments of developed nations. Third, a debt swap scheme was started in May 1985, directed to reduce debt (see Ffrench-Davis, 1990). It included two tiers that allowed the prepayment of debt by residents with creditor banks and debt/equity swaps performed by foreigners (see Box IV.1); in that time, at market prices, the foreign debt of Chile represented 130% of a sharply diminished annual GDP. Later, there were also prepayments and direct write-downs by the government (Elórtegui, 1988; Larraín and Velasco, 1990). The scheme was based on: (i) the debt promissory notes (pagarés de la deuda externa) held by creditor banks, which were priced at an average discount of 40% of the face value in the international secondary market; and (ii) the direct capitalization or conversion of external loans into equities. By December 1989, US$9 billion had been swapped through the different channels of this program; there were implied “economic rents” (the difference between the face value and market price of the debt notes) of about US$3.4 billion, which were captured by the agents involved in these operations. The main benefit for the Chilean economy accruing from the equity swaps was the reduction of the outstanding debt stock; consequently, interest

Policy Rectifications and Recovery from Debt 119

Box IV.1 Debt-swaps programs Proposals for debt conversion have been around for a long time in the academic and applied literature. As a matter of history, in the 1930s many Latin American countries resorted to a form of conversion based on repurchase of their own foreign debt bonds at substantially reduced prices: Chile enjoyed an average discount of 69%. In the course of the 1980s crisis, such proposals were renewed in Latin America, either in the framework of official programs or as isolated operations. A rapid rise in the volume of swaps was encouraged by high discounts of debt notes in international markets. The Chilean program that operated between 1985 and 1990 was one of the earlier formal schemes in Latin America and – given the size of the Chilean economy – was relatively the most significant. The official scheme was composed of two main tiers. One associated with foreign investment was a debt–equity swap program (under Chapter XIX of the Compendium of Rules for International Exchange in Chile). It was available to residents abroad and designed to convert medium- and long-term debt owed by Chilean residents to foreign banks. The latter could use their notes representing loans directly or sell them at a discount in the international secondary market. The investor then exchanged the debt paper for the debtor’s equity capital or with other debtors for cash or notes in Chilean currency. The latter could be sold in the domestic secondary market and then used for equity investment or to purchase productive assets, subject to remittances of profits and principal after a minimum period of stay. Between 1985 and 1989, Chilean debtors had an average discount of 39.5% with respect to face value. The gap between face value and secondary market value represented an “economic rent” or capital gain. In Chapter XIX, the foreign debt notes were recognized in Chile at an average of 88% of their face value (that is, Chilean debtors caught only 12 of 39.5 points). Thus, a significant share of discount was captured by investors or buyers in the secondary market (the difference between 60.5 and 88%). From the point of view of the foreign exchange market, the outcome implied that investors were benefiting from a price of the dollar significantly above the market exchange rate. The other formal component of the scheme was not associated with FDI. Its aim was to reduce foreign debt (via Chapter XVIII) without subsequent access to the official foreign exchange market. The central bank periodically auctioned to residents in Chile the right to purchase debt notes abroad. The auction enabled the bank to capture in 1985–9 around 30% of the discount of the Chilean debt notes, the remaining 70% being captured by other domestic agents. The purchase of debt paper was paid for with foreign currency obtained in the “informal” domestic market, capital that had previously “fled” abroad, or “laundered” money from other foreign sources. It is interesting to note that the central bank also made direct transactions, receiving a larger discount, of between 42 and 50%. Source: Based on Ffrench-Davis (1990).

120 Policy Rectifications and Recovery from Debt

payments and amortization commitments were diminished. However, they also generated a series of other benefits and costs, the specifics of which depended on the particular features and management of the swaps. For example, debt–equity swaps involve a change in the composition of external accounts in debtor nations; interest payments are replaced by profit remittances, and amortizations are replaced by depreciation reserves and capital withdrawals. Then, the source of external imbalance moves from “credit accounts” to “investment accounts.” It must be stressed that, in order to compensate for the expected rise in accrued revenue by foreign risk capital, the program established minimum periods of stay for converted capital.7 The drop in bank debt due to debt equity swaps was nearly offset by a rise in debt with multilateral institutions. It was only in 1988 that large swaps produced a net drop in the total debt. That year the Latin American debt also experienced a decrease, though to a lesser extent: only 2% in the region compared to 8% in Chile (ECLAC, 1988). After the negotiations with creditor banks in 1987–8, which had additionally relaxed the debt service, the external environment faced by Chile improved notably. The price of copper rose sharply, as did other export prices (such as cellulose and fish meal). The terms of trade improvement together with the postponement of debt service for 1991–58 implied that the binding external constraint prevailing in 1982–7 had disappeared in 1988. In fact, these positive shocks led to a spectacular increase in the foreign exchange available (ECLAC, 1988), which allowed the full use of productive capacity and the overheating of the economy in 1989. The improvement in domestic financial conditions from the mid-1980s was also reflected in the behavior of stock prices indexes (which tend to be notably pro-cyclical). Table IV.4 shows that between the second half of 1980 and 1985, for instance, real prices in pesos dropped by 64%.9 Given that the recession involved exchange rate devaluation as an adjustment mechanism, that decline is strengthened when stock market prices are expressed in US dollars, showing an even larger real price drop of 77%. Therefore, when debt–equity swaps were initiated in 1985, the space for 7 A significant share of debt–equity conversions was associated with privatization of public enterprises or firms temporarily under government administration as a result of the economic crisis of 1982. Consistent with the government’s desire to privatize as quickly as possible, with either local or foreign buyers, the rates of return on converted capital were considerably higher than interest rates. The creditor banks, which made some of the largest transactions directly and acquired 40% of the gross capitalization, thus converted “bad” (risky) loans into “good” equity capital (Dornbusch, 1988). 8 The rescheduling implied that the amortizations of the stock of debt by 1989 would multiply by 3.2 between the annual averages of 1987–8 and 1991–5. 9 Making comparisons of the index over time is troublesome. Aside from the dividends policy in cash and in stock issues, the Chilean economy suffered dramatic changes of firm ownership, firm boundaries, and asset and liability structures.

Policy Rectifications and Recovery from Debt 121 Table IV.4 Indexes of stock prices in pesos and converted to US dollars, 1980–9 (1980 ⫽ 100) Year

Real exchange rate

Stock price index In pesos

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

I II I II I II I II I II I II I II I II I II I II

(1)

Nominal (2)

Real (3)

104.2 95.8 87.2 82.4 81.4 111.5 120.8 116.1 119.6 127.0 140.4 161.9 164.7 168.1 170.9 176.2 186.5 183.5 176.0 185.0

87.5 112.5 102.9 87.2 79.9 78.3 65.3 63.0 78.7 77.4 87.3 113.1 164.0 229.1 318.7 394.8 407.8 461.9 629.7 686.3

93.1 105.6 88.0 71.3 64.4 56.5 41.5 35.6 41.5 36.8 35.1 40.9 54.1 70.6 89.2 100.4 97.2 104.5 131.5 129.2

Converted to US$ real (4) 89.4 110.2 100.9 86.6 79.2 50.7 34.4 30.7 34.7 29.0 25.0 25.3 32.8 42.0 52.2 57.0 52.1 56.9 74.7 69.8

Source: Based on data from the Central Bank of Chile and the Santiago Stock Exchange; averages per semester of monthly figures. Notes: (1) Nominal index deflated by the CPI and inflated by the index of external prices faced by Chile. (3) General stock price index deflated by the CPI. (4) Equal to (3) ⫻ 100/(1).

recovery was enormous. In fact, by 1989 the real index in US dollars had recovered by 187% (and by 243% in real pesos). It is interesting to underline that the strong increase in stock market prices by 1989 involved a substantial capital gain for “early” investors in debt–equity swaps.

3 A more pragmatic economic policy After the first years of adjustment in response to the debt crisis, a more pragmatic macroeconomic policy, departing from the straight “neutrality” of the reforms of the 1970s, was put into practice. It aimed, with “selective” policies, to expand non-traditional exports, increase savings, and strengthen the corporate and financial sector. It implied recognition by the authorities

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that there were failures in strategic areas such as the financial and export markets that needed to be corrected (Larraín and Vergara, 2000). When external funding dried up in 1982, an increase in national savings (that is, domestic savings minus interest and profits accrued to foreign capital, which had collapsed in 1980–3), turned out to be essential for financing investment. In order to encourage increased private savings, in 1984 a tax reform was implemented. Moreover, several measures were adopted to cope with the weakening of public finances.10 These included setting wage increases for the public sector below the inflation rate and reductions in several categories of public spending, including pensions and other social expenditure (see Table VII.1). As a result, the fiscal deficit improved from 3.5% of GDP to a balance in 1987 (Larraín, 1991). Given the way in which this balancing was achieved, it had a significant regressive bias, as discussed in Chapter VII. With respect to private non-financial companies, from 1982 most of them suffered the effects of the high interest rates, depressed demand, and exchange rate devaluation on their foreign debt (particularly, in the case of producers of non-tradables). This, together with opaque banking practices and the permissive regulatory framework generated by the financial reforms of the 1970s, laid the foundation for an enormous financial crisis, which forced the government to intervene in several financial companies that were experiencing solvency problems, including the two largest private banks. The government reacted to the financial crisis by implementing an aid program for local debtors and banks (with an estimated cumulative cost of 35% of annual GDP), which included, among other measures, a preferential rate for dollar debts, loans at subsidized rates for the financial sector, and the central bank’s purchase of the banks’ non-performing portfolios, with a commitment from the latter to repurchase them (Sanhueza, 1999). In the mid-1980s, a second round of privatization was carried out. This affected forty-six companies (including financial institutions that had been taken over in 1983, and traditional public firms, such as the large electric power company, ENDESA), which were quickly transferred to the private sector (Hachette and Lüders, 1992; Devlin and Cominetti, 1994). The Chilean banking crisis, which followed on the heels of a massive capital surge in the late 1970s, left in its wake a number of valuable lessons that were reflected in Chilean rules or “legislation.”11 Therefore, a deep financial reform was carried out, which implemented a rigorous prudential supervision and strengthening of the regulatory agency (the Superintendencia de Bancos). The prudential regulation and supervision 10 Weakening caused by the heavy financial cost to the Treasury of the 1981 social security reform (see Chapter VII), as well as of depressed economic activity. 11 See Valdés-Prieto (1992), Aninat and Larraín (1996), Reinstein and Rosende (2000), and Held and Jimenez (2001).

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included the continuous monitoring of the quality of bank assets; strict limits on banks’ lending to related agents; automatic mechanisms to adjust banks’ capital when its market value falls below thresholds set by regulators; and the authority to freeze bank operations, prevent banks in trouble from transferring funds to third parties, and restrict dividend payments by institutions not complying with capital requirements. Among other significant changes made after the debt crisis were reforms to trade and foreign exchange policies. Some tariff protection was reintroduced, with an increase in the uniform rate from 10 to 35% between 1983 and 1984, and price bands for the three main agricultural products, dumping rules against unfair competition, and a 10% drawback to minor exports were established (see Chapter V). The reshuffling of exchange rate policy was dramatic, with a return to a crawling peg, after having pegged the nominal peg for three years (1979–82), and having jumped to a totally flexible rate for a brief period. Between 1983 and 1989, the authorities used a floating band of ±2% (widened to ±3% in 1988 and to ±5% in mid-1989). The “official” rate was devalued daily, in line with the differential between domestic inflation and an estimate of external inflation. On a number of occasions, discrete nominal devaluations were added, which contributed to achieve a remarkable degree of real depreciation following the 1982 crisis: 130% between 1982 and 1988. Policies were accommodated to the severe shortage of foreign currency in Chile (initially, a sharper shortage than in most of the region, as discussed in section 1). These devaluations allowed a stronger response to external conditions by encouraging both exports and a recovery in the production of importables and reducing the demand for imports. The monetary policy also experienced a significant change. The policy of totally free interest rates was replaced by active open market operations of the central bank, and “persuasion” that allowed for significant interest rate reductions in bank loans. Consequently, the average real cost of 38% recorded between 1975 and 1982 diminished to an average of 13% in 1983–5 and to 8% in 1986–8. Thus, a competitive exchange rate, the introduction of protection to tradables output, reasonable interest rates for the real sector, and a set of public actions of sectoral support were key allocative policies behind the new exporting take off, the recovery of the output of importables and the restructuring of non-tradable production, which allowed closing the gap between actual and potential GDP.12 But the process took seven long years, 12 Inflation, which had reached one digit by 1981 (even recording negative figures by early 1982), averaged 21% in 1982–9, exhibiting a decreasing trend up to the overheating in 1989. Even though the government was concerned about inflation, the emphasis was placed on the recovery of economic activity; that is another relevant difference between the 1970s and the 1980s.

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with the Chilean economy working for most of the period under a large recessive gap; that is one main variable explaining the low average investment ratio in 1982–9.

4 Strong economic recovery, weak average growth The Chilean economy had been very unstable in past decades. In terms of output (GDP), in the 1980s Chile exhibited the worst drop in 1982 and the greatest expansion in 1989, compared to all other Latin American countries. Both changes (i.e. the fall and the expansion) were related to external shocks: worsening in the terms of trade and foreign debt service, in the first case, and a sharp terms of trade improvement in the second. Apologetic accounts of the economic policy implemented by the Pinochet regime emphasize the evolution of the Chilean economy after the fall, usually starting to count from 1986, focusing particularly on the 10% increase in GDP in 1989. This is misleading for two reasons. In the first place, the greater the fall in economic activity, the stronger the subsequent recovery can be. Consequently, it cannot be ignored that there was a huge GDP drop in 1982–3, which implies an artificially low base of comparison for performance only measured since 1986; additionally, by 1986 there was a sizable gap between actual and potential GDP, which explains the high increase of actual GDP in parallel with a low investment ratio. In assessing the results of economic policies, therefore, it is necessary to weigh the overall economic and social effects and not just one part of the results (i.e. solely the recovery) because this provides a biased view, particularly in an economy that has had so many ups and downs. Notice again that it took seven years for GDP per capita to overtake the 1981 level. Furthermore, only in 1991 did the average wage surpass that of 1981. The second reason is that the great expansion of 1989 was not sustainable. It was based on transitory factors that allowed a sharp recovery of GDP growth, and they could not avoid an overheating of the economy, causing negative effects on macroeconomic and macrosocial balances, which actually required a demand-reducing adjustment in 1990. In fact, the modest investment ratio allowed a limited sustainable GDP growth of about 4% in 1988–9. Moreover, in the whole period covered by the Pinochet regime, the average increase of GDP was a mediocre 2.9% per year, including drops of about 15% in 1975 and 1982, and increases of 8% in 1977 and 1979 and 10% in 1989. To the contrary, export performance was successful in achieving a vigorous overall expansion, in both halves of the regime. The volume of exports experienced a real increase of 11% per year between 1974 and 1989 (15% for non-traditional goods). In per capita terms, exports explain all the modest increase of GDP, while the average of the rest of the economy stagnated (see Chapter VI).

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The main reason why economic growth was so moderate from 1973 is that investment had been low. Average investment in the sixteen-year period was 15.7% of GDP. This figure is much lower than the 20.2% ratio recorded in the 1960s (both figures measured in the same constant prices). This is why, notwithstanding changes in efficiency, productive capacity expanded considerably more in the 1960s: the annual rate was 4.3%, in contrast with 2.9% during the dictatorship. Associated with this poor global performance, in the 1970s and 1980s, real wages experienced a significant drop: in 1989, wages were 5% lower than in 1981. Four factors can explain that outcome: (i) GDP per capita rose by barely 1.2% per year in 1982–9; (ii) a significant share of production leaked out abroad to service the heavy foreign debt accumulated between 1976 and 1982; (iii) the investment ratio per member of the labor force was 15% lower in the eighties than in the sixties; and (iv) the Chilean economy became much more regressive and repressive for workers (see Chapter VII). Low levels of investment were related to the fact that productive capacity was underutilized for many years; as was stressed in Chapter I, a significant gap between actual and potential GDP prevailed during most of the sixteen years of the Pinochet regime. It is worthwhile to repeat that when capacity is underutilized, it tends to reduce the average return on investment and the liquidity of firms, and consequently new capacity creation is deterred. On the other hand, real interest rates remained very high until 1982 (38% in 1975–82), which undermined the financial position of many enterprises and discouraged new projects. However, after 1982, interest rates were reduced sharply, with some intervention by the authorities, but an additional negative factor was added: the distressed financial situation of many firms and the heavy foreign debt service. This implied that a significant share of national savings was not invested domestically but was used for interest payments to foreign creditors. A last factor that discouraged productive investment was that entrepreneurs devoted a significant portion of their efforts to the purchase of existing assets in a highly active process of property transfers. These were induced by the recessive imbalances that prevailed for many years in the Chilean economy, by an intensive privatization of state-owned enterprises, and later by the government takeover of private enterprises that had gone bankrupt in the early 1980s and were subsequently subjected to reprivatization. But not all capital formation was depressed. In fact, as already underlined, the policy shift towards pragmatism included significant incentives for the private sector to invest in exportables and public utilities. As shown in Moguillansky (1999), huge transfers took place, given the form of privatization or reprivatization that was conducted, by means of the rescue of agents caught in the debt crisis, the economic rents involved in debt–equity swaps, the highly

126 Policy Rectifications and Recovery from Debt

efficient drawback to exporters, and, of course, the much needed dramatic exchange rate devaluation. What about productivity? Productivity was much higher after the opening of the economy and the liberalization of markets in several firms, in the successful surviving firms (Tybout et al., 1991). But that progress tended to be offset by a higher mortality rate among enterprises and a low average rate of utilization of productive capacity in a majority of producers. Consequently, there was greater heterogeneity among the surviving enterprises, including the new ones, than in previous years. Modernization reached into many economic sectors, but did not reach the majority of them. For example, there were peasant sectors, small businesses in trade and services, industrial workshops, and self-employed individuals that suffered severe capitalization difficulties and operated, in part, with lower productivity and income levels than two decades before. They managed to stay in business or find a job by scaling down their incomes. Recall the strong fact that average GDP growth was low and income distribution worsened significantly, data that fit the increased structural heterogeneity of the actual productivity of the Chilean economy recorded through these sixteen years.13 The foregoing coexisted with the benefits of having a growing segment of highly productive and dynamic enterprises, both urban and rural, and several of them becoming successful exporters. This was a significant and positive legacy for the future. The export-oriented economic policies and the establishment of a market for natural resources and land (which was certainly aided by the previous land reform) provided the favorable breeding ground that enabled entrepreneurial initiative, particularly among members of the younger generation, to venture into risk taking and an exploration of new forms of production. But, these positive features cannot overcome the evident fact that global growth and equity failed in the first and second halves of the dictatorship.

5 Macroeconomic (im)balances by 1989 There is a long history in Latin America verifying the importance of supporting basic macroeconomic balances. These refer to the amount of money issued, the fiscal budget, the gap between export earnings and import expenditures, the aggregate demand level and several macro-prices, such as the exchange rate and interest rates. The neoliberal approach to macroeconomic balances has focused mostly on the control of inflation and fiscal discipline, what we have called the financieristic approach, based on those two 13 The degree of informality is reflected, partly, in the fact that, by 1989, only 41% of the labor force was contributing to the privatized social security system created by the dictatorship in 1981.

Policy Rectifications and Recovery from Debt 127

pillars (see Fisher, 1993; Ffrench-Davis, 2006, Chapter II). There is no doubt that persistent large imbalances in these two areas have caused severe crises and hyperinflation, and have ended in sharp recessions in the past; several Latin American economies, including Chile in 1971–3, exhibited fiscal imbalances leading to pervasive hyperinflation. Therefore, any consistent policy must take care of those two essential components of macroeconomic balances. However, that is insufficient; moreover, frequently inflation has been repressed artificially, with exchange rate appreciation or fiscal balance being achieved by repressed expenditure in education and public works (see Easterly and Servén, 2003). The serious caveat of the neoliberal approach is the underestimation of other key elements of sustainable macroeconomic balances, in order to become functional for development. Thus, there is a third balance, which should be explicitly included in macroeconomic equilibria, consisting of the relationship between aggregate demand and potential GDP and the behavior of macroprices, such as the exchange rate. The magnitude of the gap between actual and potential GDP affects very significantly the level of capital formation, and subsequently productive employment; the behavior of the real exchange rate is determinant of the performance of the production of tradables and their link with the rest of GDP, as shown in Chapter VI. In general, the Pinochet government was very cautious with regard to monetary expansion and maintained the fiscal budget either balanced or in surplus. A positive consequence of these policies was the convergence towards a moderate one digit inflation in 1981 (quite moderate by Latin American standards). Nevertheless, there is evidence that such policies are a necessary but insufficient condition for economic stability. In fact, the external sector underwent a prolonged and rising deficit, which was financed with external borrowing for a long period of time (from 1977 to 1981). This led to the 1982 crisis, even before the explosion of the region’s debt crisis. On the other hand, during most of the second half of the regime(i.e the 1980s) a large gap again prevailed between productive capacity and its utilization. Following the severe economic recession of 1982 and a few subsequent years marked by uncertainty and huge unemployment of labor and capital, a strong and sustained recovery of economic activity began in 1986. Fiscal policy moved from a large surplus in 1981 to a significant deficit in 1982–5. In 1986–7, a sustainable recovery of economic activity took place, with a progressive decline in the capacity utilization gap, and a return of fiscal policy to a significant surplus in 1987;14 as said, relevant pragmatic adjustments to trade, monetary and exchange rate policies contributed to this recovery. However, in the following two years (1988–9) the situation changed: demand and economic activity expanded at great speed (at more 14 The surplus was achieved, partly, with a sharp drop in social expenditure (see Chapter VII, Table VII.1) and investment in infrastructure.

128 Policy Rectifications and Recovery from Debt

than twice the speed of increase in capacity) and this culminated, in 1989, in an overheated economy when the growth rate of GDP reached 10%. The great expansion was led, principally as of late 1987, by an increase in private aggregate demand as a result of a considerable monetary expansion, a significant reduction in taxes, and real exchange rate revaluation, which made imports cheaper.15 Real aggregate demand expanded by 22% in 1988–9; GDP increased by 18%. The gap between the change in expenditure and production was covered by an unexpected improvement in the terms of trade (i.e. the price of copper and other items). Productive capacity (potential GDP) expanded only by a total of 7–8% in the biennium. The increase in GDP was based on the existence of installed capacity, which became exhausted around 1989 (see Chapter I, Figure I.1), when the economy exhibited evident signals of overheating. Actual GDP had reached the productive frontier, and consequently any additional increase of output required, in contrast to the preceding years, a concomitant increase of productive capacity, which was expanding slowly and quite below the rapidly rising aggregate demand. This imbalance emerged as evident with a notorious acceleration of inflation and a strong rise in imports. In fact, on an annualized basis, inflation reached 31% between September 1989 and January 1990, a threefold increase over the 10% rate recorded by late 1988. The volume of exports experienced a vigorous increase of 23% during the biennium, but imports grew 41%. The gap was covered by the extraordinary inflow of funds generated by the previously mentioned improved terms of trade. This positive shock was centered on the price of copper, which doubled between 1985–6 (US$0.63 per pound) and 1988–9 (US$1.24). Copper represented half of Chile’s exports, was produced primarily by a state-owned enterprise, and yielded high revenues from taxes and profits to the government. Due to the intensity of maladjustments, the Pinochet government carried out successive adjustments, which included a devaluation in June 1989, increases in the interest rate in April and September 1989, and finally a sharp one in January 1990.16 Thus, in March 1990, when the democratically 15 The supply of money (M1A) increased by 56% in the twelve-month period ending in October 1988 (the same month in which the plebiscite that the Pinochet government was forced to call was carried out). Taxation decreased by approximately 4% of GDP in 1988–9, and the real exchange rate underwent a 12% revaluation between January 1988 and June 1989, when the Pinochet government reversed this policy due to the accelerated increase in imports. The reversal was effective, since it achieved a devaluation from the floor (appreciated bottom) to the ceiling of the exchange rate band, which worked fluently in those years. 16 The latter was carried out after the central bank had begun operating as an independent institution, according to the tailor-made legal framework imposed by the Pinochet regime, which was enforced as of December 9, 1989; that is, five days before the presidential election and sixteen and a half years after the coup of 1973.

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elected President Aylwin took up the presidency, interest rates were notably higher, reaching real active levels over 16%. In short, when the democratic government was inaugurated in 1990, there was a macroeconomic imbalance, and an adjustment process was already under way in order to correct it.

V Export Development during the 1980s*

The successful growth of the export sector can be seen as an outstanding outcome of the Chilean economic reforms since 1973. The debt crisis was an additional incentive for export expansion, given the binding external restriction that Latin America as a whole experienced in the 1980s. An annual growth of the volume, averaging 9.1% in the over one-third of a century elapsed up to 2008, places the export performance as an outstanding quantitative achievement of the Chilean economy;1 in that same period, WTO data show that the volume of world trade averaged a 4.8% annual growth. Notwithstanding the Chilean exporting success, the pulling capacity of its exports over the rest of the economy has been robust only in some periods, without achieving a sustained positive association across time. For instance, in the decade on which this chapter focuses (1982–9), exports of goods and services grew at an annual average rate of 7.8%,2 whereas GDP only expanded 2.9%. This poor pull effect has structural and macroeconomic causes. It is important to distinguish different stages in trade performance and policies in the one-third of a century covered by this book. The first half of the military regime, characterized by the early trade liberalization, high rates of growth of exports until 1980, and the parallel recovery of GDP recorded by the Chilean economy after the deep crisis of 1975, would seem to indicate a successful trade reform. However, this first trade reform3 was characterized * I appreciate the comments of Sebastián Sáez. 1 Several interesting studies analyze the export performance in Chile. See, for instance, Meller and Sáez (1995), Meller (1996a), Agosin (1999, 2007), Sachs et al. (1999), Herzer and Nowak-Lehmann (2004), Macario (2000), and DIRECON (2009). 2 These figures correspond to the gross value of exports of goods and services in 1996 constant prices (or quantum of exports). In Chapter VI I report estimates of exports net of imported components; that is, value-added to GDP by exports. 3 The first trade reform, detailed in Chapter II, was implemented between late 1973 and June 1979. 130

Export Development

131

by an import liberalization bias more powerful than the export promotion policies: a trade deficit of 12% of GDP in 1981 represents evidence of the bias; the liberalization of imports reduced the production costs of exports, but this pro-exports effect was much weaker than the overall pro-imports effect.4 The imbalance caused by the import-led (instead of a direct exportpromoting) nature of the reform was reinforced by exchange rate appreciation in the late 1970s, building up a discouraging environment for exports by the early 1980s (see Chapter II). Actually, by 1981 most exports were decreasing in quantum, reinforcing the negative impact of worsening terms of trade. A second export takeoff emerged after the debt crisis of 1982, as a result of improved conditions, such as a sharply depreciated real exchange rate in the 1980s and somewhat active public policies; these included a rather pragmatic second trade “reform” that reintroduced some protection to importables and direct incentives to non-traditional exports. This chapter covers the main features of the Chilean export model since 1973, with special emphasis on the export take-off during the eighties. Section 1 briefly summarizes the channels by which exports can contribute to national development, influencing the pace of economic growth. Section 2 analyzes the role of trade and exchange rate policies, both marked by the effects of the debt crisis. Then, the strategy of the seventies, simply based on unilateral tariff liberalization, was replaced by a policy that, maintaining the uniform tariff, raised its level, and introduced some interventions on imports and diverse direct export incentives. Section 3 reviews the export sector performance, in terms of dynamism, the composition of its basket, and diversification. Section 4 starts the evaluation of the links between exports, recovery, and economic growth, issues that are deepened in Chapter VI, which analyzes trade policy since 1990.

1 The role of exports in national development There are different channels by which exports can boost a country’s rate of economic growth: by (i) generating the foreign exchange that enables the purchase of imports required for economic expansion, at a lower real cost than that of producing import substitutes; (ii) exploiting economies of scale and specialization, directed to the broader external markets; (iii) giving rise to linkages with other local activities, which make it possible to exploit 4 Estimated with GDP in pesos converted into US dollars with the average RER of 1976–8, expressed in currency of 1981. In current prices, the trade deficit in 1981 was 8% of GDP. Given the sharp appreciation of the exchange rate, the current dollar value of GDP appeared artificially high in 1981, which in turn determined external deficit and debt ratios that implied an underestimation of the severity of rising external imbalances. See Chapter III.

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Export Development

underutilized capital and human resources and stimulate new investments by domestic suppliers to exporters; (iv) bringing greater contact with international best practice, exposing export activities and their suppliers to the demands of competitiveness, and generating externalities (knowledge and spillovers, partly but not only via the direct linkages in iii) in the domestic economy;5 and (v) exports also playing a macroeconomic role. In economies under a binding external constraint (BEC), as in the 1980s, increased exports contribute to raise the rate of use of resources thanks to the positive impact of the increased supply of foreign currency on effective demand. From the standpoint of generating foreign exchange, what is important is not only its volume at present, but also its future rate of growth. Thus, it is relevant to promote exports of goods and services that feature a growing and vigorous external demand over time, particularly in markets in which the country is not a small supplier. One of the pitfalls of a strong concentration of traditional exports in natural resources-based products is that their longterm world demand tends to grow slowly. In addition, many developing countries put pressure on the supply, causing a fall in international prices. In order to sustain a high growth of export quantum it is necessary to diversify the export basket towards products with more dynamic demand. As regards the spillover effects from trade on the rest of the economy, the larger the number of firms and productive sectors associated with exports, the greater tends to be the impact on the production structure. Similarly, this impact increases along with the national capacity to absorb the knowledge acquired by export firms. This is why it is important to deepen the linkages between export activities and the rest of the productive system, and to improve domestic mechanisms for the transfer and dissemination of technology, as well as human resources training. This is, in general, the concept of systemic competitivity (see Fajnzylber, 1990; Ocampo and Parra, 2007) and its feedback with exporting quality: vigorous exports in a low productivity domestic economy do not involve a dynamic economic growth; likewise, efforts aimed at systemic competitiveness in a closed small economy tend to end in a deadlock quickly. Thus, public policies to support exports are key ingredients to enhance development. A strategy of international insertion must give priority to growth and diversification of exports as a long-term goal. But, at the same time, the strategy has to strengthen the linkages of exports with the rest of

5 The generation of externalities is associated with horizontal and vertical diversification of exports. Agosin (2007) develops an interesting empirical analysis, comparing the experiences of Latin America and Asia. He concludes that the diversification (i) tends to reduce the volatility of exports value and with it that of GDP, and (ii) stimulates clusters and the transmission of best practices and “learning by doing.” Herzer and Nowak-Lehmann (2004) make an estimation of these effects for Chile, concluding that they are empirically significant.

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the economy (see Chapter VI, section 3), by coordinating export promoting policies with a set of economic policies including measures to promote productive development, via technological innovation and labor training – all in a context of consistent exchange rate, fiscal, and financial policies (see Bouzas and Keifman, 2003).

2 Trade policy in the 1980s: a departure from orthodoxy In response to the deep recession of 1982, Chile had to adjust its policies to face the severe external constraint and stimulate domestic recovery. In fact, there were some significant changes from the orthodox model implemented in the 1970s to a more pragmatic economic approach. This included some significant stepbacks, from an orthodox perspective, with respect to the first reforms (see Chapter IV and Moguillansky, 1999). In this new context, the generation of a trade surplus as a means of serving the foreign debt was given top priority. The strategy implied both the reduction of imports and the promotion of exports, which was done through three actions: an increase in the uniform import tariff, the use of a battery of instruments to encourage exports such as an innovative drawback for non-traditional items, and an active exchange rate policy to ensure external competitiveness and enhance the production of foreign currency by the Chilean economy. The strong financial external constraint stimulated substantial devaluations in Chile as well as in the rest of Latin America. (a) The export momentum in the 1970s In late 1973, a trade policy reform was launched that covered the elimination of all non-tariff trade barriers, a sharp process of tariff reduction, and the establishment of a single exchange rate. Although it was not one of the initial goals, by June 1979 a uniform tariff of 10% had been established, and the exchange rate was pegged. However, there was no systematic direct effort for export promotion. Trade policies responded to the assumption that market forces would reallocate (without net costs) resources expelled by import liberalization towards the export industries in which the country had comparative advantages; this would lead to both fast export and GDP growth. During the first trade liberalization program, sharp tariff reductions and the dismantling of quantitative controls appear to have had a great impact, favorable to export dynamism. The point of departure was one in which there was enormous room for the reduction of the costs of producing exportables by substituting imported inputs for domestic ones, and broad opportunities for improving productivity. Additionally, in late 1973 there was a significant underutilization of installed export capacity, due to the huge distortions then prevailing in the Chilean economy. That is the more significant reason for the spectacular increase and diversification of exports

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during 1974–80, especially focused in 1974.6 Nevertheless, the tariff liberalization of 1974–9 was unnecessarily costly, because a sizable share of the manufacturing installed capacity was destroyed, instead of being gradually reallocated to export sectors (Agosin, 1999). Just as import substitution has an “easy” stage, so there is an initial easy stage in the promotion of exports in emerging economies. The increase in non-traditional exports in the 1970s relates in general to this stage. In fact, it relied on rich natural resources and underutilized installed capacities, intensified by the great depression in domestic demand in 1975–6 and its subsequent slow recovery. This situation initially enabled exports to expand without major investments. The increase in exports was spurred by four additional factors. First, a crawling-peg exchange rate policy of minidevaluations was applied, which, despite contradictory movements from 1976, in combination with the sharp drop in labor costs initially encouraged exports. Second, the presence of Chile in the Andean Pact until 1976 provided an enlarged market for more than one-third of the increase in new exports (Ffrench-Davis, 1979). Third, there was a reduction in the cost of imported inputs to those exporters who had not benefited from tariff exemptions previously. Finally, together with the above factors, the privileged position assigned to export promotion in the official rhetoric gave a significant pull to the hitherto incipient export mentality of domestic entrepreneurs.7 However, the dynamism of exports transmitted quite weakly to the rest of the economy. That feature was replicated during the 1980s. The fact remains that, because of the recessionary situation in which most of the reform was implemented, its suddenness, and the subsequent trends exhibited by the exchange rate (appreciation) and interest rates (notably high), the dynamism from the strong export performance was weakly transmitted to the rest of the economy; indeed, fixed investment was far below its historical level and, as shown in Chapter II, the economy exhibited a sharp de-industrialization during the 1970s. (b) Export promotion and the second trade reform in the 1980s The domestic and balance-of-payments crises that hit Chile in 1982, as a result of a combination of errors in economic management and the three 6 The growth rate of the volume of exports of goods was spectacularly high in 1974 (38%); growth of copper exports experienced a huge jump based on the maturing of large investment projects of the late 1960s; but the volume of non-copper exports also expanded by a notable 34%. A factor that contributes to explain the strong increase in the volume of non-traditional exports in 1974–6 was the dynamic demand of countries of the Andean Community. 7 The official policy included active promotion through a public institution (PRO-CHILE). This involved a deviation with respect to orthodoxy, which claimed to base the promotion of exports exclusively on the liberalization of imports and the supposed compensatory exchange rate devaluation. As the orthodox approach gained control in public action, PRO-CHILE rapidly lost importance.

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negative external shocks, caused aggregate demand to fall by 28% and GDP to shrink by 14%. In an effort to cope with the crisis, a number of discrete devaluations were applied, and later a crawling peg was reintroduced. It was an answer to the evident need to generate a trade surplus in order to be able to serve the external debt, especially in the absence of new voluntary capital inflows and with depressed terms of trade. At the same time, the uniform tariff was raised in stages up to 35% in September 1984 (with annual averages of 24% in 1984 and 26% in 1985). As the severe shortage of foreign exchange began to ease, the tariff was gradually lowered again, first to 30% in March 1985, then to 20% in June, to 15% in 1988, and to 11% by mid-1991. It is important to mention that, in spite of these successive reductions, in 1991 the uniform tariff was still above the 10% reached in 1979. It is a serious mistake to present the eighties as a trade liberalization decade with respect to the seventies. Import liberalization took place between 1974 and 1979. Following the 1982 crisis, trade policy became more selective in several respects. The government began to make somewhat active use of anti-dumping measures to protect the economy from unfair trade practices.8 To this end, the total tariff (the uniform rate plus compensatory surcharges) was raised to a maximum of 35% – the level to which Chile had committed itself under the terms of the GATT in 1979 – on imports that Chile could prove were being dumped. In addition, in order to reduce the transmission of external instability into the domestic economy, price bands (supposedly consistent with international price medium-term trends) were set for three main agricultural products (wheat, sugar, and oilseeds); given the then depressed international prices, this had significant encouraging effects on traditional agriculture. Evidently, this also constituted a departure from the uniform tariff. The explicit promotion of exports was made through a battery of instruments, of which the simplified tariff drawback created in 1985 stands out. The objective was to reimburse exporting firms a compensatory amount for the tariffs paid on imported inputs, used to produce non-traditional exportables. The instrument allowed exporters to obtain a maximum refund of 10% of the fob value of exports. The requirements to benefit from the incentive were: (i) the firm had to export products with less than 50% of imported inputs; and (ii) the total exports of the country in the respective item should not exceed a given annual threshold. The threshold value of exports that determined the loss of the benefit was raised annually to take into account inflation. In 1987, it introduced two tiers to allow for a gradual loss of the subsidy. During 1988 the sales of inputs to exporters qualifying for the RS were added to the list of beneficiaries. 8 The domestic legislation to attack trade distortions was established in 1981, in the presence of pressures fed by the sharp appreciation of the exchange rate recorded after 1979. See Sáez (2005).

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Careful econometric research on the impact of the simplified drawback shows that after the introduction of this instrument, the number and value of manufactured exports grew more rapidly (see Agosin et al., 2009). In addition, the automatic extinction of the subsidy was an important feature; in fact, as the respective item developed, and its volume exceeded the respective thresholds, the percentage of the refund was reduced automatically and, finally, the product did not qualify for reimbursement (precisely because of its success), liberating resources for newer exports. The drawback scheme sought (with efficiency, despite some evasion and fraud) to promote the entry of new products and new external markets, enhancing productive and exporter diversification (with their respective externalities). The policy contributed to increase the number of exporting firms, especially SMEs (Macario, 2000). In 1986, the amount spent by the government in this instrument was US$25 million, a figure that rose to US$66 million in 1989. The scheme reached a peak in 1998 with an expenditure of US$200 million. Though the spirit of the instrument is a tariff refund, in practice, it corresponded to a net incentive to non-traditional exports; we return to the issue in Chapter VI. Box V.1 summarizes the main export promotion mechanisms in force by the late eighties. On the other hand, one of the outstanding initiatives of export promotion was developed by the Chile Foundation, a semi-public institution. The Foundation’s first projects, in the seventies, were directed mainly at providing technical assistance to certain productive sectors. Few of these early projects got beyond the pilot stage. In view of this problem, the Foundation decided it needed to gain more experience by launching business projects of its own. The idea was to determine which activities might benefit from new technologies, and then to acquire and adapt these technologies. Once a technology was assimilated, the Foundation would take charge of commercial production and marketing through a subsidiary. When the subsidiary became profitable, it would be sold, thereby completing the technology-transfer process. The salmon industry was an example of a very successful initiative. In 1981, the Foundation decided to carry out a pilot project using a cage-based technique of freshwater salmon farming. Commercial production began in the period 1986–7, and output doubled in the following period. The project began to deliver profits in 1988, and the technology-transfer cycle was completed that same year when the Foundation sold the project to a Japanese fish and shellfish company. This project gave a definite boost to overall salmon output in Chile, which became one of the top Chilean exports and the main non-traditional one in the 1990s (ECLAC, 1998). In the eighties, two additional changes (which involved intervention in the relationship between domestic and external markets) took place. On the one hand, the application of the debt–equity swap program, summarized in Chapter IV, did not have the neutrality and automatism with

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Box V.1 Incentives to exports by the late 1980s • Drawback. Recovery of tariffs paid when importing inputs used to manufacture exports. It allows firms to have access to a wide range of imported inputs. However, this scheme involves complex paperwork requirements, and large companies have a greater ability to comply with the requirements. By contrast, SMEs tended to prefer the simplified drawback scheme described below. • Simplified drawback. Simplified tax rebates or drawback on minor or non-traditional exports, in the form of refunds of 10 or 5% of the fob value of exports. This scheme was set up in 1985. • Value added tax refund. Exports are exempted from the value added tax and benefit from the refund of taxes paid on inputs incorporated into exports. This mechanism is designed to avoid double taxation on final products and follows the principle of taxation in the place of destination instead of production. • Export warehouses. Allow firms manufacturing exports to store imported inputs that will be used to produce exports, without paying tariffs or value added tax. • Scheme for importing capital goods. Deferred payment (up to seven years and three installments) of customs duty on imports of capital goods. This provision is of general coverage and is not confined to exporters. If the capital goods imported under this policy are used to manufacture exports, then it is possible for the company to avoid paying the tariffs (the firm must have exported at least 10% of its total sales in the previous two years – for the first installment – which increases to 60% for the next two payments). • Financing of collateral for non-traditional exports. The Fondo de Garantía para Exportaciones No-Tradicionales, set up in 1987, provides export firms with up to 50% of what banks require as collateral when granting loans to finance non-traditional export investments (with a maximum of US$200,000 per year for each exporter). • Export investment financing. CORFO has a long-term borrowing facility (at subsidized rates) to finance export firms’ investments, with annual sales under US$30 million. Also, it provides assistance with export insurance for firms with yearly sales under US$10 million. Source: Ffrench-Davis et al. (1992) and Macario (2000).

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respect to the policies implemented in the seventies. On the contrary, the program implied a strong subsidy to foreign investment in projects that were approved case by case, with priority given to new non-mining exports (Ffrench-Davis, 1990). Thus, the authorities prompted an idea of industrial policy (Agosin, 1999). During the years that it was operating (1985–91), about 60% of investments carried out under this program were directed to manufactures, forestry, wood pulp, and paper. On the other hand, the government strengthened the export-promoting public institution Pro-Chile. Given the dominant strategy in the seventies, its role had been minimized. By contrast, by the mid-eighties it was rearticulated, strengthening its role of information provider on and for external markets. In summary, after 1983, Chile carried out a more pragmatic “second trade reform,” with a mix of restrictions, tariff increases, and explicit export promotion. While it is true that the basic characteristics of the country’s trade policy – in terms of the dismissal of non-tariff barriers and the adoption of a uniform tariff – had not changed since 1979, it must be taken into account that the tariff had once again become relatively high by 1984 and was accompanied by anti-dumping measures and the price bands mentioned above. In fact, the tariff level averaged 20% in 1984–9, which was double the average rate for 1979–82 (see Table V.1).9 The greatest difference, however, Table V.1 Average tariff and real exchange rate, 1973–89 Average tariffa (%) 1973 1980 1981 June 1982 1982 1983 1984 1985 1986 1987 1988 1989 1980–2 1984–9

94.0c 10.1 10.1 10.1 10.1 17.9 24.2 25.8 20.1 20.0 15.1 15.1 10.1 20.1

Real exchange rateb (1986 ⫽ 100) 65.1c 60.9 51.8 47.0d 60.1 72.1 74.3 91.0 100.0 104.3 111.2 108.6 57.6 98.2

Source: Based on Central Bank of Chile. aAnnual average, excluding exemptions and preferential arrangements negotiated with LACs. bAnnual average. The nominal exchange rate was deflated by the Chilean Consumer Price Index (CPI; duly corrected in 1973–8) and inflated by an external price index. c December 1973. dMonthly average, until the day before devaluation. 9 Nonetheless, it was notably lower than the 94% nominal average tariff recorded by 1973, and lower than usual average rates in other Latin American countries in those times.

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was that during the first liberalization drive the exchange rate had appreciated steadily in the second half of the 1970s, and in the early 1980s. During the 1980s, on the other hand, the reduction of the tariff from its maximum level of 35% in 1984 to 15% by 1988 was accompanied by a sharp real depreciation, under the pressure of the debt crisis. This sent out powerful positive incentives to exporters, while at the same time encouraging the production of import-competing goods.10 Unlike in the first liberalization effort, the increase in exports was also coupled with a strong upturn in the output of import substitutes, especially between 1984 and the late 1980s. The modification of the exchange rate policy, stimulated strongly by the sharp shortage of external financing, played a central role. (c) The evolution of exchange-rate policy Exchange rate policy has experienced substantial change over time. In the mid-sixties, a crawling-peg policy was introduced; then, the exchange rate was actively used to stimulate the production of exportables and to reduce the current account deficit. In 1971–3 the main exchange rate was pegged as an anti-inflationary anchor. In 1973–5 it recovered the role of resource allocating, with a return to a crawling-peg policy. Starting in 1976, the nominal rate began to be used again to fight inflation. This was because inflation stubbornly refused to slow down in reaction to a deep economic recession, which also caused a surplus on current account in 1976. The real revaluation that usually results from using the exchange rate as an anchor was intensified in 1979, when the rate was fixed in current pesos, at a nominal parity of 39 pesos that was maintained until the currency and financial crisis of 1982; a significant real appreciation took place during these three years. After the crisis, there followed a period of experimentation with successive policy changes during a few months. In fact, in June 1982, after an 18% devaluation, a mini-devaluation program was announced; it appeared to be a return to the crawling-peg policy in force before the rate freeze in 1979. But, given a strong loss of credibility and the evident insufficiency of devaluation and the schedule announced, the outflow of international reserves continued disproportionably high. Then, after the ministry that had directed the neo-liberal reforms in the seventies was replaced, the full liberalization of the foreign exchange market was decreed. The authorities believed that given the liberalization, the markets would calm down. The opposite happened, because given free access, in a few weeks the remaining international reserves evaporated, in the presence of massive demand. Thus, the government reintroduced control of the exchange rate and of access to the market. A crawling-peg exchange rate was again adopted from 1983 onward. Basically, the central bank fixed a benchmark price for the dollar on the 10 See quantitative estimates in Moguillansky and Titelman (1993) and Agosin (1999).

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official market (called the “agreed” exchange rate), with a floating band that was gradually enlarged from time to time. The “official” rate was devalued daily, in line with the differential between domestic inflation and an estimate of external inflation. On a number of occasions, discrete real devaluations were added, helping to achieve the spectacular real depreciation following the 1982 crisis (130% between the monthly minimum in 1982 and the average of 1988; see Table V.1).11 During 1988, the real exchange rate peaked. In that year, revaluations together with tax and tariff reductions – financed by a huge jump in the copper price – were implemented to reconcile a reduction in inflation with a sharp recovery in aggregate demand and economic activity (see Chapter IV, Table IV.2). This preceded a significant political event: in October 1988, for the first time since 1973, Chileans were able to vote, though with extreme restrictions. A plebiscite asking Chilean people whether Pinochet should continue in power for one or eight more years took place. The first option prevailed. Economic recovery was completed in 1989, with actual GDP climbing up to the production frontier or potential GDP (see Chapter I, Figure I.1). The tax and tariff reductions and exchange rate appreciation in 1988 were directly associated with the additional income generated by the sharp jump in the copper price in 1987–9; the improvement in the terms of trade in 1988 with respect to 1986 was equivalent to 6% of GDP (measured at 1986 constant prices). A sizable increase in imports and in the current account deficit in 1989 (if the current account is recalculated using the “normalized” price of the Copper Stabilization Fund), together with new inflationary pressures, led the central bank to reverse earlier reductions in interest rates. By mid-1989, the floating band of the dollar was widened further to ±5%. The central bank’s action was accompanied by a shift in the foreign currency market expectations, which led the market to move quickly to the ceiling of the band (the depreciated corner). Thus, with efficiency and no great trauma, a significant depreciation was achieved without modifying the “official” rate. For about a year, which included the return to a democratic regime, presidential elections (in December 1989), and the inauguration of President Aylwin (in March 1990), the observed exchange rate remained at the ceiling of the band. This occurred despite the fact that, in January 1990, a sharp tightening of the adjustment process was made in order to control a sizable jump in inflation (which had reached an annualized rate of 31% in the five preceding months).

11 Because various foreign exchange controls remained in force (except for a few weeks in 1982), an illegal (but openly tolerated) market was operating in parallel. This was legalized as the “informal” foreign exchange market only in April 1990, under the provisions of the Central Bank Autonomy Act issued in the last days of the Pinochet government.

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3 Export performance: dynamism and diversification During the first half of the military regime, the Chilean economy experienced a notable expansion of exports, which represented a clear take off from previous historical performance. In the seven-year period 1974–80, it was particularly vigorous, with the volume of non-copper exports climbing over 20% per year. As shown in Chapter II, total and manufacturing exports stagnated in the early 1980s because of the significant appreciation of the real exchange rate and the slowdown of the world economy. In fact, in 1981 the total quantum of exports fell 3.3%, led by a 7% drop in non-copper items (see Sáez, 1991). Subsequently, encouraged by the sharp exchange devaluations taking place since 1982, non-copper exports recovered some speed. In all, in 1974–85 they expanded by 16% annually (Table V.2). Table V.2 Growth of export volume, 1961–89 (annual averages, %)

Copper Non-copper Total goods Total goods and services

1961–70

1971–3

1974–85

1986–9

3.9 7.8 4.9 3.6

–2.2 –8.5 –4.5 –4.2

5.0 16.0 9.4 10.7

3.3 13.1 8.8 11.1

Source: Sáez (1991) for copper, non-copper, and total exports of goods in 1961–85; Central Bank of Chile balance of payments for copper and non-copper in 1986–9; national accounts (in 1977 pesos) for total exports of goods and services.

A second cycle of high export growth rates began well after the 1982 crisis. In the second half of the 1980s (1986–9), non-copper export quantum grew by 13% a year; 9% for traditional goods and a notable 22% for nontraditional items (see Chapter VI, Table VI.1). As said in previous sections, the latter goods benefited from a highly depreciated exchange rate and the simplified drawback. Chilean exports became increasingly diversified but remained strongly natural resource-intensive. The share of copper decreased from an average of 72% in 1970–2, to 47% in 1982–9 (see Table V.3).12 Non-copper traditional exports – composed of fresh fruit, iron, nitrate, wood and natural 12

The share of copper in total exports is notably affected by the international price. The figures mentioned here are corrected by a trend copper price series; the trend was estimated on the basis of real prices and the Hodrick–Prescott filter. Additionally, keep in mind that during the eighties, substantial decreases in production costs were registered in the main copper companies around the world. Productivity improvement in mining treatment and management overcame the deterioration in the laws of minerals. For this reason, in the following years, the expected “normal price” for copper tended to be much lower than in the preceding decades (see Bande and Ffrench-Davis, 1989). Cost decreases continued in the nineties.

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Table V.3 Composition of goods exports, 1970–89 (%)

1970–3 1974–81 1982–9

Copper

Traditional non-copper

Non-traditional

74.5 53.8 47.0

17.2 30.4 35.6

8.3 15.8 17.5

Source: Based on BADECEL. The figures are in current US dollars. The value of copper exports was corrected by estimates of a trend of the nominal copper price, derived from estimates of the trend real price with a Hodrick–Prescott filter (see Figure IX.2).

resource-based manufacturing, such as fishmeal, wood pulp and paper – grew vigorously in the 1970s, jumping from 17% of total exports of goods in 1970–3 to 30% in 1974–81. In the early 1980s their real value declined as a result of the anti-export bias of the exchange rate appreciation; however, from the mid-eighties their real value resumed a dynamic growth increasing its participation to 36% in 1982–9. Non-traditional exports – which include several hundreds of manufactured items with higher value-added, and new resource-based products – initially expanded during the first trade reform. Their share increased from 8% in 1970–3 to 18% in 1980–1; their participation weakened in the next few years. As mentioned, from 1985, again this group exhibited a strong growth and, as a consequence, its share reached 22% of total exports in 1989. On the other hand, the number of products sold abroad increased from 200 in 1970 to 2,300 in 1990. The most outstanding new item was salmon. Exports became more diversified not only in terms of items, but also with respect to markets of destination. In fact, the number of countries covered rose from 31 in 1970 to 129 in 1990. Traditionally, the European Union (EU) was the most important destination for Chilean exports. In 1970–3, for instance, 54% of total exports went to Europe, while the rest was principally distributed between Japan (17%), Latin America (13%) and the United States (10%) (see Table V.4, row d). After the first trade liberalization, the geographic distribution experienced some changes, mainly due to the growing importance of Latin and North American markets at the expense of the participation of the EU. The debt crisis, and its strong impact on Latin America, however, implied a setback in that trend, with a return in the share of the region to 12% in 1983, after reaching a peak of 25% in 1980. In all, in 1982–9 Latin America absorbed 16% of total Chilean exports, the USA took 21%, while the EU decreased to 37% after having averaged 42% in 1974–81. Meanwhile, the Asian countries (other than Japan, which shows decreasing importance from a high level) and a group of numerous other countries had emerged as relevant partners, increasing their participation from 6% in 1970–3 to 16% in 1982–9; this trend became even stronger in the 1990s and 2000s (see Chapter VI).

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Table V.4 Geographic distribution of Chilean exports, according to degree of elaboration, 1970–89 Classification

Composition Geographic distribution (%) (% of total) Latin EU USA Asia Japan Other America 11

1970–3 (a) Non-processed natural resources (b) Processed natural resources (c) Manufactures (d) Total

16.9

10.0

25.7

10.8

1.1

48.8

3.7

80.7

12.4

61.5

10.0

4.5

9.8

1.8

2.3 100.0

52.8 12.8

12.1 54.2

9.6 10.1

3.7 3.9

7.7 16.5

14.0 2.4

19.9

16.5

26.2

12.4

4.3

32.1

8.5

73.9

23.6

47.9

11.3

4.5

7.7

5.0

5.2 100.0

59.3 24.0

11.8 41.5

11.8 11.4

4.0 4.4

1.8 12.2

11.2 6.5

29.1

10.9

26.8

24.4

6.8

23.4

7.7

63.3

15.7

43.6

18.5

8.2

7.3

6.7

6.3 100.0

43.5 15.5

18.6 36.7

23.8 20.6

4.6 7.5

1.7 11.5

7.9 8.2

1974–81 (a) Non-processed natural resources (b) Processed natural resources (c) Manufactures (d) Total 1982–9 (a) Non-processed natural resources (b) Processed natural resources (c) Manufactures (d) Total

Source: Based on COMTRADE (ECLAC) figures, processed by Jaime Contador. Figures in current US dollars, classified according to ECLAC (1992). Based on SITC rev. 1. The composition does not always add to 100% because of unclassified transactions summing around 1% of total exports.

The composition of Chilean exports varies hugely according to their geographical destination. Table V.4 shows that unprocessed and processed natural resources represent an overwhelming share of total exports of goods; a trend that is stronger in those directed to industrialized countries. On the other hand, more than one-half of manufacturing exports were directed to Latin American countries; in 1970–89, 52% of Chilean manufactures were sold to countries in the region, much more than the 16% sold to the USA, 15% to the EU, and 3% to Japan and Asia, respectively; on the negative side, sales to Latin American partners have been extremely sensitive to recessive macroeconomic situations in regional markets, as was the case during the debt crisis. The outstanding importance of the Latin American countries as destination of manufactured products is crucial for the expansion of the volume and quality of exports intensive in value-added. This issue is reexamined in Chapter VI.

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4 Dynamic exports and limited economic growth Exports have frequently been called the “engine” of Chilean economic growth. As has been shown, they have exhibited a vigorous expansion, growing systematically faster than GDP during the past third of a century. Actually, they were one of the fastest rising components of GDP. Consequently, the gross value of exports of goods and services raised its share of GDP from 10% in the 1960s to 25% in 1989 (measured at constant prices of 2003). Evidently, this has been a potential channel of transmission of externalities resulting from exposure to foreign markets. Nonetheless, the dynamic growth of the volume of exports of goods and services (10.7% annually in 1974–89) took place in parallel with a GDP rise that scarcely averaged 2.9%. As shown in Chapter IV, the external debt crisis and the subsequent automatic adjustment carried out meant a generalized fall in domestic output in 1982–3 (recall that there was a drop of 14% in GDP), when demand-reducing policies caused a high underutilization of productive capacity; naturally, given a sizable devaluation, tradable production tended to increase subsequently. By contrast, underutilization was concentrated in non-exportables, whose capital formation was discouraged as a consequence.13 The export-promoting measures of the 1980s worked as supply-switching policies, reallocating available resources, against the background of a very low overall investment ratio (and, as a consequence, low creation of new capacity). Depressed domestic demand and the increased export profitability, as a result of exchange rate depreciation, provided the conditions that encouraged investment and output in exportables. Consequently, it was not precisely a case of export-led growth, but rather of an export drive led by the binding external constraint and a recessionary domestic adjustment. Evidently, strong export expansion, which averaged 7.8% per annum in 1982–9, was a factor contributing to the recovery of economic activity throughout this subperiod; however, it could not compensate for the near stagnation in non-export GDP, which grew by only 1.7%, merely as much as the increase in population. This share of GDP that was sold in the domestic markets was generally working under macroeconomic disequilibria, in the sense that demand was frequently below productive capacity. Thus, exports were unable to transmit their dynamism to total GDP, which expanded modestly by 2.9% per annum (see Chapter VI, Table VI.6). Naturally, most probably, ceteris paribus, if exports had grown less, GDP would have tended to be even smaller. But the straight message is that vigorous export growth is not sufficient to generate a dynamic economic expansion. It must be recalled that, frequently, there was a huge output gap between potential and actual GDP; generally, that recessive gap was placed in the 13 In Ffrench-Davis (2006 Chapter II) I have documented the strong negative impact of the gap between potential GDP and actual GDP on the investment ratio.

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production of non-exports (an exception being, as said, 1981). This implies that a strong depressing effect of the gap was countervailing the pulling effect of rising exports. But, beyond this macroeconomic consideration, there is the structural feature of an economy with incomplete capital markets, excessively intensive in short term channels, outlier high interest rates, exchange rate instability, low capital formation and weak innovation forces for most of the domestic economy. What an unfriendly environment for the producers of wealth! I fully share the approach that exports should lead overall economic growth. However, notwithstanding the broad consensus around this view, during the seventies and eighties, we observe a significant export drive that was not accompanied by a respectable average economic growth. This reveals that a dynamic expansion of exports is a necessary, but insufficient, condition for development. I return to this relevant issue in Chapter VI.

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Fourth Part Development Challenges for Democracy

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VI Export Dynamism and Economic Growth since the 1990s*

The nineties marked a new stage for Chilean trade policy. Export dynamism was encouraged by a more comprehensive policy that combined both the principles of an open economy and free trade and integration agreements with several countries or groups of them – at the beginning, particularly in Latin America, and subsequently with diverse developed countries and other emerging regions. This strategy was implemented in a new economic environment characterized by high domestic investment and overall growing productivity, especially until 1998. In all, in the nineteen-year period (1990–2008), a 7.9% average expansion of exports was associated with a relatively vigorous GDP growth averaging 5.3%. These figures are in sharp contrast with the 10.7 and 2.9%, respectively, recorded in 1974–89 in Chile; interestingly, the two latter figures are not too different from the growth of exports (6.9%) and GDP (3.2%) exhibited by Latin America in 1990–2008. The contrast is focused on the advantage taken by Chile in 1990–8, and is associated with differences in the macroeconomic environment, particularly the quality of exchange rate and capital account policies. In section 1 the trade policy approach since 1990 is examined, emphasizing the role of the series of free trade agreements and the evolution of exchange rate policy. Section 2 describes the general performance of Chilean exports, in terms of both the basket of products and markets of destination and their diversification. The interaction between exports and foreign investment is examined in section 3. The changing relation recorded between the evolution of exports and of economic growth is explored in section 4. Finally, some concluding remarks are presented in section 5.

* I appreciate the valuable comments of Sebastián Sáez, Rodrigo Heresi, and Heriberto Tapia. 149

150 Export Dynamism and Economic Growth

1 Trade policies since 1990 The economic team that took office in 1990 maintained the basic principles of the 1980s trade policy. Principally, the economy remained open to trade, and there was continuity in terms of maintaining a uniform nominal import tariff rate towards the rest of the world. The rate of 11% established in 1991was held up to 1999, when a gradual unilateral reduction of 5 points was initiated, reaching 6% from 2003 to date. However, at the same time, numerous free trade agreements were launched, involving import liberalizations accompanied by increasing market access and tariff preferences for exports to trade partners. Undoubtedly, the net balance for Chile of this innovation differs from a unilateral liberalization: liberalization of imports from partner countries came together with liberalization of the access of Chilean exports to the markets of those partners. On the other hand, macroeconomic policies were substantially modified, in a significant reform of the reforms in the early 1990s (see Chapters I and VIII). As a consequence of the macroeconomic reform, especially in 1990–5, (i) a more stable real exchange rate stimulated exports with higher value-added and (ii) an environment was generated in which the overall economy was placed closer to the productive frontier. As a consequence, the rest of GDP – what we call non-exported GDP – recorded a notably higher growth rate than in previous periods. Then, an outstanding outcome was that the rather vigorous growth of exports was achieved pari passu with a vigorous growth of GDP until 1998. During the 1990s there were significant changes in the international environment faced by Chile. The entry into force of the World Trade Organization (WTO, which has included China since 2001) in 1995 implied changes in diverse trade policy instruments. Chile adjusted to the new rules of the multilateral system; especially relevant was the dismantling of the simplified drawback that had been benefiting, effectively, non-traditional exports (see Agosin et al., 2009). At the same time, an explosion of bilateral and regional trade agreements has taken place, which has fragmented international trade. Particularly, in 1994, the North American Free Trade Agreement (NAFTA, including Canada, Mexico and the USA) modified relations between the United States and Latin America, stimulating a wave of agreements of this type in the region. These bilateral or regional agreements have allowed Chile to rely on a (imperfect but effective) stabilization of the application of the rules that govern trade (see DIRECON, 2009). Many non-tariff restrictions have been deleted, while limiting the capacity of partner countries to adopt restrictions against Chilean exports in periods of crisis; they have provided mechanisms to solve controversies in case a country acts in opposition to the assumed commitments or the commercial interests of Chile. At the same time, they have implied continuing the opening of international markets

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independently of the multilateral negotiations of the WTO; a costly counterpart has been the implementation, forced by the Uruguay Round and some agreements, of a reform agenda that limits the space for productive development and counter-cyclical macroeconomic policies in developing economies (see Rodrik, 2001b). (a) Towards a “reciprocated” trade policy An outstanding feature of Chilean trade policy in the 1990s was the search for preferential agreements to expand access to export markets. The new political conditions allowed a turning point in the Chilean approach, moving from an across-the-board indiscriminate unilateral opening, towards a strategy that also included preferential free trade agreements (FTAs) subject to reciprocity. Actually, today, the bulk of Chilean exports receive the preferential treatment of a free trade agreement (DIRECON, 2009). Since the Chilean economy already exhibited a wide trade openness, the benefits from further unilateral liberalization were estimated to be small in a world where trade areas and economic blocks were increasingly important. Advancing toward economic integration with Latin American countries – already returned to democratic regimes – was seen as a way to be an actor in globalization, a process named open regionalism. In particular, it was considered that exports to the region would tend to be more intensive in nontraditional products, acquiring new comparative advantages with a higher share of value-added. As a result of the active trade policy, economic complementarity agreements were signed with countries of the Andean Community; that is, Bolivia (1993), Venezuela (1993), Colombia (1994), Ecuador (1995), and Peru (1998). An agreement was signed in 1996 with MERCOSUR (Mercado Común del Sur) – the main Latin American market, which then included Argentina, Brazil, Paraguay, and Uruguay. A broad agreement was reached with Mexico in 1991, which was deepened in 1999. Likewise, in February 2002, there entered into force the FTA with Central America (including Costa Rica, El Salvador, Honduras, Guatemala, and Nicaragua). Intensification of the linkages with other regions and developed economies was another ingredient of foreign policy. In 1994, Chile entered the Asia-Pacific Economic Cooperation Forum (APEC), enhancing its trade relations with this dynamic region. In 1997, a comprehensive free trade agreement with Canada was reached; it must be stressed that, among its positive features, it included a special clause to allow the use of capital controls by Chile. As a consequence of the contacts developed in the nineties, a comprehensive agreement with the European Union came into force in 2003 (with a much broader coverage than FTAs), and a FTA was made with the United States in 2004. Since then, a series of agreements with many other countries or groupings of them have taken place, including China, India, Japan, and Korea (see DIRECON, 2009).

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In all, restrictions and tariffs faced abroad by Chilean exporters have been sharply reduced. The average nominal tariff paid was 0.4% in 2008, a drop of 88% with respect to the “most favored nation tariff.” In the case of the two larger world markets – the European Union and the United States – the agreements included the immediate elimination of tariff barriers for a large number of products. In fact, the percentage of exports facing zero duty rose from 74% for the European Union, and 70% for the United States, before the agreements, to about 85% at the beginning of each agreement, and to 97% in 2008.1 For the remainder products a gradual reduction of tariffs is contemplated and, in several cases of remaining duties, there are quotas for sales free of duty. In the case of the European Union the maximum term for full liberalization is ten years, while in the case of the United States it is twelve years. These agreements are relevant for Chile since they are with the major markets of the planet, which are relatively closed to the emergent economies due to their protectionist practices. Both the European Union and the United States use tariff escalation – tariffs that increase as the value-added of the items rises – thus discouraging the expansion of upgraded exports to these markets.2 The natural counterparts of trade preferences benefiting producers of exportables are the preferences granted to imports from partner countries. The intensified liberalization via trade agreements has meant that the average nominal tariff actually paid by importers is notoriously lower than the uniform 6% in force. By 2005, the tariff actually paid averaged 2.1%, while in 2009 it was less than 1%. Naturally, the reduction of actual tariffs, together with a real exchange rate appreciation in 2005–9, has discouraged the production of import substitutes.3 But, at the same time, it has reduced the costs of imported inputs and capital goods for the production of exportables. With the trade agreements new opportunities for Chilean exports are opened, especially for non-traditional items with higher value-added. But costs also arise (such as the loss of tariff revenue and the, at least transitory, unemployment resulting from the crowding-out of local producers of importables). One of the more troubled points of the negotiations with the United States refers to the room for Chile to apply capital controls. Finally, Chile 1 The percentages are basically the same for both agreements, according to estimates based on the exporting basket of 1998–2000 in the case of the European Union, and the basket of 2001 in the case of the United States. See Leiva (2004) on the negotiations of the treaty signed with the European Union. 2 Average MFN tariffs of the USA are very low but escalated. For instance, in 2002, textile imports, shoes, and metal products imports faced tariffs averaging 33, 38, and 25%, respectively (DIRECON, 2009). 3 Official SOFOFA reports repeatedly mention the exchange rate appreciation as a cause of domestic production being crowded -out by imports.

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preserved the right to impose controls on short-term financial inflows. The agreement provides that Chile will incur no liability and will not be subject to claims for damages arising from the imposition of restrictive measures that were incurred within one year from the date on which the restrictions were imposed. Consequently, Chile kept policy space, but in a reduced form. In fact, it curtailed the degrees of freedom for Chile to handle, freely and in a transparent way, its financial linkages to the rest of the world and, consequently, its domestic real macroeconomic stability. (b) Domestic incentives At the domestic level, Chilean trade policies in the 1990s faced a quite different context to that of the 1980s. GATT rounds and the subsequent rules of the WTO restricted the use of subsidies to exports; this is particularly relevant for developing countries in the process of acquiring new comparative advantages. Therefore, the use of both simplified tax rebates (reintegro simplificado) and the deferred payments of customs duties on imports of capital goods – instruments of great effectiveness and efficiency in the 1980s and 1990s – were limited and scheduled to gradually disappear, because they were declared non-compatible by the Uruguay Round Agreements. Consequently, by 2004, fiscal expenditure under the simplified rebate was already negligible (fading away to only US$2 million, while in 1998 it had reached a peak of US$200 million). Although the simplified drawback is supposed to be a refund of tariffs paid by exporters on their imported inputs, the instrument was in fact a subsidy on non-traditional exports; the reimbursement received by exporting firms usually exceeded the tariffs paid on their imported inputs. The subsidy implied by the simplified drawback had several interesting features, which made it an efficient tool for upgrading the quality of exports, as tested by Agosin et al. (2009). In lieu of having to apply for a drawback of duties paid on imported inputs, small exports started receiving a 10% subsidy on the value of their exports. When the entire tariff line (defined at the eight-digit SITC level) surpassed a certain threshold the subsidy disappeared. From 1991, instead of an abrupt elimination of the subsidy, three rates began to be used: 10% for annual exports below US$10 million, 5% for exports between US$10 and 15 million, and 3% for exports between US$15 and 18 million. As a follow-up to the Uruguay Round Code on Subsidies and Countervailing Duties, in the mid-1990s, even though no complaints had been received from trading partners, the government declared its existence as a subsidy to the WTO and committed to dismantling it, which it finally did in 2003. In modern terms, the mechanism worked as an effective way of subsidizing self-discovery (Hausmann and Rodrik, 2003) and letting the market select the sectors to benefit from the incentive. The fact that the continuation of the subsidy depended not on exports from a specific firm but on all

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firms exporting the same product discouraged rent-seeking and ensured that it was in effect a subsidy to infant exports (Agosin et al., 2007). Additionally, in contrast to the standard drawback, which encourages the use of imported components, it encouraged domestic value-added; it was restricted to exporters with less than 50% of imports, which paid taxes on their imports and received a fixed percentage subsidy on the revenue returned to Chile. The research available shows that the incentive was effective in diversifying exports, and discovering new comparative advantages, particularly in the early 1990s.4 During the 1990s the authorities developed other efforts to promote exports by seeking to correct more directly some market failures. The main programs, managed by the Chilean export promoting institution, PROCHILE, provide information to exporters and support activities fostering Chilean products in new markets, launching campaigns to create a positive image of the country. Corporate groups are stimulated to form associations in order to promote their products and to perform activities that allow a better knowledge of markets.5 These policies have been successful in terms of easing market access to participant firms (Álvarez and Crespi, 2000). The growth of exports quantum continued to be vigorous during the 1990s – around 10% per year, similar to that of the Pinochet regime. Nevertheless, it lost dynamism from the late 1990s, as documented in section 2. (c) Exchange rate policy and the new capital surges During most of the 1990s, a crawling-band exchange rate regime was maintained, but with much intensified activism. In line with the experience of other emerging economies, Chilean authorities had to deal with a sharp private capital surge that heavily influenced the exchange rate in the opposite direction to the 1980s’ depreciating pressures. Chile’s real exchange rate tended to appreciate in response to a large supply of capital inflows to LACs during the first half of the 1990s (see Chapter VIII). However, due to the counter-cyclical policies implemented by Chile, the actual appreciation was notably more moderate than in other LACs; measured in a comparable way by ECLAC methodology, by late 1994, just before the tequila crises, the Chilean RER had appreciated by only 4.1% with respect to the average of 1987–90, while in Latin America (weighted average of sixteen countries)

4 As shown by Agosin et al. (2009), “the exports from sectors that did receive the incentive grew more rapidly than sectors that did not. The effect is strongest during the 1991–96 period, when, according to the different estimates used, exports from supported sectors grew by 89 to 60 percent more than other exports.” 5 The financing of the activities abroad and the costs of administration of these associations or Committees of Exporters are subsidized in a diminishing scale for a maximum period of six years.

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it had appreciated by 23%.6 Additionally, since Chile was coming out of the severe debt crisis of the 1980s and its productivity was increasing more rapidly than that of its trade partners, there was space for some relative appreciation in a movement towards equilibrium, rather than the destabilizing RER misalignments brought about by excessive appreciation in most of the region. As witnessed by the moderate current account deficit (2.3% of GDP in 1990–5), the appreciation recorded in Chile was actually equilibrating, consistent with net increases in productivity and the improvement in the terms of external debt. The behavior of the RER responded to a very active public policy, coordinated between the central bank and the Ministry of Finance. In fact, significant modifications were introduced to exchange rate policy to resist the appreciating trend; among them, the official exchange rate became pegged to a basket of currencies, rather than just the US dollar, in order to deter speculative capital inflows predominantly in dollars, and the central bank actively intervened in the foreign exchange market, including intramarginal intervention (within the band). Furthermore, taxes and unremunerated reserve requirements were applied to foreign loans and deposits to soften the external supply in the face of capital surges, in such a way that the share of short-term capital inflows was actually reduced. An explicit goal of avoiding an excessive RER appreciation and instability was protecting the export model and its contribution to economic development (Ffrench-Davis et al., 1995; Zahler, 1998). However, prudential macroeconomic policies lost their strength in the second half of the decade, when a larger capital surge seeking the Chilean markets was not faced with a timely and proportional reaction from the central bank. Therefore, the overflood by inflows led to a real appreciation of 15% between 1995 and October 1997, whereas the current account deficit jumped to 4.8% of GDP in 1996–7 (see Chapter VIII, Table VIII.2). The Asian crisis meant a sizable capital outflow and subsequent depreciating pressures. The central bank resisted them by narrowing the band and raising interest rates sharply up to September 1999, when the exchange rate was left to float freely. This change of regime allowed the correction of the over-appreciated real exchange rate, but it did imply introducing higher

6 See Ffrench-Davis (2006, Table VII.2). There are diverse estimates of the magnitude of real appreciation. The central bank of Chile reports 15%; it must be recalled that the bank uses for external inflation indices of wholesale prices, whereas ECLAC uses CPI. See figures for RER by ECLAC and central bank in Table VI.2. In all, the diverse estimates give a significantly smaller real effective appreciation in Chile than in other countries like Argentina, Brazil, and Mexico. Additionally, in the nineties, the reduction of import tariffs in the region involved a drop of imports costs that was several points higher than that of Chile. Consequently, depreciations instead of appreciations were required in Latin America in relation to Chile.

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volatility,7 harmful for the objective of maintaining real macroeconomic stability and for enhancing the contribution of exports to a vigorous and sustained economic growth. In the subsequent years, exchange rate instability prevailed, with sharp devaluations through 1999–2003 and sharp appreciations in the course of 2004–7, followed by sharp ups and downs during 2008 and 2009. As said, that is a pervasive feature for upgrading the quality of exports.

2

Export performance

There are diverse export indicators that are relevant for understanding their role on development. In this section I examine the evolution of export value, volumes, and prices, as well as the evolution of the export composition (diversification) or “quality.” (a) Quantum Exports quantum of goods continued to grow strongly through the 1990s. This expansion was mainly explained by non-traditional exports, with an annual increase that averaged 14.1% in 1990–8, while copper and noncopper traditional exports grew by 9.4 and 5.1%, respectively. Export dynamism remained strong despite the real exchange rate appreciation recorded during the second half of the decade (see Table VI.2, and Chapter VIII, Figure VIII.1). Four factors contributed to this positive outcome of exports. First, world trade was more dynamic during the 1990s. After the

Table VI.1 Growth of export volume, 1986–2009 (annual averages, %) 1986–9 1990–8 1999–2003 2004–7 1990–2007 2008–9 Copper Non-copper Traditional Non-traditional Total exports Total services

3.3 13.1 9.0 21.7 8.8 16.2

9.4 9.8 5.5 14.1 9.6 10.6

4.5 7.0 5.7 7.9 6.1 6.3

4.8 8.2 6.7 9.3 7.1 7.3

7.0 8.7 5.8 11.3 8.1 8.7

–1.7 –3.1 –1.4 –4.3 –2.6 1.1

Source: Balance of Payments of the central bank for exports of goods. Traditional non-copper exports, due to availability of information, include fresh fruit, fishmeal, cellulose, paper, iron, nitrate, silver, gold, molybdenum, raw and sawn wood, and methanol. Exports of services are from National Accounts of the central bank. Figures for 2009 are preliminary.

7 Caballero and Corbo (1989) and Moguillansky and Titelman (1993) show empirically that RER volatility has strong negative effects on both the level and quality of exports. Rodrik (2007a, b) and Williamson (2000) analyze the key role of the exchange rate on exports and productive development. Dodd and Griffith-Jones (2006) examine the performance of the Chilean derivatives markets and implications for RER stability.

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Table VI.2 Average tariff, collected tariff, and real exchange rate, 1984–2009 Average tariff a (%) 1984–9 1990–5 1996–2000 2000–4 2005–9

20.1 12.0 10.8 6.8 6.0

Collected tariff b Real exchange ratec (1986 ⴝ 100) (%) Central bank ECLAC 20.1 10.0 8.0 3.6 1.4

98.2 99.5 80.8 99.0 94.5

96.4 100.6 85.6 100.3 93.2

Source: DIPRES, Central Bank and ECLAC; data for 2009 are preliminary. a

Simple averages of nominal tariffs, excluding exemptions and preferential arrangements in trade agreements. bThe collected tariff is the ratio between the actual value of import taxes and total imports of goods. cThe real exchange rate is the observed nominal exchange rate multiplied by the ratio between external and domestic inflation indexes. The central bank uses WPI of trade partners as external inflation, weighted by their relative importance in imports and exports – excluding oil and copper, respectively. ECLAC uses CPI for external inflation and does not exclude any item of the basket trade. All figures are annual averages.

stagnation of world trade in the early 1980s, from 1984 it recovered speed, and during the 1990s the volume of world trade expanded 5.7% annually. Second, Chile gained access to new markets under preferential access thanks to the several trade agreements. Third, the record domestic investment ratio of the period allowed a great increase in productivity and external competitiveness. Fourth, it must be kept in mind, on the one hand, that a major part of the moderate exchange rate appreciation of the first half of the 1990s was an equilibrating movement after the currency drought of the 1980s, and, on the other, that during those years there was a deliberate policy to protect the export development model through prudential management of the capital account with positive lagged effects on the second half of the 1990s. In all, the 9.9% growth of the volume of exports of goods and services in 1990–8 was vigorous in comparison with the eighties (7.8% in 1982–9) and, in particular, with respect to the world trade growth average in the decade (5.7%). The trade boom was interrupted by the Asian crisis that hit the Latin American economies in 1998–9. It implied a sharp negative terms of trade shock, which strongly reduced the export value, especially in traditional items. The value of non-traditional exports, on the other hand, exhibited strength during the crisis; commodities were the main victims in this period. The vigorous growth recorded by that group of exports, from their take-off in 1984, explains why their set matched the value of copper exports in the late 1990s. However, after the exceptional growth of the quantum of non-traditional exports from the 1970s, their dynamism has experienced a significant deceleration: annual growth averaged 21.7% in 1986–9, 14.1% in 1990–8, and 8.6% in 1999–2007 (see Table VI.1). The real exchange rate appreciation

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during the second half of the 1990s and the persistent instability from there on appear as the main cause of the declining competitivity of nontraditional tradable sectors (Díaz and Ramos, 1998). Econometric estimates (Moguillansky and Titelman, 1993) of the price elasticity of the Chilean export supply with respect to the real exchange rate across industries support this hypothesis. The research indicates that movements in the RER have differentiated effects, depending on the type of good exported, and that a persistent real depreciation (instead of instability and appreciation) tends to have a positive (negative) impact on the volume and diversification towards higher value-added. Thus, it is likely that a depreciated and stable RER constituted a strong incentive for investment in exporting sectors, for basket diversification and the fortification of its pulling-up effect on the rest of the economy; and vice versa for periods of overvaluation, due to a mix of financial volatility and lack of counter-cyclical exchange rate policies. Slowing of the diversification of exports towards non-traditional items explains most of the drop in the overall rate of expansion of exports. In fact, since the late 1990s, the volume of exports has shown a deceleration; initially, directly, due to a drop in Asian demand, and an overall depressed world demand with a terms of trade deterioration. These factors, together with exchange rate volatility, seem to have weighed more than the significant real depreciation recorded between 2000 and 2003; anyway, soon after there came another stage, with deep appreciation from 2004 (see Table VI.2).8 The pervasive feature of RER instability prevailed, in that when optimism reigns during capital surges or booms, the exchange rate appreciates, thus discouraging the production of tradables, while in recessive periods the RER is sharply depreciated but the macroeconomic environment and liquidity constraints are discouraging for most productive investment. Already for a decade, the quantum of exports has been moving on a plateau that, even though it is “respectable,” is sharply below that of the previous decade. Additionally, progress in the upgrading of exports has weakened. Poor foreign currency policy bears the major responsibility, but there also are structural factors behind the decaying export dynamism. Despite the weakening recorded since the late 1990s, in the nineteen years from 1990 to 2008 exports of goods and services expanded by 7.9% annually. That is a significant record; however, its contribution to overall productive development and wellbeing is not that significant, an issue that needs to be addressed by substantial corrections in macroeconomic and productive development policies. 8 Although during 2002 the Chilean RER was relatively depreciated with respect to the set of all trade partners (Table VI.2), with respect to Latin America it experienced an appreciation of 28% in that year, determined principally by the Argentine maxidevaluation. Chilean exports to MERCOSUR fell in 2002 by nearly equivalent to 1% of GDP, beyond the already depressed level of 2001.

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(b) Export prices and terms of trade The real evolution of trade prices has three types of significant effect in the domestic economy: (i) on private and social returns of each sector; (ii) on disposable national income that a given volume of exports contributes; and (iii) on the domestic macroeconomic environment, through exchange rate, monetary, and fiscal effects. Chilean exports are highly concentrated in traditional natural resourcebased products. A distinguishing characteristic of this kind of products is the great volatility of the prices, not only of copper, but also of other items such as cellulose, fishmeal, and molybdenum (see Box VI.1). Naturally, not all prices always move synchronously; thus, although they have great individual fluctuations, the average price of the set of exports is less unstable. Nonetheless, in practice, there is a significant synchronization or contagion of fluctuations, even with imports (for example, copper and oil prices in recent years). This is an effect of the intensive globalization of volatility. For developing economies, many export prices constitute a given parameter (this is the common assumption for “small open economies”); then, price fluctuations are a consequence not of domestic policies but of international market forces. Notwithstanding this, several developing countries have become large producers of some commodities (thus influencing international prices), as is the case with Chile for copper, molybdenum, and salmon. As documented by Moguillansky (1999), Sachs et al. (1999), and Agosin (1999), the impressive growth of copper output exhibited in 1995–9 (rising 15.1% annually, and more than doubling in the period) was not sustainable, due to both investment constraints and the fact that markets were becoming limited for Chile. In that sense, too high a growth in the production of an item for which world demand grows slowly (in the case of copper, then by about 3% per year) can negatively affect the average price received, damaging the profitability of the activity and the economic rent captured by Chile. Indeed, the copper price was remarkably depressed in the following years; for instance, by late 2002 a pound of copper was selling at less than US$0.60. After, as usual, a new cycle followed with significantly high prices of commodities in 2005–8, averaging US$3.23 in 2007. It was followed by a sharp (though very short, on this occasion) new recessive cycle that started in the course of 2008 (see Chapter IX, Figure IX.3). For that reason, it is so relevant to diversify the exporting basket towards greater value-added, as well as keeping a stabilization fund of copper income, as the government has done. (c) Diversification Table VI.3 summarizes the overall diversification achieved by Chilean exports. Between 1990 and 2008, the number of markets of destination increased from 129 to 190 countries (nearly all the countries in the world). In turn, the number of exporting firms increased from 4,100 to 8,240 in the

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Box VI.1 Molybdenum in the national economy Chilean mining exports reached a total value of US$43.1 billion in 2007, of which US$3.8 billion corresponded to molybdenum sales abroad (US$37.6 billion were of copper). Molybdenum, for CODELCO a significant by-product in the production of copper, constituted the second largest export product of Chile, even exceeding fruit, forestry, cellulose, and salmon. A jump in the share of molybdenum is related to the particular dynamism shown by its price since 2004. In fact, after recording levels in the range of US$2–5 per pound (an average of US$3.6 per pound in 1985–2003), the nominal price observed in 2005 was US$32. The price fluctuated around this high plateau (US$30–35) up to well into 2008, when it collapsed to US$10, in November, somewhat after the sharp drop of the copper price. There are several reasons for the high plateau. First, on the supply side, numerous molybdenum mines in China were closed. Second, there was greater demand due to the recovery of the worldwide steel industry, which intensively uses molybdenum. Third, there was a broad speculative pull in commodities. The increasing share of molybdenum in total exports and in fiscal revenue became a significant issue from the point of view of public finance. There was broad consensus that current prices were not sustainable in the long run, as increasing incentives to invest in new projects of primary mines and to increase the capacity in copper mines that produce molybdenum as by-product will arise. Consequently, since 2006, a cyclical correction to fiscal revenue from molybdenum sales by CODELCO has been incorporated in the estimate of the structural fiscal balance, differentiating it from copper revenue. It is interesting to note that CODELCO does not estimate the cost of producing molybdenum but subtracts the value of its sales from the total costs of production to estimate the net costs of producing copper. The cyclical adjustment made by the Ministry of Finance is as follows: the cyclical component is estimated as the physical molybdenum sales of CODELCO multiplied by the difference between the actual price and the “expected long-term reference price.” The fundamental difficulty is to determine the long-term price, since market information is scarce. Through expert assessments, for the estimation of the 2007 fiscal budget, a trend price of US$14.7 per pound was used, a figure equivalent to the moving average of monthly prices in 2002–6. 45

45 40

Av. real price in 2008

40

35

Real price October 2008

35

30

Real price November 2008

30

25

25

20

20

15

15

10

10

5

5

0

0 1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

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Table VI.3 Indicators of export diversification, 1990–2008 (number of markets, firms, and products)

Markets of destination Firms exporting Products exporteda HHI indexb Corrected HHI indexc

1990

1994

1998

2002

2005

2008

129

141

172

158

184

190

4100

5844

5847

6118

6880

8240

2300

3622

3828

5160

5303

5161

0.399 0.364

0.280 0.273

0.279 0.305

0.271 0.305

0.345 0.275

0.383 0.258

Source: ProChile and UNCTAD for HHI. a

In 2002, a further disaggregation of the trade nomenclature was made. bThe Herfindahl– Hirschman index, calculated in current US dollars, reflects the degree of concentration of the export basket, and takes values between 0 and 1 (maximum concentration). In 2001–5, the simple average for Latin American countries was 0.273; for Korea and Taiwan it was 0.156; for the G-7 nations it was 0.099. The indexes were calculated by the author, based on UNCTAD methodology. c Corresponds to a modified HHI, based on the UNCTAD methodology, but using a trend copper price. This reduces the distortion created by the rise of the copper price in recent years.

same period;9 however, the degree of concentration is notable, as fifteen firms captured nearly 60% of total sales in 2008. The number of products sold abroad increased notably too; although, still, ten items (out of over 5,000 items exported) represented as much as 69% of the total value of goods exported.10 The concentration of the Chilean exporting basket is also remarkable in an international comparison. The Herfindahl–Hirschman Index (HHI), a measure of exports concentration that takes values between 0 and 1 (where 1 represents maximum concentration), places Chile as far more concentrated than other developing and developed nations. According to UNCTAD figures, in 2000–5 the index averaged 0.289 for Chile, whereas Latin America averaged 0.273. The index for developing economies like Korea and Taiwan was 0.156, whereas the G-7 developed nations averaged 0.099. In Table VI.3 it can be observed that Chile appeared to be worsening further in 2005 (0.345) and 2008 (0.383), due to the increasing share of copper in total exports, as a consequence of the high copper price. Table VI.3 presents a “corrected” HHI Index, re-estimated with a trend price of copper.

9 That figure represents about 1% of the number of firms registered by the internal revenue service. However, among large firms (close to 10,000), one-quarter have become exporters. 10 See ProChile (2007). In 2007, 58.3% of exporters (4,611) sold less than US$100,000 annually and covered just 0.1% of total exports.

162 Export Dynamism and Economic Growth

Nevertheless, even normalizing with a trend copper price, the corrected index shows that Chilean exports are comparatively concentrated, but after the step back during the contagion of the Asian crisis, they continued to improve, though slowly. Table VI.4 depicts product diversification by markets of destination. The first column shows that, despite diversifying in recent decades, Chilean exports continue to rely heavily on natural resources. In fact, it can be seen that manufacturing exports also include a high share of commodityintensive goods. Nonetheless, there is a trend towards more manufactured goods and several non-traditional natural resources. The classification in Table VI.4 signals that the percentage of natural resource-based exports decreased from 95% in 1983–9 to 90% in 2004–8, but they still cover a notably high share.11 This feature is not surprising because Chile has a rich endowment of natural resources combined with geographic factors that provide strong static comparative advantages. Nevertheless, this dependence on natural resources and the limited value-added of manufactures also underlies the price instability faced by Chilean exports and the low dynamism of the demand for its exporting basket. Additionally, it verifies that there have not been effective, systematic, and powerful efforts to change in a more significant way the inertia of this composition. The geographic distribution of Chilean exports exhibits a significantly larger diversification than in previous decades. The European Union’s share has been falling sharply from 37% in 1983–9 to 24% in 2004–8. The United States’ share also diminished, from 21 to 14%, whereas Latin America receives 18% of Chilean exports, associated with several trade agreements covering the vast majority of the markets of the region. Likewise, the Asian market increased strongly in importance in the first half of the nineties, becoming as a region the principal destination for Chilean exports. The group Asia (10) doubled its share in 2004–8 (to 10.8%) with respect to the average in 1983–9, whereas Japan’s share remained at 11%. The sharpest change is with China, which jumped from 2 to 12%, concentrated solely in natural resources. The share of Asian markets suffered a setback in 1998 as a result of the crisis that originated in that region. Nevertheless, the fast recovery of the East Asian nations and the strong expansion of exports to China made this region by far the most important, taking 34% of exports in 2004–8 (adding together China, Japan, and the other Asia 10 countries). The negative effects of the Asian crisis were multiplied in Latin America, since it found several countries in a financially vulnerable situation. Especially, by 1998 the international capital markets had “dried off,” provoking severe crises in several countries, which translated into a “half lost 11 The share of natural resources is biased upwards since 2004 due to the sharp rise of the price of copper, expected to be transitory.

Table VI.4 Geographic distribution of Chilean exports, according to technological content, 1983–2008 Classification

1983–9 (a) Primary goods (b) Natural resource-based manufactures (c) Manufactures and others Low technology Medium technology High technology Other transactions (d) Total 1990–7 (a) Primary goods (b) Natural resource-based manufactures (c) Manufactures and others Low technology Medium technology High technology Other transactions (d) Total

Composition Geographic distribution (%) of total Latin EU (15) America (33)

USA

Asia (10)

China

Japan

Other

77.4 17.4

10.6 26.4

40.8 26.4

22.0 13.5

5.4 8.5

1.8 4.7

12.8 8.2

6.5 12.1

5.2 1.2 2.6 0.3 1.1 100.0

44.4 42.3 56.2 39.8 25.9 14.9

11.0 10.2 13.6 19.6 0.8 36.8

21.0 37.8 17.7 35.7 1.0 20.8

1.7 1.5 2.7 0.8 0.2 5.6

2.1 0.1 3.3 0.0 0.0 2.3

1.8 0.6 3.3 0.3 0.0 11.5

17.9 7.5 3.3 3.8 72.1 8.1

67.9 21.5

11.1 23.8

32.4 22.4

14.9 14.9

14.7 11.6

2.0 1.7

20.3 17.0

4.6 8.4

10.6 3.2 4.4 0.6 2.3 100.0

57.1 58.8 66.0 63.7 36.7 18.8

8.6 8.0 13.0 4.5 1.9 27.8

15.0 27.2 10.9 25.9 2.2 14.9

2.0 2.8 2.3 1.2 0.7 12.7

0.1 0.1 0.2 0.0 0.0 1.7

1.6 0.6 3.4 0.3 0.3 17.5

15.6 2.9 4.2 4.4 58.2 6.5

(Continued) 163

164

Table VI.4 Continued Classification

1998–2003 (a) Primary goods (b) Natural resource-based manufactures (c) Manufactures and others Low technology Medium technology High technology Other transactions (d) Total 2004–8 (a) Primary goods (b) Natural resource-based manufactures (c) Manufactures and others Low technology Medium technology High technology Other transactions (d) Total

Composition Geographic distribution (%) of total Latin EU (15) America (33)

USA

Asia (10)

China

Japan

Other

61.9 25.4

13.2 27.5

28.7 22.3

16.5 22.0

11.6 7.1

6.8 4.6

16.7 10.1

6.5 6.5

12.7 3.0 6.0 0.8 2.9 100.0

55.6 66.2 60.3 74.7 29.0 22.2

10.1 5.9 14.2 4.7 7.0 24.7

14.9 22.6 14.9 16.5 6.6 17.7

2.4 1.7 3.5 0.5 1.2 9.3

0.6 0.6 1.0 0.3 0.1 5.4

1.1 0.2 1.6 0.3 1.2 13.1

15.3 2.7 4.5 3.0 55.0 7.6

71.9 18.6

10.9 29.1

26.2 22.1

12.5 20.4

12.4 7.0

14.7 8.3

13.8 6.5

9.4 6.6

9.6 1.6 5.1 0.4 2.5 100.0

47.1 70.9 49.6 72.3 22.2 17.7

14.8 5.4 22.7 6.4 5.6 24.3

10.5 17.0 9.7 16.8 6.4 13.8

6.1 1.7 10.4 0.8 0.9 10.8

0.6 0.9 0.7 0.3 0.2 12.1

1.3 0.1 2.2 0.3 0.4 11.3

19.7 3.9 4.7 3.1 64.3 9.9

Source: Based on United Nations ComTrade database, in current US dollars, classified by technological content, based on the Standard International Trade Classification Rev. 1.

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decade” for the continent in 1998–2003, with a negative per capita growth (–0.3% per year). The most dramatic case was that of Argentina, whose GDP fell by 18% in 1999–2002. Evidently, the regional market became notably restricted for Chilean exports, with a diminishing participation from 24% in 1998 to 18% in 2004–8. Among Latin American destinations, Mexico has been the most dynamic, with a growing share in both total exports and manufactures. Actually, as was analyzed in Chapter V, the composition according to geographic markets indicates that manufactures (with higher value-added) are sold principally on Latin American markets, whereas commodities are exported principally to the developed countries; in 2004–8, nearly one-half of exports to the region, including MERCOSUR, were manufactured, as compared to 10% of total exports. Furthermore, Table VI.4 shows that the higher the degree of manufactures elaboration the larger tends to be the participation of LACs. On the other hand, only 11% of primary goods have intra-regional trade as their outlet. Thus, Latin American countries play a crucial role in the diversification of Chilean exports towards manufactured products. This diversification has been closely associated with the significant trade liberalization of the region, including numerous regional trade arrangements. The question remains, however, as to the sustainability of Chile’s manufacturing export growth. On the one hand, much of the demand for these products continues to depend on the Latin American region’s economic growth performance, macroeconomic sustainability, and exchange rates favoring intra-regional trade. On the other, it also depends on the strengthening of productive development policies focused on building capacity in goods and services more intensive in value-added and innovation, as discussed below.

3 Exports and foreign investment One desirable effect of FDI is its contribution to export development. Besides the intrinsic advantages that the expansion of exports could have, there are at least two reasons why it seems desirable to link them to FDI. First, from the point of view of the balance of payments it is necessary to take account of the long-term equilibrium between the supply and demand of foreign currency. Though capital inflows generate an increased supply of dollars in the short run, this situation may not necessarily be permanent; it depends on how much of this supply is allocated to the production of tradables; even more, the profits earned will be repatriated, and then the capital will follow. That is, FDI inflows also become a liability for the host economy and, therefore, it must generate the resources to pay itself. Naturally, exports are the only sustainable source of foreign currency in the long run. Consequently, for the foreign exchange market it makes a great

166 Export Dynamism and Economic Growth

difference whether inflows are directed to creating new capacity instead of acquiring existing firms, and, in the case of creation, whether they are allocated to the production of tradables or to non-tradables. In large developed economies with deep capital markets this might not be a relevant issue, but in emerging and small economies it has been quite relevant, as the case of Chile demonstrates. There are two opposite effects of FDI on exports. On the one hand, there is the direct and positive impact that foreign capital can have in the development of sectors geared to external markets and, on the other hand, there is the indirect effect on the foreign exchange market; that is, the exchange rate appreciation resulting from capital inflows and its negative impact on the competitiveness of exports. In the case of Chile, the trade pattern has been strongly affected by FDI in its dual role. In fact, FDI has significantly contributed to the growth of Chilean exports,12 particularly in copper output.13 These larger inflows, in turn, were partially responsible for the peso overvaluation in 1996–8. This process had not only negative macroeconomic consequences (see Chapter VIII), but also productive effects because of the Dutch disease affecting several tradable sectors, especially non-traditional exports, which are more elastic to the level and stability of the RER (ECLAC, 1998, Chapter IV).14 Second, the space for trade policy to stimulate export development has experienced a great tightening in the past decades. The WTO agreements have imposed narrow limits on the use of incentives to exports. Part of this is positive and benefits Chile, which is a much open economy; but there is also a negative effect since restrictions were imposed on the use of mechanisms such as the simplified drawback, of great importance since the mid-eighties for non-traditional exporters. Thus, some selectivity in FDI is 12 The importance of foreign capital in exports is revealed by the fact that fourteen of the twenty largest exporting firms are foreign-owned, and nine of them are in mining. 13 The value-added to the Chilean economy in this copper output is notably lower than that of CODELCO, because privately produced copper is less processed and actual taxes on profits are lower (Meller, 2002). Another important factor is that a high share of FDI during the late 1990s and the subsequent recessive period included acquisitions of existing assets that do not directly generate new productive capacity (Ffrench-Davis, 2003). According to UNCTAD data, 58% of FDI gross inflows in 1990–7 corresponded to greenfield FDI, falling to 19% in the recessive 1998–2002 period. In contrast, during 2003–6, greenfield FDI reached four-fifths of total FDI inflows. 14 In those years, there arose propositions to ration FDI in the production of copper through auctions. The main objectives were (i) to reduce the volume of inflows (thus moderating the exchange rate appreciation), (ii) to weaken the depressive impact on the future copper price, and (iii) to capture part of the natural resource economic rent, which was subject to a low taxation that was unlinked to the quality of the resource (Agosin and Ffrench-Davis, 1998). A royalty that captures an additional (though small) share of the copper economic rent began to be applied only in 2006.

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outlined as one of the most important mechanisms available in the future to upgrade the quality of exports (Agosin and Bravo-Ortega, 2007);15 recently, the authorities have been moving in this direction. These facts highlight the importance of a comprehensive set of policies to ensure a sound export development, more diversified, with higher value-added and with a dynamic international demand. An active exchange rate policy and coherent productive development policies are absolutely necessary for a successful outcome. This approach has started to take form in recent years, departing from the “policy neutrality” inherited from the Pinochet dictatorship. CORFO has developed a program to attract FDI in information and communications technology. More significantly, beyond FDI, the government has selected seven areas on which to focus public support in order to build productive clusters around them. I return below to this relevant progress in use of policy space.

4 Exports and economic growth Exports have been frequently called the engine of Chilean economic growth. The growing share of exports in GDP has been a transmission channel of externalities resulting from exposure to foreign markets. The direct incidence, however, is not easy to estimate quantitatively and research on this issue is limited.16 In this section I concentrate on two issues. In the first place, I identify the actual weight of exports in the domestic economy, because that is the main determinant of how much their evolution directly affects GDP: for example, a 10% increase in a component with a weight of 30% gives a direct 3% change in GDP. There follows an analysis of the “microeconomic” interrelation between exports and the growth of productive capacity. Finally, a macroeconomic interrelation between exports and the rest of GDP, which has been very influential on the rate of economic growth, is examined. (a) What is the real weight of exports? It is commonly repeated that foreign trade represents around 60 or 70% of the economy. That is based on adding exports and imports and dividing them by GDP. In practice, exports are part of GDP, but imports are part of domestic 15 It would have been relevant that the WTO new round (Development Round) would have made a clear distinction between productive and financial investment. Regarding the productive dimension, it requires that developing countries could apply functional selectivity to “complete” markets of technology, human capital, and long-term financing. With respect to financial investment it is crucial that developing countries strengthen their capacity to apply active counter-cyclical macroeconomic policies; among others, it implies being able to regulate capital flows. See Ocampo (2001, 2007). 16 See Macario (2000) for pioneering research on Brazil, Chile, Colombia, and Mexico.

168 Export Dynamism and Economic Growth

expenditure and belong to the output of the rest of the world. Additionally, it is necessary to differentiate between gross exports (which are the figures we normally observe) and net exports. The former correspond to the total value of exported output (reported in the trade balance and national accounts), while the latter discount the imported content of exports goods and, therefore, reflect the actual direct value-added contributed to GDP.17 Alternative measures of the ratio between gross exports and GDP are presented in Table VI.5. In the period 2004–9, for example, they represented 43% of GDP measured at current prices, 48% in 1977 prices, and 39% in 2003 prices. The resulting ratios depend on the level of the RER and relative prices of exports in the respective base year of national accounts; both variables have been extremely unstable. In 2003 prices, the present base year of National Accounts, gross exports of goods and services represented, as said, 39% of GDP in 2004–9, while net exports – that is, the value added by exports to GDP, which is a sum of value added by all sectors of the economy – only makes up less than 30% of GDP. This is still a very significant weight, and has been rising vigorously from 9% in the 1960s. (b) Bases for export-led growth The pulling capacity of exports on the rest of the domestic economy is associated with the linkages between exports and national development.

Table VI.5 Export participation in total output, 1961–2009 (% of GDP) Gross exports Current prices

1961–70 1971–3 1974–81 1982–9 1990–8 1999–2003 2004–9

15.8 11.7 21.8 28.1 29.0 32.4 43.0

Constant prices of 1977

1996

2003

12.1 10.1 20.2 27.9 35.5 43.6 47.6

8.8 7.3 14.9 20.6 26.3 32.3 35.3

9.6 8.0 16.4 22.5 28.8 35.4 39.0

Source: Based on official central bank figures and Marcel and Meller (1986). Exports include goods and services. Annual averages. For exports net of imported imports see Table VI.6.

17 GDP, on the expenditure side, is the sum of value-added on goods and services consumed and invested domestically, and of net exports of goods and services (gross value minus imported content).

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Undoubtedly, there was progress in the past decades, since together with traditional natural competitive advantages, there was also a development of dynamic advantages (many of them natural resources-based). Nevertheless, there are other arguments for additional diversification towards goods and services with greater degree of elaboration, beyond purely natural resource-intensive products. To achieve progress on this issue is an important challenge. First, the fact that a high share of Chilean exports are still concentrated in primary goods means that the economy as a whole becomes highly vulnerable to the intense commodity price fluctuations. Second, the long-term dynamism of those products is limited, which in the future could become a negative factor for potential economic growth (Sachs et al., 1999); this argument assumes that the optimism in fashion today that China will continue to pull up vigorously the demand for copper is not sustainable, and that supply will not respond as much. Third, the production of goods with a greater degree of elaboration involves positive externalities for the rest of the economy, by means of the learning-by-doing processes and the benefits caught in the acquisition of new dynamic competitive advantages in related products. There is some encouraging progress in economic activities developed around some of the successful exports, such as forestry, wine, salmon, and fresh fruit. According to some analysts, those successful experiences could support a “Nordic” development strategy for Chile, based on higher incorporation of value-added to natural resources (Díaz and Ramos, 1998). However, the speed of emergence of new exports diminished by the late 1990s.18 The exchange rate policy became detrimental for non-traditional exports and the simplified drawback for small exports disappeared. More recently, in a significant step forward, the newly created National Council for Innovation and Competitivity has identified seven existing exports on which to focus public support of and cooperation with the private sector, in order to foster the development of productive clusters around them. The selection includes sectors such as copper mining, aquaculture, fruit production, processed foods, and tourism. This is relevant progress in policy space. A strong positive link between exports and national development implies achieving systemic competitivity; that is, succeeding in becoming productive in producing for exporting and for the domestic market. That would require the correction of market failures in the capital market, labor training, and research and development. In order to capture the potential gains from these corrections a reform in macroeconomic policies is crucial.

18 Export discoveries tend to bunch in the period 1991–7. In 1998–2003, export discoveries fall off dramatically. The weakening of export discoveries has much to do with the lagged impact of the real exchange rate (see Agosin and Bravo-Ortega, 2007; Agosin et al., 2009).

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(c) Macroeconomic environment and non-exported GDP Here I concentrate on the influence of domestic macroeconomic policies on the association between the evolution of exports and the rest of GDP. In fact, there is a significant positive correlation between export growth and actual GDP growth after the 1980s debt crisis, and in the nineties. During such periods the exports were of great dynamism, whereas actual GDP did recover in the late eighties (after its dramatic fall in 1982–3) and, in the nineties, it entered the period of greatest vigorous and sustainable growth in its history. Most econometric research on this matter has detected a clear positive effect of exports (especially non-copper) on overall GDP growth (Meller, 1996b; Coeymans, 1999; Agosin, 2007); however, the elasticity of GDP with respect to exports is quite variable and notably less than one. For exports to be the real engine of growth, their expansion must be linked to the creation of new productive capacity in the rest of the economy, a feature strongly present solely in the 1990s. In that decade, the capital formation ratio rose to unprecedented levels, and this process was intense not only in the export sector. Non-tradables exhibited notably higher rates of expansion that in the seventies and eighties: for instance, infrastructure works and telecommunications recorded annual growth of 18.3 and 32.4%, respectively, in 1990–7.19 Therefore, in the 1990s, global actual GDP growth was led by both the tradable and non-tradable sectors. Actually, (gross) exports and non-exported GDP grew 9.9 and 6.5% per year, respectively, in 1990–8 (see Table VI.6).20 This, accompanied by an environment of full utilization of productive capacity (see Chapter I, Figure I.1), with real macroeconomic stability and prudential regulation, accounts for the high growth rate of the Chilean economy during most of the decade. In the second half of the 1990s, however, the real exchange rate overappreciated, led by excessive capital inflows (see Chapter IX), implying a distortion in resource allocation and the trade balance. As a consequence, a significant macroeconomic vulnerability was generated that led to a recession in 1999, after the contagion from the negative external shocks from Asia. During 1999–2003 the economy worked significantly below its productive frontier. Some share of the poor performance in those five years can be explained by the falling growth rate of exports. Nevertheless, given that 19 These figures must be compared with an annual growth in infrastructure investment of 2.6% in 1982–9 (Moguillansky, 1999). 20 Most of Latin America had also embarked on an export-led strategy. Actually, the volume exported by the region rose by 8.3% in 1990–7, up to the peak before the arrival of the Asian contagion; but, in contrast with Chile, its GDP expanded merely 3.3%. In that sense, the region exhibited an export and GDP outcome rather similar to that of Chile in the 1970s and 1980s, but quite worse than the good performance of Chile from 1990.

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Table VI.6 Exports and economic growth, 1961–2009 (annual average rates of growth, %) Exportsa

Non-exported GDPb

4.4 1.2 3.0 2.9 7.1 2.6 4.9 –1.5

3.6 –4.1 13.6 7.8 9.9 5.5 6.6 –5.6

4.5 1.7 1.5 1.7 6.5 1.7 4.2 –0.1

5.3 3.2

7.9 6.9

4.6 2.7

3.4

5.9

–

GDP 1961–70 1971–3 1974–81 1982–9 1990–8 1999–2003 2004–8 2009 Chile 1990–2008 Latin America 1990–2008 World 1990–2008

Source: Based on Central Bank National Accounts and Marcel and Meller (1986). For Chile exports include goods and services at constant 2003 prices. ECLAC and IMF for LACS and the world, respectively. a

Diverse sources and methodologies explain differences from figures in Table VI.1. bNonexported GDP is equal to GDP minus the domestic content or value-added in exports. Imported inputs in exports were assumed to be equal to the share of non-consumer imports in GDP. For Latin America, based on Ffrench-Davis (2006, Table V.2) and data processed by ECLAC for nineteen LACs.

exports then represented only a quarter of the domestic value-added, that fall only translated into around 1 point of lower GDP growth. The growth rate of the volume of exports diminished by around 40% in 1999–2003 (from 9.9 to 5.5%), but that of GDP diminished by two-thirds (from 7.1 to 2.6%). That is to say, the fall from a 7.1% growth plateau to 2.6% is mainly explained by the meager increase in the rest of GDP; that is, the output directed to domestic markets. The non-exported GDP grew by hardly 1.7% in 1999–2003, in contrast with 6.5% in the previous period. In 2004–8, a moderate recovery of the volume of exports (to 6.6%) as well as a significant recovery of non-exported GDP (from 1.7 to 4.2%) took place, determining growth rates of total GDP averaging 4.9% in that period. As shown, while the prices of exports are notably more unstable than their volume, the volume or quantum of non-exported GDP – that is, GDP sold in the domestic economy – has been quite unstable, reflecting failures in macroeconomic policies: sharp changes in aggregate demand and the RER. The exception was the period 1990–8. It is interesting to compare the performance of Chile with that of Latin America in the whole period 1990–2008. Table VI.6 shows that the sharp difference between the 5.3% GDP growth of Chile and the meager 3.2% of Latin America is not focused in the export behavior, which is rather similar

172 Export Dynamism and Economic Growth

(7.9% versus 6.9%). Actually, the gap is located, principally, in the evolution of the rest of the economy: a rise of 4.6% in Chile in contrast with 2.7% in Latin America. This is quite illustrative for the coherency of development strategies. Finally, it is evident that the abrupt changes that have taken place in the relation between exports and GDP, recorded from year to year, do not respond to structural swings. They are associated, principally, with instability in the domestic macroeconomic environment, which has affected the production sold in the domestic market. This instability, naturally, additionally, weakens the productive link between exports and GDP and conspires against the export-led strategy.

5

Concluding remarks

In all, during the past three decades, Chile witnessed a period of significant export growth. This outstanding performance was associated, during the past decades, with some active heterodox policies aimed at sustaining a competitive real exchange rate and generating export capacity, rather than solely with the neo-liberal (orthodox) economic reforms of the 1970s. Four reciprocally reinforcing groups of factors appear to be more significant for explaining the behavior of exports. First, it is a well known fact that the level and stability of the real exchange rate has a determinant impact on the overall export performance. Second, the diversification toward goods and services with value-added is crucial for enhancing the quality of exports, in the sense of benefiting from (i) more dynamic demand and better international prices and (ii) stronger linkages of exports with the domestic economy; the stability of the real exchange rate, incentives like the simplified drawback for non-traditional exports, and intraregional integration have been significant variables at hand. Third, to upgrade the quality of exports there is a need for an intensive national effort to complete domestic markets for technology, labor-training, and long-term segment of the capital market; all these are crucial ingredients for achieving systemic competitivity. Fourth, the export drive needs to be accompanied by a domestic macroeconomic environment suited for economic growth, sustainable and with the right macroprices, consistent with productive development, in order to contribute to export-led growth. This was the determinant factor in explaining the positive association between export dynamism and sustainable growth of overall GDP during most of the 1990s. The Chilean economy seems to be at a crucial point with respect to its international trade insertion. The signing of free trade agreements with large economic blocs represents opportunities for many productive sectors to extend their potential markets, but at the same time it raises challenges. The case of Mexico, whose performance has been disappointing since the enforcement of NAFTA, shows that the benefits of these associations are not

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173

automatic. On the other hand, there are potential costs derived from the losses by the authorities of degrees of freedom to implement certain wise interventions. In this new scenario, it is essential to maintain the principles explored above to guarantee an export development that not only takes advantage of static comparative advantages but also generates a dynamic systemic competitiveness.

VII Inequality and Poverty since the 1970s*

Inequality has once again become a major public policy issue in Chile. Despite effective efforts made from the 1990s to reverse the ramping inequality of the 1970s and 1980s, poverty is still a fact of life for too many Chileans; a sharp inequality in opportunities, wealth, and income still prevails. Lack of equity is a marked feature of the Chilean economy and society. Significant changes in poverty and income distribution have been recorded over the past one-third of a century. Its evolution can be summarized in the following four points: 1 In the 1970s and 1980s, during Pinochet’s dictatorship, income distribution deteriorated sharply, and the share of the population living under the so-called poverty line rose to 45% in 1987; that situation, associated with the crises of 1975 and 1982, was the result of the higher concentration of wealth, worsening of real wages, increased unemployment, and the fall of per capita social expenditure. 2 Poverty was reduced substantially from 45% of the population in 1987 to 14% in 2006. 3 After the great deterioration recorded during the dictatorship, income distribution exhibited an improvement in the first half of the 1990s, but it stepped back partially with the Asian crisis contagion; subsequently, partial progress has been recorded, due to some economic reactivation and new quite significant social reforms, moving closer to the best level reached in the first half of the 1990s. 4 Today income distribution is less unequal than in the 1980s, rather similar to the 1970s, and more regressive than in the 1960s. The ratio * I am grateful for the valuable comments of David Bravo, Juan Carlos Feres, Osvaldo Larrañaga, Carlos Massad, Jaime Ruiz-Tagle P., Jaime Ruiz-Tagle V., and Humberto Vega; the exchange of views with Harald Beyer, Leonardo Moreno, Dagmar Raczynski, Joseph Ramos, Claudia Sanhueza, Claudio Santibañez, Daniel Titelman, Arístides Torche, and Andras Uthoff; and the efficient assistance of Rodrigo Heresi, Heriberto Tapia, David Coble, and Felipe Labrín. 174

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175

rich/poor quintile (GINI), which was around 13 times (GINI 5 49) in the 1960s, worsened to 20 (GINI 5 57) in the 1980s, and in recent years has averaged about 14 times (GINI 5 52). Notwithstanding the significant social improvements achieved during the two decades of democracy, the net balance of income distribution, comparing the 1960s and recent years, indicates that Chile lost ground over the past four decades rather than progressing towards greater distributive equity. Equity and macrosocial balances (that is, employment, wages, social programs, sense of partnership in the national society, with life conditions improving in a sustainable manner) are essential ingredients of modernization. In this chapter, I review the most outstanding distributive developments over recent decades. Several social policies can affect poverty and distribution. They include, among others, pensions, family allowances, the minimum wage, incentives to job search for women, health and housing subsidies, and unemployment insurance. But, in a developing country, the top priority is to improve the performance of the labor market, creating better job opportunities for mid and low income workers; generating “decent jobs,” with rising real incomes. Three aspects are stressed in this area. Two of them are structural, the need (i) to improve the quality and quantity of investment in people, or human capital, and (ii) to enhance productive investment and its link to productive employment. Both factors contribute to raise productivity across society, and thus to spread opportunities to larger segments of the labor force. The third aspect is (iii) the attainment of sustainable macroeconomic balances of the real economy. The efficient approach for obtaining both growth and equity implies a comprehensive definition of macroeconomic equilibria. This includes far more than low inflation and a sustainable fiscal balance. It also requires equilibrium of the real economy; that is, making full use of available productive capacity, avoiding excessively fluctuating and outlier real interest and exchange rates, and securing a favorable macroeconomic environment for productive investment. I show that the sharpest setbacks in income distribution and poverty have been caused by critical macroeconomic imbalances: the hyperinflation of 1973, and the recessions of 1975 and 1982. To these should be added the cases in which macroeconomic “balances” have been achieved at the expense of other balances, such as the cases of macrosocial disequilibrium with drops in social expenditure in 1985–7, and of external imbalance in 1996–8, followed by a recessive environment and a distributive set-back in 1999–2003. The subsequent recovery of economic activity, in 2004–7, brought an improved distribution, encouraged by notable improvements in social policies, but, in all, merely to regain the situation achieved in the first years of the return to democracy in the 1990s. Real macroeconomic imbalances generate structural, long lasting, regressive effects.

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Inequality and Poverty

1 Trends in income distribution and poverty Despite vigorous economic growth, particularly in the nineties, Chile is still a developing emerging economy. Its per capita income level (in purchasing power parity, PPP) is less than one-third that of the most developed economies, and income inequality is notably higher, as can be seen in Figure VII.1. For instance, the ratio rich/poor quintile in the G-7 nations is 7/1, while in Chile the comparable measurement was 15/1. (a) How is it quantified? Good measurements are important because they provide information on the effectiveness of socioeconomic policies aimed at reducing the inequalities and poverty characteristic of underdevelopment. Nonetheless, the measurement of poverty and inequality is beset with great difficulties. The definition of poverty is a conventional one. The generally accepted definition of the poor is that they are “those whose income per capita is lower than the cost of two baskets of food and basic non-food needs” (ECLAC, 1997, Box 1). This is the dividing line between the poor and the non-poor used in the CASEN survey in Chile, conducted by the Ministry of Planning (MIDEPLAN). The poverty line has remained constant in real terms in the nine surveys made between 1987 and 2006, based on the household budget survey of the National Bureau of Statistics of 1987–8. The urban poverty line is equivalent to about US$100 monthly per capita; US$400 for an average poor family of four. Box VII.1 shows the urban and rural level of the poverty line, and presents diverse income indicators for different groups in society in 2000 and 2005. The definition does not tell us anything about how far the many people who ceased to be numbered among the poor between 1987 and 2006 have risen above the poverty line or about the previous position of those who

40.000 35.000 30.000 25.000 20.000 15.000 10.000 5.000 0

Per capita GDP

G-7 38,578

20% richest v/s 20% poorest

Per capita GDP

7 times

20% richest v/s 20% poorest

(USA 8 times)

15 times (USA 44,765) 13,745

G-7

Chile

Figure VII.1 Chile and developed countries, per capita GDP and income distribution, 2007 (PPP US$). Source: IMF, World Economic Outlook Database (2008), World Bank, World Development Indicators (2008).

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Box VII.1 Wages and the poverty line, 2000 and 2005 (monthly income in UF) The Table shows the monthly amounts in Unidades de Fomento (UF, the priceindexed unit of account, is a financial unit of account, adjusted daily by changes in CPI; in 2005, one UF was equivalent to US$31) of monthly wages in Chile according to the main sources available. It also shows the value of the (per capita) poverty line (rural and urban). It must be noted that the sources do not all register the same concept of wage. While some gather the liquid wage, others report the assessable salary. If workers’ contributions to social security (of approximately 20%) are discounted from assessable salary, then the monthly average liquid wage in 2005 was between 12.2 UF (according to unemployment insurance figures) and 17.4 UF (University of Chile); that is to say, between US$380 and 545 (2005 prices). The information from private health insurance (ISAPREs), which includes the population with higher income, exhibits an average liquid wage of 26.5 UF (US$830 of 2005).

Average wages ACHSa AFPa Male Female INEa ISAPREa Unemployment insurancea CASENb Male Female University of Chiled Minimum wagea Poverty line Urbanb Ruralb

2000

2005

Wage

Coverage

20.0 18.3 19.3 16.7 15.5 27.4 – 14.2 15.6 11.9 16.6

21.4 19.3 20.3 17.7 15.7 33.3 15.4 14.2c 15.4c 12.2c 17.4

Assessable Assessable Assessable Assessable Assessable Assessable Assessable Liquid Liquid Liquid Liquid

National National National National National National National National National National Greater Santiago

6.4 5.1

7.1 5.7

Assessable Liquid

National National

2.6 1.7

2.6 1.7

National National

a December. bNovember. c Year 2003. dJune. The assessable wage is the gross salary before health and pension fund contributions. The liquid wage is the net amount actually received. Universes (2005). ACHS: Chilean Association for Labor Accidents includes 1,718,166 workers in 35,421 enterprises. AFP: Pension Fund Administrators includes 3,321,793 contributors (98% dependants, 63% male). ISAPRE: Private Health Insurance System includes 1,241,018 contributors and 2,673,409 beneficiaries. In 2005, the population was 16.3 million and the labor force 6.8 million.

The average number of persons by household for quintiles I and II was somewhat larger than four. This means that an urban household of four people, for example, needs a monthly income of 10.4 UF to surpass the poverty line. This amount was somewhat less than twice the liquid minimum wage of 2005.

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Inequality and Poverty

have fallen into poverty. A complementary measurement is the estimation of points of GDP needed to raise the income of all the poor up to the poverty line: that objective could be achieved with funds equivalent to 2% of the incomes of non-poor people (see Feres, 2001b). Poverty is not static. In particular, the precariousness of the poor or close to poor population is accentuated under recessive economic situations. In MIDEPLAN (2008), as will be seen later, this volatility is quantified, showing the household shifting away from and towards poverty between 1996 and 2006. Inequality is much harder to measure. Here I focus, principally, on income distribution. The inaccuracies correspond, especially, to the extremes of the distribution, and particularly the high income brackets and the rent of capital. The measurement of the income of dependent workers is more accurate, in particular of mid and low wages, due to its being formal and subject to social security contributions. In turn, even if the figures available were correct, there are still many alternative ways of organizing the information – for example, by income or by expenditure per household or by per household member – and the differences are substantial among diverse indicators. Once the information has been classified, there are also various ways of measuring distribution; indicators range from the more cryptic (such as the traditional GINI indicator) to simpler ones such as the ratio between the shares of the richest and poorest quintiles or deciles. One drawback of the latter indicator is that it does not take into account the 60% or 80% in the middle brackets and it gives great weight to the richest income bracket, where measurements are very defective. The evolution of the intermediate sectors is caught, among others, implicitly by the GINI coefficient (see Table VII.5). There are different sources of information on income and expenditure distribution in Chile. Some distributive outcomes differ radically between the various sources. The data source of longest standing is the employment survey of the University of Chile, which has been collecting information on income in the capital, Santiago (covering over 40% of the Chilean population), annually since 1958.1 The CASEN national survey is available for 1987, for every two years between 1990 and 2000, and for 2003 and 2006; the new 2009 survey is being processed. Both the coverage and the survey itself were improved in the 1990s, so that comparability with 1987 is limited; nevertheless, its aim is the characterization and measurement of poverty and the access of the poor to social transfers and services, and it is weak in the measurement of income distribution, particularly in the higher 1 The distribution data refer to household per capita income according to the University of Chile employment survey. See Larrañaga (2001) and Center of Micro Data (Centro de Micro Datos), Department of Economics, University of Chile, January 2010.

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179

quintile. Paradoxically, notwithstanding those weaknesses and the fact that it has been available only since 1987, it contains the data most commonly used by analysts and mass media to measure income distribution in Chile. This is due, probably, to the fact that the CASEN data are easily available and have national coverage. Reliance on it is a risky option that leads to wrong conclusions, such as that distribution has been rather stable for decades. It misses the sharp worsening in the 1970s and 1980s. Once a decade or so, the National Bureau of Statistics (INE) carries out a detailed survey of household budgets in Santiago, which is solid on expenditure levels and their composition. Data are available for 1969, 1978, 1988, and 1997; a newer survey, for 2007, is partially published at present, covering on this occasion most large towns. INE also collects income data in a survey on employment.2 (b) Progress and setbacks during the Pinochet regime, 1973–89 Notwithstanding social improvements made in the 1950s and 1960s, and the comparatively progressive position within Latin America, the distribution pattern that prevailed around 1970 was regarded as highly inequitable (Ahumada, 1966). Consequently, a number of proposals for improving the situation were put forward. Several of these were implemented during the administrations of Presidents Frei and Allende. A significant land reform was carried out between 1965 and 1973 (Ffrench-Davis, 1973; Bitar, 1979; Ortega, 1987). In 1971, in Allende’s presidency, wages and social spending (pensions, family allowances, education and health budgets, etc.) were increased massively, although in an evidently unsustainable manner. The inflationary surge of 1972–3, with annual rates in excess of 200 and 600%, respectively, and the fall in real wages testify to it. Some social indicators continued to improve during the Pinochet regime, while others went sharply into reverse. The illiteracy rate, already down to 20% in 1952, fell to 10% around 1973 and to 6% in 1989, while the number of students enrolled in primary schools, as a percentage of the population aged six to fourteen, rose from 65 to almost 100% in 1973. As for secondary education, the proportion of fifteen- to eighteen-year-olds enrolled climbed from 10% in 1952 to 51% in 1973 and 75% in 1989.3 Developments were very positive with regard to life expectancy and infant mortality. In particular, infant mortality fell markedly. In the early 1960s the infant mortality rate was 110‰ and by 1970 had improved to 82‰. 2 There are many other expressions of inequality, such as in relation to gender, the environment, the political system, wealth, power, the social or ethnic origin, transparency or corruption, participation and voices. See, for example, Sen (2000), Garretón (2003), and UNDP (2004). 3 See ECLAC, Statistical Yearbook, based on official Chilean information.

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Inequality and Poverty

Between 1973 and 1980 it progressed from 66 to 33‰. In the 1980s Chile exhibited the lowest level in Latin America, along with Costa Rica, Cuba, and the English-speaking Caribbean. This enhanced performance was the result of public efforts to improve mother and child care, including nutrition programs for nursing children; a decline in the number of births; and irreversible factors such as improvement in the education of mothers (Raczynski and Oyarzo, 1981; Monckeberg, 1998). Nonetheless, the performance of other indicators was quite negative (see Table VII.1). This was essentially a reflection of: (i) economic and labor reforms since 1973 that were strongly biased against workers and their economic organizations; (ii) great real macroeconomic instability; and (iii) a low ratio of investment per member of the labor force (generating a negative impact on productivity per worker). As a result, average real wages in 1989 were 8% below their 1970 level. In other words, over nearly two decades, average wages fell; the worsening was enhanced by an increase in wage inequality (Ruiz-Tagle V, 2007). The minimum wage declined by a similar percentage over the period, and its coverage narrowed considerably, with even lower levels being applied to apprentices, workers under twenty-one (later changed to those under eighteen), and those over sixty-five (Cortázar, 1983). Similarly, family allowances, which had played a progressive role, growing continuously in importance until the early 1970s (Ffrench-Davis, 1973), went into a steady decline after 1974; a regressive trend continued until 1989, when they were 72% below their 1970 level. Per capita public social expenditure (including health, education, housing, and retirement pensions) also fell, declining 16% in 1989 in comparison with 1970.4 Public spending on education and health dropped substantially, by 37 and 30%, respectively. Only social security spending increased, owing to a rising number of pensioners, which over-compensated a reduction in the average pension. However, some social spending (though not the major part) was targeted at the poorest members of society, which appears to have partially offset the decline in labor income.5 Many of these indicators worsened during the 1970s, exhibited a partial recovery in 1979–81, and deteriorated again with the long recession started in 1982; average and minimum wages began to rise only in 1988, and family allowances in 1990 and public social spending in 1991, under the return to democracy (see Table VII.1). The declines in labor income and in monetary social expenditure, as well as the regressive bias of tax reforms in the 1970s and 1980s, were reflected in a worsening distribution of consumer spending. Household budget surveys 4 Public spending is financed by fiscal funds and the contributions of beneficiaries. A large discrepancy between official and “corrected” figures for social spending in the 1970s is discussed in Marshall (1981). 5 Sometimes faulty targeting implied the crowding-out of the middle class or even the poor; for example, exclusion from the university, after the rather free access was suppressed without a comprehensive system of scholarships.

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Table VII.1 Wages, family allowances, and social expenditure, 1970–2009 (real indices, 1989 ⫽ 100) Per capita public social expenditure Average Minimum Family GDP per Education wage wage allowance member of labor force (1) (2) (3) (4) (5) 1970 1980 1981 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

109.2 97.2 105.7 90.9 92.4 92.1 98.1 100.0 101.8 106.8 111.7 115.6 121.0 129.2 134.5 137.8 141.4 144.8 146.8 149.2 152.2 153.7 156.5 159.4 162.5 167.0 166.7 173.9

108.9 141.6 147.8 93.7 89.5 84.0 89.6 100.0 106.8 116.8 122.2 128.2 132.9 138.9 144.9 150.1 162.5 173.8 186.1 193.2 198.9 201.5 207.2 211.2 216.6 220.3 219.4 229.8

352.1 287.3 284.8 192.2 160.9 134.2 117.0 100.0 118.7 145.8 149.3 151.9 154.6 159.4 166.0 174.9 182.9 187.8 189.1 191.0 194.6 196.3 199.3 198.9 200.6 227.0 244.7 265.1

98.8 100.6 103.8 81.8 83.3 89.2 91.8 100.0 103.1 108.9 121.0 123.8 124.1 136.9 147.2 153.9 155.7 148.0 151.2 154.8 153.6 149.7 148.8 150.5 145.6 151.0 158.4 –

159.7 141.5 147.1 121.4 114.2 105.0 102.6 100.0 94.9 105.0 118.7 127.2 137.1 151.1 168.5 183.4 201.8 213.1 228.8 244.9 260.5 261.4 278.7 274.6 288.9 318.9 364.6 –

Health

(6) 143.7 118.2 107.3 92.0 89.8 88.4 101.1 100.0 94.0 108.9 125.1 138.6 150.9 155.3 166.7 174.4 186.4 189.7 203.0 217.1 225.1 236.1 250.9 270.3 284.4 338.9 359.2 –

Total

(7) 119.2 107.4 116.2 107.9 103.6 101.0 102.6 100.0 97.4 104.6 113.7 123.1 129.1 136.7 148.0 154.5 164.1 174.7 183.2 192.4 196.1 198.0 206.7 214.9 226.1 242.4 261.7 –

Average annual growth 1982–9 1990–7 1998– 2009

–0.7 4.1 2.0

–4.8 5.2 3.6

–12.3 7.2 3.5

–0.5 5.5 0.3a

–4.7 7.9 6.4a

–0.9 7.2 6.8a

–1.9 5.6 4.9a

Source: National Bureau of Statistics (INE) and Jadresic (1990) for wages; Cortázar and Marshall (1980) for corrected CPI; Cabezas (1988) and the Budget Office (DIPRES, since 1986) for social expenditure. Column (1) is the general wage index until April 1993, and later the hourly wage index; the latter increased by 6% more than the other index between April 1993 and 2005. Column (2) represents liquid income. Column (3) is the family allowance of blue-collar workers in 1970, then the uniform allowance, and later that for the low-income bracket. Column (4) is an estimate of net national product based on national accounts and depreciation from Table IX.2. Column (7) includes expenditure on education, health, housing, pensions, and others. All are average figures for each year. aIncludes only up to 2008.

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(Encuestas de Presupuestos Familiares, EPF) conducted in Santiago in 1969, 1978, and 1988, on which the basket of the CPI has been successively built, show a steady decline in household spending in the three lowest quintiles.6 Furthermore, the poorer the sector of the population, the proportionally greater is the decline (see Table VII.2). For example, the share of expenditure of the poorest 40% of households (the first and second quintiles) fell from 19.4% in 1969, to 14.5% in 1978, and to 12.6% in 1988; in other words, they lost one-third of their share of total expenditure. By contrast, the relative situation of the richest quintile improved consistently, with its share rising from 44.5% in 1969, to 51.0% in 1978, and 54.9% in 1988. Furthermore, this is the only quintile in which spending per household rose in real terms between 1969 and 1988. This information on the distribution of expenditure shows that the second half of the Pinochet government (1982–9) was even more regressive than the first half, so that the concentration of wealth and income observed during the first stage, from 1974 to 1981, was accentuated in the 1980s.

Table VII.2 Distribution of household expenditure in Santiago, 1969, 1978, 1988 (%) Quintile I II III IV V Total QV/QI

1969

1978

1988

7.6 11.8 15.6 20.6 44.5

5.2 9.3 13.6 21.0 51.0

4.4 8.2 12.6 20.0 54.9

100.0

100.0

100.0

5.9

9.8

12.5

Source: National Bureau of Statistics, Household Budget Surveys for Greater Santiago. Quintiles ranked according to household expenditure; excluding imputed rent for home-owners, which is available only since the 1988 survey (see Table VII.5).

6 We have searched for a possible distributive bias in the household budget survey (EPF) associated with the fact that Santiago includes only 40% of Chile’s population and that it is essentially urban. After comparing the results of the five CASEN surveys recorded during the 1990s, Feres (2001a) finds that the GINI coefficients are relatively similar for Santiago (average of 57.2) and for Chile (average of 57.4). Preliminary data of the new EPF, for 2006–7, that now covers all regional capitals, exhibit the same similarity: the GINI is not significantly different between Santiago and the average of the rest of capitals. The EPF is used by the INE to build the CPI, which from 2010 will be national instead of only for Santiago.

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Information from the University of Chile employment survey for Santiago likewise shows deterioration in income distribution, though differing in intensity and with large fluctuations from year to year. According to this source, between 1975 and 1987, the situation worsened steadily, stabilizing temporarily during the upswing of 1977–80 only to deteriorate again afterwards. The worst indicators were reached in 1987, whether measured by the GINI coefficient or the ratio between the first and fifth quintiles (Larrañaga, 2001). In previous chapters it was examined the role that a number of reforms and policies of the dictatorship played in exacerbating the severe crises that Chile faced in the 1980s. The dogmatic approach, particularly during the first half of its rule, increased the country’s vulnerability to external shocks. Among the worst consequences of the resulting recessions was the persistent domestic unemployment that prevailed (see Figure VII.2). By 1975, the percentage of unemployed already stood at 15.7%, a figure that rises to 17.6% if those working in the PEM (minimum employment program) and the POJH public programs (employment program for heads of households) are included. By 1983, the number of unemployed stood at 19% of the labor force; emergency job programs absorbed another 13% of the labor force,7 for a total of 31.3%. The problem was later alleviated by the recovery of

35 Excluding emergency programs 30

Including emergency programs

25 20 15 10 5

2008

2006

2004

2002

1998

2000

1996

1992

1994

1990

1988

1986

1984

1982

1980

1976

1978

1974

1970

1972

1968

1964

1966

1962

1960

0

Figure VII.2 National unemployment rate, 1960–2009 (percentage of the labor force). Source: National Bureau of Statistics and Jadresic (1986), and Budget Office for Emergency programs. Annual averages.

7 Although the emergency jobs programs were originally designed for a working week of only fifteen hours, in practice full-time work was required. The wage paid, meanwhile, eventually fell to less than one-third of the minimum wage, with no social security coverage. Unemployment benefits were virtually non-existent, although the PEM performed partly as a subsidy in exchange for work. Earnings from the POJH varied between 1.6 and 2 times those for PEM.

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Inequality and Poverty

economic activity, but only in 1989 was there a return to single-digit unemployment rates, with open unemployment of 8%. In a situation in which unemployment hit the lowest income groups the hardest, with a lack of unemployment insurance and weakened public social networks, the worsening in income distribution is easily explained. (c) Income distribution and poverty after the return to democracy, 1990–2009 Since 1990, four periods with different socioeconomic outcomes can be distinguished. During the first years (1990–5), there were significant real improvements in the average and minimum wages and social expenditure, which meant a recovery from the depressed levels of the two prior decades. In parallel, employment, coverage by social security, and labor participation increased persistently. The macroeconomic environment, with factors of production (labor and capital) operating close to full employment, provided a significant progressive equity dividend. In the second period (1996–8), progress in poverty reduction slowed and wages experienced smaller increases, while other social indicators kept improving. In the third period (since 1999), under a reappearing recessive output gap, the environment worsened dramatically, with a sharp rise in unemployment and a noticeable moderation in poverty reduction (CASEN 2000, 2003). However, the minimum wage – which is proposed annually by the government to the Parliament – rose significantly through the establishment of a triennial program for 1998–2000. Similarly, wages of teachers and workers in the national health service as well as public pensions experienced special raises. The associated higher fiscal expenditure was duly financed with tax revenue. Finally, the fourth period starts with the recovery of economic activity in 2004 and sharp reinforcement of social policies, especially intensive in 2008–9, notwithstanding the contagion of the global crisis. The CASEN 2006 survey shows substantial progress in poverty reduction, of 5 percentage points with respect to the 2003 survey (18.7–13.7%). The moderation in poverty reduction in 2000–3 as well as its acceleration in 2003–6 shows how determining the macroeconomic environment is, through its impact on the labor market. In parallel, employment has recovered and with greater formality, and the minimum wage has continued to rise (Table VII.1 signals that in 2009 it corresponds to an amount 2.3 times the real level inherited from the dictatorship); meanwhile, social programs, such as Chile Solidario and the solidarity pillar of the ambitious Social Security Reform of 2008, were focused on poor and more vulnerable people. In 2007, the authorities and public opinion acknowledged with force the severity of the income inequality still prevailing in Chile, and the government launched a Presidential Advisory Council for Labor and Equity.

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185

(i) Poverty In 1987, 45.1% of the Chilean population was living in poverty according to the CASEN survey.8 Subsequent measurements by CASEN, always maintaining the same methodology and keeping a constant real height of the poverty line, are summarized in Table VII.3.9 It shows the steady progress made in this area, the percentage of poor people having fallen to 21.7% of population in 1998, and to 13.7% in 2006.10 The percentage of extreme poor diminished from 17% in 1987 to 3% in 2006. Poverty is a dynamic concept: some households may have risen above the poverty line, but be close to it, and a minor income deterioration can throw them under the line again; or may have been employed at the time of the survey, which refers to one month only (not to the year average), though in many other months they were unemployed, given the precariousness of labor markets. Table VII.4 shows that a high number of people move around the poverty line, even if only three (monthly) points of time are considered in a very revealing panel survey: in 1996, 2001 and 2006. Of the 23.5% of poor in 1996, 12.2% were not poor in 2001, but in this year 7.4% fell into poverty, completing 18.7% of population in 2001. Considering the third point in time, only 4.4% appeared as poor in the three instances (a figure close to that of indigents), while 29.8% were in poverty once or twice. Consequently, in at least one of the three surveys (concentrated in the months of November), over 34% of the population was in this situation; evidently, many more suffered poverty in the course of the decade between 1996 and 2006. Those that never appeared as poor in the panel survey averaged 14.3 years of education, 8

Previous studies with a rather similar poverty indicator but methodologies that are not fully comparable reveal that 20% of the population was poor in 1970 (Altimir, 1982; ECLAC, 1991). It is evident that the share of poor people in 1970 was lower than in 1987, even if the 20% figure for 1970 were highly underestimated with respect to a percentage resulting from the present criteria of measurement. 9 Expenditure on food was adjusted, in the official estimate, by the increase in the CPI of food and then was multiplied by 2. In 1987 (a year of record concentration of income in the richest quintile), the government chose quintile III as the reference bracket for the basket of food of the poverty line. This quintile recorded in that year a factor close to 2 between food and total expenditure. The overall CPI shows that between 1987 and 2006, the price index of non-food increased 12.7% more than that of food; if that percentage were representative of the poor, the coefficient 2 should have been raised to 2.13 (that is 6.3%) in order to keep constant the level of the expenditure basket of the poor (instead of that of food). The Fundación para la Superación de la Pobreza (FSP) estimated, based on CASEN 2003, that the coefficient for the poor should be raised to 2.2. 10 Historically, the incidence of poverty in the rural sector has been greater than in urban areas, in spite of a lower absolute poverty line. The rural poverty line is lower on the assumption that they benefit from self-provision and lower food prices. That situation has reverted in the 2006 survey, since poverty reached 12.3% of the rural population, whereas for the total it was 13.7%.

186

Table VII.3 Poverty evolution in Chile, 1987–2006 (%)

Population Indigents Other poor Total poverty Households Indigents Other poor Total poverty

1987

1990

1992

1994

1996

1998

2000

2003

2006

17.4 27.7 45.1

12.9 25.7 38.6

8.8 23.8 32.6

7.6 19.9 27.5

5.8 17.4 23.3

5.6 16.1 21.7

5.7 14.9 20.6

4.7 14.1 18.7

3.2 10.5 13.7

13.5 24.5 38.0

10.6 22.7 33.3

7.2 20.5 27.7

6.2 17.0 23.2

4.9 14.8 19.7

4.7 13.1 17.8

4.6 12.0 16.6

3.9 11.5 15.4

2.7 8.5 11.3

Source: MIDEPLAN, national data from the CASEN surveys.

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Table VII.4 Poverty dynamics in Chile, 1996–2001–2006 (% of population) 1996

2001

2006 Poor

Poor (11.3) Poor (12.2) Non-poor Non-poor

Poor (11.3) Non-poor Poor (7.4) Non-poor Total

Non-poor

Total

4.4 1.6 1.5 3.2

7.0 10.6 5.8 65.9

11.3 12.2 7.4 69.1

10.7

89.3

100.0

Source: Based on CASEN Panel Surveys 1996–2001–2006, covering Santiago and three other regions that represent about 60% of the total national population (MIDEPLAN, 2008). In the National CASEN 2006 survey, the poor population was 13.7% for all Chile, while in the regions covered by the Panel Survey it was 13.3% as compared to the 10.7% recorded in the Panel Survey.

while the remaining 34.1% averaged only 10.3 years of education (well below the threshold of 12 years. There is another relevant issue in a country whose income per capita has doubled since the definition of the poverty line in the 1980s. Poverty is not an absolute concept.11 The “poverty line” should not be identical in an economy with US$40,000 per capita and in one with US$1,000. Several specialists recommend a relative concept of poverty; for instance, a moving line that is a given percentage of the average wage or of national income. Naturally, a shift in this direction converges with measures of income distribution and hides the positive effects of economic growth on social welfare. In the specific case of Chile, which has achieved such a substantive average income improvement in the past two decades, the policy target should be adjusted in the fight against poverty. That implies raising the height of the poverty line so that the basic food needs are satisfied with higher quality goods and a larger share of non-foodstuff.12 In parallel, despite the progress obtained in poverty reduction, solving the unacceptable inequality remains a pending challenge for the Chilean economy.

11 The sensitivity of the number of poor is notably intensive with respect to the height of the line. Estimates by Fundación para la Superación de la Pobreza (FSP, 2005) show that increasing the line by 11.4% augments the number of poor from 18.7 to 22.8% in the CASEN 2003. 12 The Ministry of Planning (MIDEPLAN) is in the process of revising the poverty line for the CASEN 2009, probably ending with a new higher line.

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Inequality and Poverty

(ii) What has happened with income distribution? The evolution since the return to democracy shows an improvement; according to several sources, progress was significant in the earlier 1990s, with subsequent reversals in the recessive 1998–2003 period, and an improvement in the late 2000s. In any case, while the information available generally points to a significant improvement compared to the 1980s, it is clear that distribution is still very regressive. A major national effort will be required, then, to correct this sharp inequity. The most comprehensive source of information on expenditure distribution is the EPF of INE, for Santiago; it is a survey of wide coverage, collected systematically for twelve months, with annotations in a passbook and checkups. The last fully published survey was carried out in 1996–7 (INE, 1999). Due to methodological differences, these results are not comparable with the series of the three previous surveys reported in Table VII.2, in particular with respect to the treatment of the rent of housing.13 The omission of imputed rent in an evaluation of income or expenditure distribution represented a severe bias for the estimation of progress in the well-being of poor households, which were increasingly becoming homeowners, as a consequence of intensive government programs. Estimates of imputed rent are recorded from the 1988 survey on. The progress in housing programs achieved by Chile has had a significant effect on quintile I, by raising its share of total expenditure by 1.3 percentage points in the 1997 survey and 0.5 points in 1988, as compared to data without imputed rent (see Feres, 2001a). Demography has also played an important role. Per capita data (it would be even more accurate to work with “an equivalent adult”)14 turn out to be more precise than figures per household, since a “representative household” of a given quintile in 1988 is not comparable with one in 1997. In fact, the average number of members of households fell in all quintiles between 1988 and 1997, with a 6% drop in the total average (from 4.09 to 3.84 persons).15 This change has been stronger in quintile I than in quintile V. It implies that the fight against inequality presents, rightly so, a greater improvement with quintiles ordered by per capita expenditure and income rather than household income. Table VII.5 exhibits the distribution of per capita expenditure (cols 1 and 2) and income (cols 3 and 4) for “comparable” quintiles of households in 1988 and 1997. It shows an overall improvement in 1997, when the poorest quintile 13 These three surveys rank households by paid expenditure, excluding imputed housing rent. The 1997 survey records acquired expenditure and generated disaggregated data on imputed housing rent. 14 It would seem advisable to adjust for the number of household members, age, and economies of scale (see Contreras and Ruiz-Tagle V., 1997). 15 The average fell further to 3.55 members per household in the 2007 EPF.

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Table VII.5 Distribution of household expenditure and income in Santiago, with imputed rent for homeowners, 1988 and 1997 (%) Expenditure distribution

Income distribution

Quintile

1988 (1)

1997 (2)

1988 (3)

1997 (4)

I II III IV V Total

6.4 10.2 13.6 19.8 50.0 100.0

6.7 10.4 14.2 20.4 48.2 100.0

4.8 8.6 11.8 18.6 56.2 100.0

6.3 10.0 13.6 19.5 50.6 100.0

GINI QV/QI

0.39 7.8

0.37 7.3

0.45 11.8

0.39 8.0

Source: Adapted from Feres (2001a), based on tabulations of the fourth and fifth Household Budget Surveys for Greater Santiago. Data ordered by per capita figures of the household.

raised its participation between 0.3 and 1.5 points of GDP, and the GINI improved by between 3% and 13% with respect to the 1988 survey. It also shows that income inequality is more intense than that in expenditure, but precise differences are unavailable given the larger weakness of the quality of income figures. In brief, the information from the EPF for 1988 and 1997 shows, on the one hand, that extreme care must be taken in analyzing the distribution, since the same surveys processed with different criteria can show very different results.16 On the other hand, the EPF shows a reduction in both expenditure and income concentration in the nineties.17 These improvements are reconfirmed by provisional figures from the 2007 EPF. The results provided by income data from the University of Chile employment survey for Santiago are consistent with those from the INE household expenditure survey. Figure VII.3 presents the ratio between quintiles I and V. It shows a statistically significant improvement since 1990 (an average of 15.7/1 in 1990–2009) compared to the 1970s and 1980s (an average of 17.7/1 in 1974–89, with close to 20/1 in the 1980s). Nonetheless, despite that improvement, the data indicates that today income inequality is still

16 For example, the GINI calculated according to different criteria of ordering and disaggregation changes by as much as twelve points. Feres (2001a) presents twelve alternative forms of organization of data. 17 The comparison of income with expenditure of the same survey of 1997 shows indebtedness in deciles 1 to 7 and savings in deciles 8 to 10 (INE, 1999).

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24 22

19.9

20 18

16.3

15.1

16

14.4

13.7

12.9

14

12.3

12

2008

2004

1996

1994

1992

1988

1990

1986

1984

1982

1978

1980

1974

1976

1972

1970

1968

1966

1964

1962

1960

51.8

53.7

2006

50.9

2002

56.6

51.9

46.6

2000

GINI = 48.9

8

1998

10

Figure VII.3 Income distribution in Greater Santiago, 1960–2009 (Q5/Q1 ratio, threeyear moving average). Source: Based on the University of Chile Employment Survey, processed by Larrañaga (2001), and revisions and updates by the Center of Micro Datos, Department of Economics, University of Chile, January 2010. The data are ordered by income per capita of households. The numbers on the horizontal lines correspond to the average of the ratios richer quintile/poorer quintile in each subperiod under each line. Figures at the bottom are the averages of the GINI coefficients in the same subperiods.

worse than it was in the 1960s (12.9/1 in the 1960s).18 Similar conclusions arise from GINI coefficients. This survey is annual, so that it allows the identification of changes in shorter periods than a full decade. After improvements in the early years of the return to democracy (to a ratio of 13.7/1 in 1992–5), a trend reversal is recorded in the University of Chile employment survey for Santiago, with a partial worsening in the second half of the nineties (an average of 16.3/1 in 1996–2002, and recovering to 14.4/1 in 2003–9). Thus, progress in distribution took place mainly in the early years, when the reforms of the reforms were carried out; these injected a dose of equity into the regressive neoliberal inheritance. An expression of it was the sustainable increase in both real average wages and minimum wages in the first period, as well as rising employment. The average wage rose 4.2% in 1991–8 (4.8% in 1991–6). In the second period, in 1999–2009 annual rises averaged only 1.9%. In parallel, unemployment figures were already showing some deterioration in 18 These figures are based on a classification by household income per capita (Larrañaga, 2001). Ruiz-Tagle V. (1999) provides data for total family income and income per capita adjusted by economies of scale and per adult equivalent (see also World Bank, 1997). The ranking for the averages of the sub-periods into which we have grouped the information is similar in the three categories. The signs of changes are also similar if the GINI coefficient is used. Nonetheless, the observations (which refer to June of each year) suffer from a great deal of “noise”; that is why I use moving averages of three years in Figure IX.3.

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1998, under the contagion of the Asian crisis, which intensified with the recessive gap in 1999–2002, but recovered thereafter.19 The best known indicator, the CASEN survey, shows an increase in the share of monetary income received by the poorest quintile of households between 1987 and 1992 and a decrease in the share of the richest quintile. From that time onward, however, the survey depicts ups and downs. But, still in 1996, all available data, both original and adjusted, ranked both by household and by per capita income, show an improvement in the poorest 40% of households (and, in most cases, in quintile I) and a reduced share in the richest 20% of households. That year, the GINI index had improved in all cases with respect to 1987 (see Feres, 2001a). In 1998, when the longlasting recessive adjustment began – it was already evident in November, the month when the survey was applied – a worsening is observed with respect to the 1996 survey, which persists in the 2000 survey (nonetheless, these changes have low statistical significance). The 2003 CASEN survey shows some distributive improvements, capturing the start of economic recovery; that trend was accentuated during the following years. Consequently, in the 2006 CASEN, the ratio between the richest and the poorest quintile diminished to 13.1, from 14.4 in 2000 (the GINI improved from 0.58 to 0.54 in the same years).20 Finally, there has been a significant increase in “investment in people” since 1990. The effects take time to make it felt. Consequently, it is interesting to observe what happens to distribution when the monetary transferences and the free services provided by the state (whose benefits emerge in the long term) are added to people’s monetary incomes.21 As can be seen above, in Table VII.1, there has been a substantial rise in per capita public spending on education and health care, aimed essentially at the poorest quintiles. Consequently, when corrected for non-monetary items, income distribution improves considerably, bringing down the gap between the richest and poorest quintile from 13.1to 7.1 for the CASEN survey of 2006 (considering the 19 As against this outcome, there were substantial improvements in pensions and the minimum wage in 1998–2000, which reflected the public concern over social issues, but also the frustrated expectation that GDP would keep growing at around the 7% plateau. 20 Figures based on household per capita autonomous income; that is, income from labor and capital. 21 The monetary subsidies are transfers mostly targeted to low-income people. The main programs corresponded to the family allowance, which is paid to low-wage earners according to number of dependents; the welfare pension (PASIS), paid to poor senior people or invalids; and the unique family subsidy (SUF), which is a family assignment for poor persons without social safety. Other monetary transfers include the subsidy for consumption of drinkable water (SAP), a monetary payment to the beneficiaries of Chile Solidario, and a public complement of the pensions paid by the AFP to guarantee a minimum level.

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monetary transferences such as pensions of non-contributory seniors, family allowances, and unemployment insurance). As social spending rises, a key variable is whether it actually leads to an increase in the volume and/or quality of services or whether the same services are merely provided at greater cost to the State.22 The actual volume has evidently improved; in the case of education, the number of years studied has increased sharply as reported here; quality needs to be improved sharply in education and in the services provided by the National Health Service. To ensure that spending produces results, effective pressure needs to be applied to achieve higher productivity and a better service to beneficiaries. (iii) The social situation and public policies The return to democracy brought with it greater attention on the part of the state to equity and poverty issues. Consequently, in the 1990s the authorities introduced reforms to the reforms. Public spending was restructured to increase funding in social areas, in parallel with a fiscal reform that raised progressive taxation and the VAT rate. In the labor market, reforms led to a substantial improvement in the minimum wage and reduced the imbalance of power between workers and employers. Furthermore, innovative targeted social programs were carried out, such as priority for basic schools in poor zones and young labor training in the early 1990s (Raczynski, 1996); and, in the present decade, the ambitious, more comprehensive, Chile Solidario, which directly benefited the poorest households, the gradual health reform AUGE, and a notable reform of social security. Additionally, significant reforms concerning macroeconomic management in the first half of the nineties had major positive effects on productive employment and wages. The introduction of the unremunerated reserve requirement and other prudential mechanisms for regulating volatile capital inflows played a key role in achieving sustainability of macroeconomic balances and the 7% average GDP growth (see Chapter VIII). The result of this set of policies was a substantial growth in the real average wage, which in 1998 was 41% higher than in 1989, while the minimum wage was 63% above that in 1989. The recessive adjustment initiated in 1999 weakened the growth rate of wages; nevertheless, in 2009 the average real wage exceeded by 74% that of 1989, while the minimum wage had grown 137% in the same period. The family allowance had multiplied by 2.6, which meant recovering nearly 90% of the fall recorded in the eighties 22 A substantial share of the increase in social spending in the 1990s was directed to raise the wages of teachers and national health system personnel. In 1990 their salaries were extremely out of line with the market and below the minimum required for efficient functioning. Unfortunately, while the quality of services fell as a result of the decline in wages and in the social status of these public servants in the 1980s, improved incomes are not automatically followed by a recovery in quality.

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(see Table VII.1). Additionally, as said, per capita social expenditure in education and health multiplied by 3.6 in 1990–2008 (7% annual average growth), strongly directed to recovering the wage levels notably reduced in the eighties. The unemployment rate also improved considerably, averaging 8.7% in 1990–2009 compared to 18% in 1974–89 (see Table I.1 and Figure VII.2). Naturally, the macroeconomic conjuncture has had a significant impact on employment. This is revealed in the rate of 6.1% of open unemployment during the boom year 1997 compared to 10.5% in the depressed 1999–2003 period, or the extremely high rate of 31.3% recorded in 1983 during the debt crisis compared to 7.9% at the 1989 peak. There are two positive trends in the labor market that must be underlined. One is the rising share of workers in formal segments, as reflected by the number contributing to social security. Democracy inherited a low share of workers contributing to the private social security scheme created by the dictatorship in 1981; the majority of the market was informal, with only 41% of the labor force contributing monthly. A rising trend from 1990 led to 46% contributing by the mid-1990s; then, there was a standstill until 2003, broken thereafter in parallel to the recovery of economic activity and a legal reform enforcing some formalization of the labor market,23 with the share climbing to 54% in 2008. The other outstanding trend is the increase in the participation of women in the labor force, as documented below. Social policies, together with more efficient macroeconomic management – which in the early 1990s laid the foundations for faster growth and large-scale job creation – enabled a drastic reduction of poverty and indigence, and some modest improvements in the still unequal income distribution. At the beginning of this chapter, I noted the dissatisfaction that was felt regarding the macrosocial imbalances prevailing around 1970. Although income distribution has improved during these two decades, inequality continues to be a quite negative feature of the Chilean economy. More consistent, vigorous, and effective efforts need to be made.

2 The role of neoliberal reforms The economic reforms applied in Chile in the 1970s and 1980s have had a significant incidence in the social field. There were large, direct, negative effects on various social indicators owing to the enforcement of a model that focused on the neutrality of policies. The failure to take account of the structural heterogeneity of agents, combined with significant market failures and segmentation, translated into costly adjustment processes and severe recessions, generating a background of low productive investment 23 President Lagos enacted legislation demanding large firms to take responsibility for the fulfilment of labor contracts and payment of social security by their sub-contractors (Ley de Sub-contratación).

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and high unemployment (see Chapter I). Thus, indirectly these policies had a negative impact on an unprotected population, and underlie the sharp worsening taking place between 1973 and 1989. Naturally, the regressive effects were compounded by the debt crisis. But, as shown in Chapter III, the severe social and economic effects of the crisis were not totally independent of the model adopted by the dictatorship. As far as the reforms are concerned, one of the greatest changes was in the fiscal sphere. Reforms to the tax system, in 1975, included the abolition of wealth and capital gains taxes and a substantial reduction in the burden on profits. On the other hand, the adoption of a value added tax was completed and existing exemptions for basic consumer goods were abolished.24 The official objective of these changes was to reduce the tax burden and concentrate it on taxes that were “neutral and efficient.” In 1984 a second sizable tax reform took place (see Marfán, 1998). The income tax was drastically changed. A 40% additional tax on profits was removed, while a 10% general tax on profits was retained; additionally, the latter tax paid by the firm became a credit to the personal progressive income tax of shareholders. The marginal rates of the income tax were sharply reduced and the income brackets were enlarged. Shortly after, extremely generous tax privileges were created for purchases of stock of firms being privatized. The progressiveness of the tax system was notably weakened (or regressiveness increased). Finally, before the plebiscite of 1988 VAT was reduced from 20 to 16%, taxes on several luxury goods were diminished or suppressed, and in 1989 the 10% tax on profits was eliminated for reinvested profits. Thus, in practice, taxation on profits was gone, since distributed profits benefited from the full tax credit already mentioned. The tax burden fell to 16.5% of GDP in 1989. An evidently transitory high price of copper, collected by CODELCO (the copper-producing public firm), filled the vacuum left by reduced tax revenue. The regressive tax reforms were accompanied by a progressive effort to fight tax evasion: equal tax collected for equal income is an evidently equitable principle. Public spending, as a percentage of GDP, was reduced by more than a quarter, in comparison with the late 1960s, after having spiraled out of control in 1972–3. There was a dramatic fall in public investment, which declined by more than one-half between 1970 and 1979 as a share of GDP. Support for private productive activities, in the form of subsidies and infrastructure, also fell. Per capita social spending in 1981 was lower than it had been in 1970, exhibiting a further drop with the debt crisis. By 24 There is no doubt that the replacement of progressive taxes with the VAT was regressive in itself, and it was accompanied by regressive exemptions from this tax (such as to the building industry) and by drops in social spending. This should not lead to overlook the efficiency and high yield of VAT or the fact that a rate rise directed to increasing focused social spending is clearly progressive.

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1990, the democratic regime had inherited a level 18% below that of 1970 (see Table VII.1). The privatization of many of the means of production owned by the state took place from the mid-1970s. The process was conducted against the background of a domestic recession and extremely high domestic interest rates. For this reason, only a few private groups were able to buy the privatized enterprises, mainly those groups that had greater access to external credit; hence, further strengthening the concentration of wealth and power (see Dahse, 1979; Devlin and Cominetti, 1994; Monckeberg, 2001). Interestingly, in spite of a quite liberal treatment of FDI, it was rather absent in Chile during the 1970s. Chapter III analyzed the way in which the reforms in the financial market, far from enhancing productive investment, were characterized by extremely high real interest rates and a great deal of financial activity, but contributed none or little to the generation of new productive capacity and were associated with crowded-out national savings. Increasing financial inflows led the economy through a path of unsustainable current expenditure, which ended in the deep crisis of 1982. Then, the state had to intervene in the financial system to avoid a deeper collapse; the high cost of subsidies to the financial system and to borrowers contributed to a markedly regressive redistribution of wealth, involving reductions in social spending and public sector investment in the 1980s and the long-lasting recession in the years following the crisis (see section 3d). Recall that only during 1988 was the 1981 level of GDP per capita restored. Labor legislation also underwent major changes that had a negative impact on workers: the level and coverage of the minimum wage were reduced, the dismissal of workers was made easier, and labor tribunals were abolished (being restored in 1986). The unions were suspended in September 1973; later, in 1979, they were authorized but with limited powers that excluded collective negotiation inter-firm, restricted the rights of union leaders, and fomented the segmentation of labor unions (Cortázar, 1983; Mizala and Romaguera, 2001). In combination with political repression and economic depression, the legislation was effective in reducing the power of social organizations and their ability to defend their rights (Tokman, 2004). In the early 1980s, deep reforms in the architecture of social security were introduced, affecting the health and pension systems. They had a major impact on the fiscal budget, and distributive effects at the time the reforms were implemented. The structural changes to health care culminated in the creation of a dual system, with a public component acting through a National Common Fund (the Fondo Nacional de Salud, FONASA) and a private component consisting of health insurance companies (ISAPRES). By then, to a large extent, health care was being financed by a payroll tax. The reform initially meant that 11% of the beneficiaries moved to the new ISAPRES system with 48%

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of the revenue from health contributions (Titelman, 2001). Regardless of the quality of the reform, this effect evidently constituted a regressive form of “targeting,” and it contributed to deepen the crisis in the public health system. Most people in the four poorest quintiles are covered by the public health system, and only in the richest quintile do ISAPREs cover a higher proportion of people than FONASA.25 In 2007, only 17% of the population was covered by health insurance with ISAPREs. Private pension fund management companies (the Administradoras de Fondos Previsionales, AFPs) began to operate in 1981, in what marked the transition from a pay-as-you-go system (which remained alive for a reduced and decreasing number of people) to an individual capitalization one. There are varied consequences for distribution. On the one hand, the higher pensions became conditional on a larger present value of contributions, which involved clearly progressive effects. On the other hand, there are three negative features we emphasize here. First, the reform led to a decline in public revenue as revenue was transferred to the AFPs from 1981. As the public sector was left with the responsibility for financing existing pensions and the pensions of those due to retire in the coming years, the public social security deficit rose from 2% of GDP in 1980 to 7% in 1983–6 (Uthoff, 2001). In a time of recession, this increased the strain on the fiscal accounts and was one more factor behind the spectacular cuts in social spending, particularly on education and health, between 1980 (before the social security reform was implemented) and 1987. Second, the reform did not succeed in including lower income informal or self-employed workers. Whereas 60% of workers were contributing to the social security system in 1974 (some 79% were affiliated), in 1988 just 55% of the working people were contributing to the private and public systems; in between, the rate had fallen, spectacularly, to a point as low as 40% in 1982 (Arellano, 1989). In turn, only 41% of the total labor force (including employed and jobless) were contributing in the private system in 1989. Third, another significant distributive implication is the enormous concentration of diverse expressions of power (see Molina, 2006). In this respect, we have to mention the concentration of power in the hands of AFP owners, who use the funds of workers to buy shares and thus acquire a strong say in appointing directors in the boards of corporations, with no voice for the actual owners of the funds. Finally, the trade reforms introduced since the mid-1970s have proved to be a key factor in explaining factorial income behavior. On the one hand, 25 Another important point, with regard to distribution, is the risk of discrimination in the private system in the way in which the insurance premium is linked to the health risk of the person concerned. It discriminates greatly against the elderly, children, women of fertile age, and in general those who are most in need of health services. It is noteworthy, for example, that for those aged sixty-five or over, even in the richest quintile most people, some 56%, are treated by the public sector (Titelman, 2001).

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they had a great impact on the production structure of the country (see Chapter II), which led to a significant relative decline (and often an absolute one) in employment in some sectors (this was particularly steep in manufacturing), accompanied by a positive but weaker dynamism in expanding sectors (Valdés, 1992); with it, a clear negative net effect on employment, productive investment, and activity level was recorded during the deep adjustment to import liberalization. This net negative balance was strengthened by the exchange rate appreciation of 1979–82 and by the pro-cyclical bias of macroeconomic policies. Since the economy was opened up, there has been a marked increase in the premium to higher education, with worsening wage income distribution. The forces behind this change in relative prices are rooted in the relative decline in the demand for unskilled labor accelerated by abrupt import liberalization and low productive investment, acting in tandem with greater human capital requirements in the economy following the reforms. But this tendency towards a growing wage gap would appear to be, partly, the result of an exogenous increase in demand for qualified workers (this trend is associated with the direction of global technological change and is transmitted via growing trade links with the rest of the world, where wage inequality is also on the rise), vis-à-vis a rather inflexible composition of the supply of human capital. At the same time, the productive structure in the 1980s was dominated by a natural resource intensive export sector using little unskilled labor, while the rest of the economy was mostly depressed, accentuating the inequality of income distribution.26 In 1990–8, the vigorous export expansion was accompanied by a 6.5% annual rate of growth of the rest of the economy, thus pulling up the demand for labor, which contrasts with a negligible 1.7% in 1982–9 (see Chapter VI). The concentration of human capital investment opportunities was quite intense: (i) only a minority of the labor force, rising but slowly, attained more than twelve years of schooling (which was then the threshold denoting a break in the yield curve to school years); (ii) there were significant gaps in the quality of education between that for students from the richest quintile and that for the rest; (iii) labor training efforts were extremely weak and biased towards trained people;27 and (iv) the system of higher and professional education became even more regressive when public funding for the universities was cut back in the 1980s and public institutions yielded in 26 Like other countries in Latin America, Chile has comparative advantages in the production of natural–resource–intensive goods. The use of capital-intensive processes to produce them entails a worsening of wage and income distribution, in contrast to what would happen in other developing countries that specialize in the production of labor-intensive goods, such as the Asian ones (Fischer, 1999). 27 Labor training can contribute significantly to flexibilize the supply of labor. There has been some mild progress in this field since the 1990s. The percentage of the labor force trained under the tax-exempt National Training and Employment Service (SENCE)

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importance to private ones. All these contributed to perpetuate historical inequities across generations.28

3 Reforms to fight poverty and income concentration The debate over which variables best determine poverty, distribution patterns and development was reactivated in recent years (see MIDEPLAN, 2002a; FSP, 2005). The analysis of the preceding sections demonstrates that there have been remarkable changes in income distribution and poverty. We have stressed the significant role of socioeconomic reforms – corrections and stepbacks – over the past third of a century. Here I mention four strong variables determining poverty and income distribution in which there have been progress in recent years, progress that needs further enhancement. Then, challenges in two development policy areas that are crucial for growth with equity are discussed. (a) Factors underlying income distribution Evidently, different factors are interrelated, and in turn, they are a result of socioeconomic structures and of public policies. Two of these variables are of structural character and can be improved only gradually. The three following ones – unemployment, social expenditure and macroeconomic environment – affect both the structure and the conjuncture and can experience sharp changes in the short run. First, income levels have a highly positive relationship with years of schooling. In particular, there is a notable wage gap between people who completed university and those who only completed secondary school. A worker with a complete university education earns, on average, more than three times per hour what another with full secondary education earns (Mizala and Romaguera, 2004). Additionally, the returns to tertiary education have been increasing over time. Though the coverage of tertiary education grew from 16 to 37% (2.3 times) between 1990 and 2003, the differences by quintiles continued to be notable; for the first quintile it increased from 4.4 to 14.5%, whereas for the fifth quintile it rose from 40.2 to 73.7%. In general, scheme increased from 4% in 1990 to nearly 8% in 1998. Nonetheless, only 20% of companies made full use of this benefit and the distribution of their spending was highly regressive (Benavente and Crespi, 1998). The problem remains, as stated by the Consejo Asesor Presidencial de Trabajo y Equidad (2008). In fact, 1% of firms captured 42% of the resources, with 80% of the public subsidy being received by large firms; additionally, nearly four as many workers in the highest quintile as in the poorest received some training (10.8 and 2.9%, respectively) according to CASEN 2006. The public program requires a sharp reshuffle, with a significant increase in the funds allotted. 28 Núñez and Gutiérrez (2004) develop deep research on the persistence in the correlation between the economic level of parents and the probable income level of their children.

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as a result of the broader coverage in all educational levels, the average years of schooling of the population aged eighteen years or more increased from 9 to 10.2 years between 1990 and 2006 (CASEN 1990, 2006).29 This relationship is subject to two qualifications, which have deep implications for public policy. On the one hand, high-quality education and the matching of supply of and demand for skills are essential. This is illustrated by the fact that, although the average worker had 3.5 years more schooling in 1992 than in 1970 (Hofman, 1999), the average wage was similar, having been depressed in the intermediate years. On the other hand, schooling is measured on the basis of the number of years of traditional education, without taking into account the training accrued during people’s working lives. Training is essential as a way of enhancing the productivity of workers with few years of education or schooling whose quality does not match the current demand for labor. Labor training makes it possible to partly compensate the international trend towards higher wage inequality, principally associated with the bias of technological change and educational differences (Beyer, 1997; Bravo and Contreras, 1999; Larrañaga, 2006). Second, increasing participation of women in the labor force is a key factor for reducing the number of households in poverty. According to the Census of 1992, 28% of total workers were women; this percentage rose to 38% in the 2002 Census, and to 43% in the 2006 CASEN. That is significant progress, but still quite short of the 73% employment rate for men. The gender inequality is particularly acute among poorer women. According to CASEN 2003, only 25% of women in the poorest quintile were in the labor force, a percentage that doubles for the richest quintile (52%), with an almost linear progression in the intermediate brackets. CASEN 2006 reports that among women head of households, 49% of those in the lower quintile were in the labor force, rising to 73% in the richest quintile. What has happened is that progress in the participation of women has been located in the higher income brackets.30 In fact, in households with a head and couple, in the lowest quintile, 12% were both employed in 2006 as compared with 5% in 1990, while in the highest quintile the figures were 61% and 43%, respectively; that is, an improvement of 18 points in the richer people versus 7 points in the poorer. Improving opportunities and facilities (such as day nurseries and pre-school for children, and part-time jobs) for working women with lower incomes, as well as the elimination of the wage gaps between men and women with similar qualifications, are key factors for increasing gender and overall equity. 29 According to the CASEN surveys, the coverage of primary education increased from 96.8 to 99.1% between 1990 and 2003, whereas that of secondary education rose from 80.3 to 92.8%. 30 Paradoxically, labor income distribution can be worsened by the increase in women’s participation, if the increase is focused on women who are from high income brackets, more educated, and with a lower fecundity rate (see Larrañaga, 2001).

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Third, unemployment is another very influential factor. In the CASEN surveys from 1987 to 2006, the unemployment rate averaged nine times as high in the first quintile as in the fifth, and its sensitivity to the economic cycle, and even to slight fluctuations such as those of the late 1990s, is very intense. In the first quintile, unemployment fell from 24% in 1987 to 15% in 1992, as a consequence of improving macroeconomic balances and economic growth. With the arrival of the Asian crisis it worsened from 16% in 1996 to 26% in 2000, evolving again to 16% in 2006. Unemployment is also substantially higher among young people and those with less schooling. CASEN 2006 shows that in the lower quintile, with deficient or limited education, close to 30% of youngsters (15 to 24 years of age) were not working, studying, or searching for a job; the percentage of women was twice that of men (see Jélvez and Alvarado, 2009). Consequently, policies intended to strengthen the demand for labor, to reduce the gender gaps, and to make the supply more flexible and better able to adapt to technological changes – with sustainable macroeconomic stability, vigorous physical capital formation, and increasing investment in people – play a very significant role in improving the distribution of opportunities. A palliative to the unemployment effects is the increasing coverage of a new insurance for private workers. Previously, there was only an unemployment subsidy of a negligible amount, and a severance payment of one month per year of work (with an eleven-year limit) with the same employer and under some conditions of dismissal. It was mostly applicable to organized workers with stable jobs. The new insurance scheme was implemented in October 2002, being operated by a society of all the AFPs. In very abridged terms, it includes two separate funds. One is financed by workers’ and employers’ contributions, which are credited to the individual account of the worker; the contribution of the employer (1.6% of the wage, in the case of contracts without time limit) is credited against the severance liability of the employer. The other is a solidarity fund, which is financed by the government (with a given annual lump sum) and contributions by the employer (0.8% of the assessable wage). All wage earners who sign a new contract (with some exceptions, such as public officials) are part of the new system, and also those who apply voluntarily for the insurance (very few, actually). In September 2009, after seven years in force, it had 6.2 million registered members (afiliados, workers who at some point in time have passed through the new system), and among them there were 3.2 million active contributors (about 85% of AFP active contributors); this implies that fewer than one in five waged workers had not left or lost their job in the seven-year period. The mechanism started to operate in a relatively high unemployment period, mostly as self-insurance. In an economy averaging about 600,000 unemployed workers in the over seven years in which the insurance has been in force, a large number of workers have made use of the scheme; 4.8 million benefit payments have

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been delivered. The huge number of operations reflected the precariousness or actual flexibility of the labor market. But the benefit received, covering an average of 2.5 months per request, has been quite small and has been almost completely self-financed by their own contributions while they were employed. In turn, up to 2008, only 3% of the benefits paid included a complement from the solidarity fund. In all, notwithstanding that the insurance was created in a recessive period, the two funds had accumulated a stock of US$2.1 billion. Actually, the scheme had behaved pro-cyclically, given that it accumulated funds during recessive years. This unemployment insurance, overall a relevant progress, needed strengthening or deep corrections in: (i) the magnitude of benefits; (ii) the access to benefits; (iii) the extent of the solidarity fund; (iv) its macroeconomic impact; and (v) the connection with effective training programs, with the solidarity benefit conditional to participating effectively in the training. In 2009 the parliament approved a government project that enhances the extent of and access to the solidarity fund, giving access to workers with short-term contracts, introduces counter-cyclical features in the benefits, and seeks to improve job search intermediation for the unemployed and to provide access to labor training for them. Fourth, social expenditure has had a progressive incidence, representing a rising share of the access of the poor to goods and services since the 1990s. A small share was made up of monetary transfers, while the great majority corresponds to free or subsidized goods and services delivered to the poorest. However, recently, there have been sizable programs in progress that imply significant flows of monetary transfers. In fact, besides the improvements made to the unemployment insurance, there has been a deep reform of the pensions system since 2008. It changes the balance of the 1981 reform, from principally a private self-insurance system to one with an ambitious solidarity pillar. The reform launched a progressive process, starting with members of households in the two poorer quintiles and rising gradually up to three quintiles of households in 2011. It establishes a higher basic pension for people over 64 years old since 2008; it will provide a complementary subsidy, that decreases gradually up to a pension more or less equivalent to 1.5 times the minimum wage (255,000 pesos in 2011); it starts a subsidy equivalent to the social security contributions for two years to workers up to 35 years old, in formal jobs; it offers a subsidy for mothers when retiring for each child they have had (including adopted children). Additionally, the reform allows the creation, in parallel with the private AFPs, of a public AFP, a proposal that was strongly disputed by the opposition; the government had not made use yet of the “policy space” gained. The reform improves significantly the welfare of senior people, with a high financial cost to the government. The reform was designed and enacted when the fiscal budget was in a huge surplus in 2006–7, led by the high price of copper.

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A very relevant program to fight extreme poverty is Chile Solidario. This program seeks to improve the life conditions of the poorest 225,000 families through three specific objectives: (i) to make effective the access of indigent families to social benefits and services available, which, because of their marginalization, they were not benefiting from; (ii) to give psychosocial support, promoting the development of productive potentialities; and (iii) to generate minimum conditions for the most vulnerable members of the families to improve their employment position (this last has been less successful).31 (b) Structural factors The regressive trends of the 1980s were not exclusive to Chile. In general, income distribution worsened, real wages fell, and the level and quality of employment declined throughout Latin America. Something similar happened in the United States and Great Britain in that decade, with the ratio between the richest and poorest quintiles rising. In the United States, the household income of the poor fell, while that of the richest 10% improved substantially in the 1980s (Krugman, 1990). Poverty and income distribution are determined essentially in the production process itself.32 Consequently, it is of great relevance to ensure that productive transformation is associated with equity, which requires a consistent move from “neutral” policies (that actually use to favor the upper segments) towards strongly biased policies that improve the productivity and workability of middle- and low-income sectors of society. It is clear that the choice is not between growth and equity. It is not simply a matter of choosing growth, since to achieve this, and make it sustainable, is no easy matter: Chile has succeeded only in exceptional periods, one of which was 1990–8. Consequently, the key thing is to identify the determinants of growth, which encompass, at the present stage of Chilean development, crucial complementarities between the sources of growth and equity, and between macroeconomic and macrosocial balances. The generation of productive employment is the main channel through which economic and social progress is transmitted. This depends, obviously, on supply and demand, and both are affected by public policies. To create a vigorous demand for labor, productive investment must be notably higher than it was during the neoliberal regime. Larger capital formation makes it possible to achieve higher growth with greater job creation and better wages. The fact that average wages were still lower in 1989 than in 1970 is closely associated with the low investment ratio recorded in the 1970s and 1980s. Similarly, the rising investment ratio between 1992 and 1998 helps 31

See Galasso (2006) for a preliminary evaluation of the program. Bourguignon and Walton (2007) demonstrate why and how poverty is detrimental for development. 32

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to explain the sustained although still insufficient improvement in wages that occurred in those years. Enhanced capital formation does not take place in a vacuum. It works together with technological innovation. Much of it is embodied in machinery and equipment and in the capabilities of labor. This means that much higher productive, physical and human, investment will be needed in order to incorporate technological development and thus improve national total factor productivity. A high rate of technical progress requires a rising stock of capital and flexible and increasingly highly qualified labor if excessive “technological unemployment” is to be avoided. In particular, in order to countervail the expanding gap between low and high wages, an increase in physical investment and investment in people associated with SMEs is essential. Crucial aspects are improving the skills of labor and providing better training for workers and small entrepreneurs during the course of their active lives, whence the importance of reforming education, strengthening labor training, and encouraging the development of SMEs. They all contribute to increase average productivity and to reduce the inequality gaps. There are two ways of looking at productivity. One does not control for economic cycles or changes in the rate of utilization of capacity, issues related to the quality of macroeconomic balances, to which we return later. When in the course of an economic cycle output falls sharply, say by 14%, as happened in Chile in 1982, what is really falling is the actual rate of resource utilization, not the structural capacity of factors (TFP) or potential GDP. That reduced actual productivity is restored once the recessionary stage of the cycle has given way to the expansionary one, even when structural or potential productivity (the second concept) remains unchanged. Actual productivity is quite variable in economies with pro-cyclical macroeconomics; those changes do not reflect structural changes in productivity. The structural or potential productivity is concerned with efforts to innovate, with new combinations of productive resources and improvements in their quality. This second type of productivity is one of the determinants of long-term growth. Frequently, research mixes up these two components,33 which obscures the interpretation of what has happened with the TFP in Chile. In all, nonetheless, it appears to be evident that, after a jump in the 1990s, it has slowed its speed and its contribution to reducing equity gaps. Naturally, physical investment and innovation are not enough. There is also a need to increase and enhance the supply of human capital, given the dynamics of innovation and technological progress. Investment in people, one of the two components of social spending, is a factor of production. 33 See essays by several authors in Morandé and Vergara (1997) and Loayza et al. (2005).

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An even more important feature, though, is that investment in people – particularly education, labor training, and healthcare from the first seconds of life – prepares them to participate more effectively in the market and is instrumental in bringing to a halt the perpetuation of poverty, whereby the children of the poor are condemned to be poor themselves (see Núñez and Gutiérrez, 2004). Better nutrition and education of higher quality are key inputs for a more flexible labor supply, which contributes to an effective adjustment to the demand requirements, within a globalized environment. The other component is continuous redistributive spending, aimed at compensating those who lose from modernization, those who cannot earn a better living in the market, or those who have ended their working lives and have insufficient pensions or none at all. The rights-based social policy approach of the Bachelet government, that is a culmination of the progressive social policies of the four presidential regimes of the Concertación Democratica, has made significant progress in facing this human rights challenge. (c) Macroeconomic stability, investment, and income distribution The macroeconomic environment affects poverty and income distribution in the short term through its impact on the labor market, as stressed throughout this book. It also affects structural evolution through the effects on: (i) physical and human capital formation, vis-à-vis mergers and acquisitions and purely financial investment; (ii) the SMEs’ situation; (iii) the value-added in non-traditional exports; and (iv) the authorities’ capacity to focus on the future, on the long term, instead of on short-term critical emergencies. Comprehensive stability – what we call real macroeconomics – is essential to equity and economic growth. If we look at what happened to wages and employment during recessive periods in the one-third of a century, two asymmetries emerge: (i) the fall in labor income was disproportionately high and informal working increased during the bust, which tends to be abrupt; and (ii) the recovery is usually slow. With both asymmetries, given the instability of economic activity, the level of employment and formality in the labor markets deteriorate more intensively than GDP. Given the regressive effect that adjustment processes normally have on low-income sectors and wage earners, it is clear that efforts need to be made to remove the factors that cause instability and uncertainty (Rodrik, 2001a). The definition of stability is crucial. CPI stability is essential, but it is only one ingredient of comprehensive stability, of which the stability of the real economy is the most significant. That implies using productive capacity (potential GDP) with right macroeconomic prices. This conclusion is even more compelling when we observe that real instability also discourages productive investment. When firms are producing below capacity and capital is underutilized, it is obvious that there are fewer market incentives to invest in the creation of new productive capacity. Empirical evidence shows that

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one of the most common tendencies during recessive adjustment is a sharp drop in private investment.34 Public investment is generally cut as well, and this discourages private investment still further. Economies with large fluctuations tend to discourage not only productive investment but also technological innovation, as instability leads both to large losses and great opportunities for easy profit. In such periods, the profits of some are frequently made at the expense of others (in a zero or negative sum game). What happens, therefore, is that cyclical instability processes tend to result in underscoring medium- and long-term structural productivity, and to generate an environment that is prone to speculative investment (which creates neither new productive employment nor economic growth) rather than to technological innovation and productive investment. Environments of great real instability, like those recorded in Chile during the 1970s and 1980s, tend to be accompanied by other phenomena whose effects on society as a whole are regressive. In fact, in these situations, losses tend to emerge in productive or financial sectors, with an inclination to sustain them by public sector subsidies. One case at hand is that of the Chilean banking system after the 1983 crisis, as discussed earlier, with a total final cost equivalent to 35% of a year’s GDP (Sanhueza, 1999). Thus, over the course of a few years, the equivalent of one-third of national output (or public expenditure on education during a full decade) was transferred from some sectors to others in order to cope with this banking crisis. Most of the large transfers of wealth that took place in the 1970s and 1980s were only possible in the framework of great real instability, reinforced by the regressive and ideology-driven approach of the dictatorship. It has been shown throughout this book that financial volatility has been at the heart of real macro-instability. Most of the spectacular increase in international capital flows up to the explosion of the present global crisis were not tied to productive investment, but were of a speculative financial nature. These movements are guided by short-term expectations about differentials in interest rates, exchange rates, and stock market prices among countries, which have brought about a dizzying increase in the speed at which speculative capital can move from one country to another. This has led to great instability in macroprices and economic activity. There are too many agents devoted to the capture of capital gains rather than generating productivity gains. This neo rent-seeking financierism appears to be one of 34 See Solimano (1990), Agosin (1998), and Ffrench-Davis (2006). Another consequence has been underinvestment by domestic SMEs. Correcting this imbalance has been slowed by downward adjustment processes, as increases in interest rates above “normal” levels and domestic demand restriction affect such firms more severely than large ones, which are more diversified and can obtain financing through diverse channels.

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the reasons for the weakness of productive investment and the inequality in Latin America (see Ffrench-Davis, 2006, Chapter VI).

4

Concluding remarks

Equity is an outstanding feature of developed nations, which are remarkably more equitable than developing countries like Chile. Nevertheless, the more successful emerging economies have improved their income distributions, conscious that poverty and inequality are negative for development. There is a need for a close interrelation of progressive productive and social agendas. Undoubtedly, the net balance since the 1970s shows a highly skewed income distribution in Chile. Nevertheless, it is a mistake to state that it has been always as inequitable as today. There have been large changes over time. In the sixties it was not satisfactory, but it worsened notably in the 1970s and 1980s. A significant improvement was recorded in the first half of the nineties, owing to better economic and social policies in democracy than in dictatorship. However, subsequently, a long-lasting recessive adjustment took place across the economy from 1998, and despite government efforts to increase social spending the least affluent sectors suffered most. The result in 1999–2003 was an increase in unemployment, a slowing in the reduction of poverty, and some worsening of income distribution. Then, the recovery of economic activity, in 2004–7, and a noticeable increase in progressive social reforms, partly countervailing the global crisis, brought an improved distribution in 2004–9, but merely to the same level achieved in the first years of return to democracy in the 1990s. In all, inequality continues to be a demanding challenge for the Chilean democracy. Three key variables that are behind these different outcomes are: (i) the size and allocation of social expenditure, today restricted by a low 18% tax burden;35 (ii) the macroeconomic environment in which investors, producers, and workers operate, i.e. the real sector of the economy; and (iii) how account is taken of the enormous structural heterogeneity prevailing in domestic markets and of the disadvantageous environment in which SMEs operate. The environment and the signals received by the set of producers have played a decisive role in the phases of increased inequality in this onethird of a century. The deep and loud message for economic policy is that macroeconomic responsibility is related not only to low inflation and fiscal discipline, but also to the recessive or expansive environment of the domestic economy, and to key macroprices such as the exchange and interest rates, which asymmetrically affect small and medium firms versus large 35 In recent years the restriction imposed by the low tax burden has been sharply relaxed by the jump in the price of copper benefiting fiscal revenue.

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corporations, traditional versus non-traditional exporters, workers with low qualifications versus highly qualified workers. Indeed, the macroeconomic environment makes a remarkable difference for both growth and equity. An alternative approach to the neoliberal fashion is what we have called real macroeconomics or macroeconomics for development versus the merely financieristic macroeconomics (excessively focused on inflation control and capital account opening). Equity and growth capacity also depend upon specific sectoral policies: how trade, financial, and tax reforms are designed and executed. These three reforms – implemented with a neoliberal approach – left regressive tracks, which help us to understand why they were associated with low productive investment ratios and worsened income distribution. The structural reforms were carried out with a very regressive bias, in contrast with, for example, those in Korea or Taiwan, where trade and financial reforms were successfully executed pragmatically, with greater harmony between growth and social equity. The challenge is to grow while distributing equity; that is, distributing the capacity to operate efficiently in the markets, particularly for small and medium firms and for workers with lower qualifications. It is in these sectors that the large income and productivity gaps are located. There, also, lies the source of the huge GDP per capita gap between Chile and richer economies. It is in these sectors of the Chilean economy that there is broad room for efficiency gains. Then, growth-with-equity would become attainable. Securing structural improvements in the distribution of opportunities and income is a long-term task. It has been addressed willingly since the return to democracy, but with inconsistencies. Although considerable progress has been made in reducing poverty and indigence, and there has been some improvement in income distribution, there still is pending a major challenge for the nation. Among other macro- and mesoeconomic corrections required, the approach that needs to be taken includes:36 1 Improving active counter-cyclical macroeconomic management to make the economy less vulnerable to external shocks, the effects of which are regressive; this includes rebuilding an active exchange rate policy in order to provide greater predictability for non-traditional exports and importcompeting output. 2 Strengthening the fight against tax evasion and legal avoidance (regressive loopholes), which are detrimental to fiscal equity. 3 Implementing a systematic educational reform, improving and standardizing educational quality, and upgrading programs and teaching staff. 4 A sharp increase in the quantity and quality of labor training, in order to enhance the flexibility of the labor supply. 36

A more comprehensive and detailed list is developed in Chapter X.

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5 Fostering the productive development of SMEs with significantly greater access to long-term domestic financing, modern technology, entrepreneurial and labor training, and more stable domestic markets; and enhancing their ability to conquer foreign markets or to become suppliers of large domestic exporters.

VIII Managing Capital Inflows in the 1990s and the “Encaje”*

In the nineties, private capital inflows returned to Latin America (see Calvo et al., 1993; Ffrench-Davis and Griffith-Jones, 1995). Undoubtedly, the resumption of capital flows, which had been interrupted in the eighties with dramatic recessive effects on economic activity, had positive short-run effects. In fact, it implied relaxing the shortage of foreign currency (binding external constraint, BEC) under which most countries had operated during the debt crisis. However, both the large magnitude of the new capital inflows and their composition (prone to volatility) caused a growing macroeconomic disequilibria in the recipient countries. Chile was one of the first Latin American countries to attract the renewed flows of foreign capital and one that faced the largest supply in relation to its economic size. One main feature in Latin America was that the huge capital inflows were directed to consumption and to the acquisition of already existing assets; Argentina and Mexico were outstanding examples in 1991–4 of a crowding-out of their national savings. It will be argued that, in the nineties, one reason for the greater degree of Chilean success in channeling foreign capital to investment was the explicit policy set that included, as an outstanding component, counter-cyclical regulations discouraging an “excess” of short-term inflows; associated with this, a high participation of greenfield foreign direct investment (FDI) in total capital inflows was recorded. The Chilean experience does indeed suggest that, when capital inflows take the form of FDI, there is a greater likelihood that flows will be more permanent and complement national savings instead of crowding-out them, in contrast with the case in which foreign capital is in the form of liquid or short-term flows or acquisitions of existing capacity. Policies during most of the 1990s represented a significant move towards a pragmatic, counter-cyclical, pro-development approach to capital flows. * This chapter is partially based on Agosin and Ffrench-Davis (2001). I appreciate the authorization of Manuel Agosin, Oxford University Press and UN/WIDER to make use of that material. 209

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Managing Capital Inflows

In a nutshell, the policy response during the 1990s surges in the supply of foreign capital can be described as a successful attempt to discourage shortterm inflows while maintaining openness to long-term flows. Particularly, policies were directed towards increasing the cost of short-term inflows via non-interest-bearing reserve requirements (el encaje); this is a price-based regulatory policy tool intended to modify relative market costs or profits. Its level and coverage were modified in a counter-cyclical way. The authorities also resorted to intra-marginal intervention in order to slow down RER appreciation (in the face of inflows that surpassed the barrier of the reserve requirement) and sterilize the monetary effects of reserve accumulation. In parallel, there was a fiscal budget surplus and prudential regulation and supervision of the financial sector was enhanced. This set of policies sought to protect a development strategy whose main elements were (i) the growth and diversification of exports, and (ii) a stimulating and sustainable macroeconomic environment for productive activities and employment. Policies were effective in achieving their targets during most of the 1990s. During this period, productive capacity expanded briskly and economic activity was close to its output capacity up to 1998. This ensured a persistently rising investment ratio and increased employment and wages, in a virtuous circle. Crucial variables were macroeconomic prices, such as interest and exchange rates, which stayed well aligned. For example, the latter had a very moderate appreciation in Chile in comparison with the rest of Latin America. As a consequence, the current account deficit averaged only 2.3% of GDP in 1990–5; in that period, exports grew vigorously and diversified strongly (see Chapter VI). In those years the regressive trend in income distribution of the seventies and eighties stopped, and social equity exhibited an improvement (see Chapter VII). However, in 1996–7 this policy mix and the strength with which it was applied remained rather unchanged, in spite of a new vigorous surge in capital flows to most countries in the region; even more, the systematic monitoring made up to 1995 in order to avoid leakages lost force. As a consequence of the lack of stronger comprehensive counter-cyclical action on the capital surge – such as a higher reserve requirement or other similarly restrictive policy tools – and despite heavy intervention in foreign exchange markets, the central bank allowed a sharp real exchange rate appreciation and a worrisome rise of the deficit on current account during this biennium. In parallel, broad exit channels of national capital were being opened (principally for the privatized social security funds), without significant outflows as long as there prevailed optimistic expectations and exchange rate appreciation was expected. In this way, for both capital inflows and outflows a pro-cyclical macroeconomic vulnerability was being created, which exploded in 1998–9. Nonetheless, as discussed below, the benefits of the active regulation implemented in previous years had left large net international reserves, a rather low stock of foreign liabilities, and a small share of volatile inflows,

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which allowed a recessive adjustment in 1999 that was remarkably less traumatic than those in 1975 and 1982. This chapter studies the phenomenon of massive capital inflows in Chile in the 1990s, the policy approaches utilized to deal with it, and their effects on the domestic economy. Section 1 describes the size and composition of capital inflows. Section 2 discusses the policy approaches taken to deal with capital surges. Section 3 analyzes macroeconomic impacts and the effectiveness of counter-cyclical policies implemented. Section 4 briefly presents the outcomes in investment, savings, and economic growth. Finally, section 5 concludes with a discussion of counter-cyclical policy lessons.

1 Capital inflows: magnitudes and composition The return to democratic rule in 1990 coincided with a new capital surge to emerging economies (EEs). By 1986 there had been an initial spurt of private capital towards Chile, which was associated almost exclusively with the debt–equity swap program started by the authorities in 1985. Owing to the large exchange rate subsidy implicit in the swap scheme, the program was successful in attracting significant amounts of foreign investment; it is well known that generally they did not involve an actual currency inflow to Chile, even though in a process of financial engineering they implied a reduction of the debt with foreign banks (Ffrench-Davis, 1990). The swap program was abandoned by foreign investors in 1991, mainly because the rise in the international price of bonds (pagarés) representing Chilean debt, at the same time that the new authorities reduced incentives, made it no longer profitable to invest via debt swaps. However, FDI not associated with swaps did gain strength. In fact, during the 1990s, greenfield FDI became a major share of net capital inflows (see Table VIII.1). Acquisitions, following a strong world trend, also rose in Chile, but up to 1998 remained the minority of FDI inflows; the composition would revert sharply in the recessive environment of 1999. The supply of short-term private inflows also figured prominently in the capital surge towards EEs. For interest-arbitraging capital inflows to take place, the domestic interest rate must exceed the international rate by a margin that is more than sufficient to compensate for the expected exchange rate depreciation and the country risk premium. These conditions prevailed in Chile from the late 1980s, supported by a combination of five circumstances. First, in 1992 and 1993 international dollar interest rates reached a thirty-year low. Second, notwithstanding the record high investment ratio of Chile in the 1990s, it still had a low stock of productive capital. Obviously, that shortage of physical capital tends to provide a higher trend rate of return. Therefore, the interest rate must tend to be higher than in a developed economy. Thus, monetary policy, in order to be consistent with sustainable macroeconomic balances, must hold real interest rates over the

212

Table VIII.1 Composition of capital flows, 1980–2008 (2008 US$ as % of GDP)

FDI net inflows

a

Greenfield FDI M&A FDI net outflowsb Official gross loansc

1980–81

1982–89

1990–95

1996–97

1998–99

2000–03

2004–07

2008

1.4

1.1

3.5

7.8

9.0

4.9

6.8

8.9

1.4

1.0

2.5

4.8

2.3

1.8

5.1

6.4

0.0

0.1

1.0

3.0

6.7

3.0

1.7

2.5

–0.2

0.0

–0.8

–1.7

–2.7

–2.3

–1.7

–4.7

0.4

2.1

0.9

0.2

0.1

–0.1

–0.1

0.0

Public amortizationsd

–5.0

–1.5

–1.5

–2.7

–0.6

–1.1

–1.3

–1.4

Private amortizationsd

–2.9

–1.7

–1.2

–2.4

–3.9

–7.3

–8.0

–6.7

0.2

0.0

0.7

1.8

–3.8

–1.2

–6.0

–5.2

Other capital

25.6

5.5

4.0

4.3

2.5

8.1

7.1

14.3

Net Capital Inflows

19.5

5.4

5.8

7.4

0.6

0.9

–3.3

5.2

Portfolioe f

Sources: Balanza de Pagos data from the Central Bank; Mergers and Acquisitions (M&A) from UNCTAD. Balance of payments figures in current US dollars were deflated by an index of external prices faced by the Chilean economy, obtained from Ffrench-Davis (1984) and Central Bank, scaled to 2008 100. The GDP series in 1996 constant prices was scaled-up to the 2008 price level, and transformed to 2008 US dollars using the average nominal exchange rate of that year. a FDI in Chile, net from repatriation of capital. Includes net loans associated with risk capital of FDI and excludes debt-equity swaps. bNet investment by Chilean firms abroad. cIncludes loans from foreign official and multilateral institutions. dAmortizations, including pre-payments. eNet balance of flows of investment funds, ADRs and bonds. fShort and mid-term credit lines of banks and others.

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international ones. Third, in addition to the “structural gap” in interest rates, in 1990 a downward adjustment in economic activity took place that relied on a significant rise in domestic interest rates. In January 1990, as discussed in Chapter IV, before the assumption of President Aylwin in March of that year, the central bank had carried out a sharp interest rate hike.1 Two other requirements for interest arbitrage were also favorable to capital inflows. Chile experienced a RER depreciation of 130% in 1982–8, in response to the sharp scarcity of foreign currency; together with improved terms of trade it appeared that Chile was leaving the debt crisis behind. Consequently, expectations regarding the RER turned from depreciation to appreciation. Additionally, there was a dramatic reduction in country risk expected in EEs by international rating agencies and investment funds. Consequently, in the early 1990s expectations of exchange rate appreciation, the capital inflow itself, and an improved current account position made short-term round-tripping in Chile appear very profitable. Short-term private flows were very sizable until 1992, when they began to decrease as a consequence of the new policy measures adopted in 1990 and 1991 to stem them and their intensification in 1992 (see section 2). Novel components of flows were portfolio inflows. They took two forms: investments through mutual funds set up in the major international capital markets and the issue of American Depositary Receipts (ADRs) by large Chilean corporations. The ADR is a mechanism by means of which foreign corporations can issue new shares on the US stock markets. The original or primary emission of ADRs is put under rigorous requirements; for example, the issuing company must satisfy established minimums on capital and exceed requirements on risk classification, and still more importantly, the ADR must correspond to an increase in the capital of the issuing firm. The “primary” issue of ADRs implies an expansion of the capital of large firms at relatively low cost, since capital in US markets naturally tends to be less expensive than in Chile. The relatively developed domestic stock market and the low country risk made Chilean stocks a prime candidate for investors seeking new and more exotic financial vehicles. There is also a “secondary” issue of ADRs through the purchase by nonresidents, in the Chilean market, of the rest of the stock of the Chilean firms that have issued ADRs in the USA. Subsequently, this purchase can be converted into ADRs, after which they become tradable in the US markets (see Ffrench-Davis et al., 1995). This “secondary” operation does not constitute an enlargement of the capital of the issuing company but only a change in ownership from nationals to foreigners. These shifts in ownership (without expanding risk capital) involve exposing the economy to an additional degree of volatility, since when foreign investors’ mood changes they can easily reverse the operation. These flows have played a destabilizing role. 1

In the first months of 1990, the real lending interest rate averaged 16% annually.

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Managing Capital Inflows

They inflated the stock exchanges in 1994 and 1997 and depressed them in 1995 and 1998, in a clear case of pro-cyclical behavior. At the same time that private flows were increasing, public debt was being reduced. This reduction corresponded to amortizations of liabilities contracted during the debt crisis (see Table VIII.1); these amortizations, including substantial prepayments, were undertaken to alleviate the large accumulation of international reserves by the central bank, to reduce net financial costs, and to relax appreciating pressures on foreign exchange markets and improve the balance of the bank. From 1991, several large Chilean corporations made direct investments abroad (see FDI outflows in Table VIII.1). The destinations were mainly neighboring countries. The largest investments, which increased through the 1990s, were principally directed to electricity generation and distribution (mostly in recently privatized companies, first in Argentina and then in other Latin American countries), and to other sectors such as light manufacturing and retailing (Calderón and Griffith-Jones, 1995). In 1996–7, after persistent expansion since 1991, the net flow of investment abroad represented 1.7% of GDP.2 In turn, the main institutional investors (private pension funds, AFPs), in spite of the increasing facilities provided by policy to invest abroad, in mid-1997 had only exported 0.5% of their total assets. As is documented in section 3, the measures to discourage speculative short-term inflows were effective in isolating the Chilean economy from the contagious effects of the tequila crisis. Thus, while the economies of Argentina and Mexico contracted dramatically in 1995, the GDP of Chile expanded vigorously (10.6%), with an increasing investment ratio (22.2% of GDP in 1995 versus 17.6% in 1990; for Argentina and Mexico the investment ratio in 1995 was 16.5 and 15%, respectively). Only the stock market experienced a drop of foreign portfolio investment. However, it did not have recessive macroeconomic effects, due to its small share in total inflows; particularly, the depreciation that took place was within the margins of the exchange rate band. Again, the contrast with Argentina and Mexico is remarkable: between September 1994 and March 1995, the stock price index of those countries deteriorated by 32 and 65%, respectively, whereas in Chile an almost negligible drop of 4% took place. The Mexican and East Asian crises are illustrative of these dangers of financial destabilization. In the case of Mexico, as emphasized by Sachs et al. (1996), domestic policy failures, particularly the large increase in credit that resulted from a poorly regulated financial system, were important factors. In both crises, domestic credit booms, however, were triggered by large 2 Balance of payments data underestimate the size of these investments because a large share of them is financed with funds raised on international capital markets that never enter the country. A similar situation emerged regarding Korean investments in its neighbors (see Mahani et al., 2006).

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capital inflows, in a similar process to the one that took place in Chile in the seventies. The herding behavior displayed by foreign portfolio investors has been recognized as a critical element in the Mexican crisis (Calvo and Mendoza, 1996); a similar pattern preceded the Asian crisis. Since assets of firms from a particular developing country are normally a very small proportion of international investors’ portfolios, it may not pay to go to the trouble of obtaining costly information. Therefore, they tend to follow “signals.” The pro-boom signal by the early 1990s was that Mexico was undertaking decidedly market-oriented reforms (and was entering NAFTA and then the OECD) that would, in the eyes of the international banks, raise returns on Mexican corporate assets. By late 1994, the signal for a reversal of the financial capital inflow was the notion that current account deficits had become “unsustainable” and the exchange rate had appreciated “excessively” in Mexico; but that should have been a surprise to no one because it was an ongoing process at least since 1992 (see Ffrench-Davis, 2006, Box VII.1). Of course, (i) the large current account deficits and outlier macroeconomic prices, particularly an appreciating RER, had principally been a consequence of the exogenous (and collective) behavior of foreign investors in the first place. And (ii) it had been going on for several years. Paradoxically, a “successful” country can see its fundamentals – such as the deficit on the current account, exchange rate, savings, and bank portfolio – worsened by a large capital surge. From a theoretical point of view, what we have is the possibility of multiple equilibria: an appreciated exchange rate with large capital inflows, and a depreciated exchange rate with capital outflows. Moreover, there are dynamics involved: capital inflows appreciate the RER, and the latter, if it is gradual, encourages additional inflows. This can proceed for several years, as happened in 1976–81 and 1990–4 in several LACs. After a while, when the deficits on current account accumulate due to increasing stocks of external (particularly liquid and short-term) liabilities, the appreciation trend is replaced with expectations of depreciation, which in turn tends to lead to a reversal in the flows direction (see Ffrench-Davis, 2006, Chapters VI and VII). This indicates that there is a need for policies that reduce the more volatile components of capital inflows, and demonstrates that the “fundamentals” are dependent on policies towards financial flows. Moreover, some equilibria are more “desirable” than others, in terms of their effects on economic growth and its sustainability. Nevertheless, the new capital surge towards the region in 1996–7, especially to “successful” countries like Chile, which had weakened its countercyclical strategy, generated new macroeconomic vulnerabilities.3 In 1998, for the third time in sixteen years, a drastic generalized reversal of financial 3 Surprisingly, capital inflows as a percentage of GDP were only slightly larger in 1990–5 than during the debt crisis (5.9% versus 5.5% in 1982–9). Nevertheless, in 1997 total inflows peaked to 9% of GDP.

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flows to Latin America took place. Then, the Chilean economy suffered the counterpart of the financial inflows received in 1996–7: financial outflows began by late 1997 and accelerated in 1998–9. Unlike what happened in 1982 – when the majority of creditors were banks, and loans were subject to flexible interest rates – now most resources caught by Chile corresponded to FDI, a more “friendly” component in periods of crisis (see Table VIII.1). Furthermore, the “service” of greenfield FDI tends to be counter-cyclical in recessive situations because of the reduction of profits under a domestic recession.4 In fact, their net profits after taxes fell from US$1,850 million in 1997 to US$1,050 million in 1999.5 The recessive situation that emerged in 1998 and dominated the macroeconomic environment in 1999 was caused by the reversal of financial inflows by foreigners and by a newcomer to crises: outflows by domestic institutional investors.

2 The policy counter-cyclical response In the 1990s, the Chilean monetary authorities deployed a wide range of macroeconomic policies to regulate capital surges and their effects. On the one hand, the central bank attempted to discourage short-term and speculative inflows while maintaining open access for FDI. On the other hand, it sought to moderate the impact of financial inflows on the domestic economy, by intervening in foreign exchange markets so as to prevent an unduly appreciated real exchange rate and sterilizing the excessive monetary effects of the rapid accumulation of international reserves (see Ffrench-Davis et al., 1995). Two other policy factors contributed to the success achieved in managing capital inflows. The first was fiscal discipline. A higher level of social expenditure was financed through new taxes. Chile ran a significant public sector surplus during 1990–7, amounting to 2% of GDP.6 The responsible stance on fiscal policy, including compliance with the rules of a copper stabilization fund,7 eased the task for the monetary authorities in managing capital 4 Even though they have significantly different productive and macroeconomic implications, acquisitions are customarily registered together with greenfield FDI inflows. They have been disaggregated as M&A in Table VIII.1. 5 Interestingly, the behavior of profits is counter-cyclical, but that of the rate of remittances tends to be pro-cyclical: the share of profits remitted rose from 59 to 75% between 1997 and 1999. However, the net effect was a drop in total profit remittances; this compensating effect must be taken into account when examining the implications for the domestic economy of terms of trade changes. 6 Only in 1999 was a deficit recorded, determined by a significant drop in fiscal income. This effect, evidently not a cause, was associated with the severe adjustment process that depressed aggregate demand. 7 Given the weight of copper in the balance of payments and fiscal accounts, and the instability of its price, a Buffer Fund was created in the 1980s under a SAL with the World Bank. The fund was active throughout the 1990s, playing a stabilizing role for fiscal income and the foreign exchange market.

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inflows and aggregate demand, while a counter-cyclical macroeconomic approach was applied decisively and with consistency. Second, subsequently to the 1982–3 banking crisis, prudential banking regulations were introduced and have been perfected over the years. This, again, prevented capital inflows from unleashing a lending spree by the commercial banks, which, in turn, eased the task of keeping the current account and the exchange rate within sustainable bounds up to 1996. (a) Implementing a new macroeconomics and the reserve requirement: 1990–2 In a context of a massive supply of capital inflows, the two main goals of exchange rate and inflow management policies should be (i) to achieve sustained macroeconomic balances, especially in an economy prone to huge cycles (recall that in 1975 and 1982 Chile had experienced the sharpest recessions in all Latin America) and (ii) to protect the growth model adopted by the authorities, which granted a leading role to the expansion and diversification of exports. For the former, it is crucial to manage aggregate demand at levels consistent with the evolution of potential GDP; for the latter, it is crucial to manage the exchange rate at ranges consistent with a sustainable balance of the current account. For exports to act as an engine of growth for the Chilean economy, the level and stability of the real exchange rate are crucial. Consequently, the Chilean authorities opted to regulate the foreign exchange market in order to prevent large misalignments in the RER relative to its long-term trend. The option chosen to make long-term fundamentals prevail over short-term factors, influencing the exchange rate and the aggregate demand, assumes that there exists an asymmetry of information between the market and the monetary authorities, because the latter have a more comprehensive set of objectives and knowledge of the factors driving the balance of payments and economic activity; and, principally, because they have a longer planning horizon than agents whose training and reward are associated with the results that they get at the short-term end of the market. Here I give an analytical account relating policy changes implemented in the 1990s. The changes taking place in global markets, the increasing international approval of domestic economic policies, the vigorous economic activity, high domestic interest rates in Chile, and a smooth transition to democracy stimulated a growing capital inflow since 1990. These events were quickly reflected in a RER appreciation. By July 1990, the exchange rate was at the floor of the band managed by the central bank (in Latin American terms, i.e. the appreciated extreme). Even during the Iraq crisis in September 1990, the market rate stayed on the floor of the band, despite the fact that Chile was then importing 85% of its oil needs; Chile reacted to the shock brought by the oil price by drastically raising the domestic price of fuel, which caused an inflationary shock in September

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and October. The CPI, whose inertial component implied a rise of about 2% monthly at the time, jumped to 4.9 and 3.8%, respectively, in those months. The speed and close coordination with which the central bank and the government reacted to external shocks may explain why pressures in the foreign exchange market continued to encourage appreciation and inflation was quickly reduced. In early 1991, the strict crawling-peg system that had been followed by the monetary authorities was modified, still without intra-marginal intervention. The adjustment was in order to introduce “exchange-rate noise,” which would discourage short-term flows, while deeper reforms were being designed. The rate was moderately revalued on three different occasions and then, in compensation, devalued gradually. Thus, at the end of each of these moves, the “official” rate returned to its initial real level; the devaluations within each move made it more costly for short-term inflows and thus served as an effective tool for temporarily stemming the excess supply of foreign exchange. However, the measure could not be repeated too often, since the market would then anticipate the revaluation and the policy would lose its effectiveness, which actually happened in the third move. Nevertheless, during almost six months the authorities gained time to design a policy that would act efficiently in a more prolonged transition period: that main policy reform was the imposition of an unremunerated reserve requirement (URR) on financial inflows. Undoubtedly, this policy reform advanced against the fashionable opinion of multilateral institutions and financial agents, which stressed the need for an across-the-board capital account opening. The reform adopted by the new national authorities was based on the expectation that the large supply of financing was not permanent, and short-term factors affecting the current account – such as the high price of copper, the high domestic interest rates, and the transitory depressed level of imports – would tend to change in the near to medium term. It was recognized, however, that part of the observed improvement in the current account – a considerably improved non-financial services account, a more vigorous non-traditional exports, and a reduction in the external debt burden – was more structural or permanent. In June 1991, in response to this combination of factors, and pari passu with a 2% revaluation and an import tariff reduction from 15 to 11%, a non-interest bearing reserve requirement (URR) of 20% was established on foreign loans (covering the whole range of foreign credits, including those associated with FDI to trade credit). The reserves had to be maintained with the central bank for a minimum of ninety days and a maximum of one year, according to the maturity of the operation. At the same time, a stamp tax on domestic credit, at an annual rate of up to 1.2%, was extended to foreign loans. In July, an alternative to the reserve requirement was allowed

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for medium-term credits, which consisted of making a payment to the central bank of an amount equivalent to the financial cost of the reserve requirement. This cost was then calculated by applying the LIBOR rate plus 2.5% (at an annual rate) to the amount of the reserve requirement. The URR, the option of paying its financial cost, and the tax on credits all had a zero marginal cost for lending exceeding one year, and, as discussed below, the first two were particularly onerous for flows with short maturities (see Table VIII.3, below). It should be noted that the stages of the business cycle in Chile and in its “financial center” (the United States) coincided during most of 1991. However, in the ensuing months, US interest rates continued to decline, exerting pressure on the central bank. In parallel, the Chilean economy was booming, and its GDP growth rate had risen well into two digits. Consequently, for the sake of macroeconomic equilibrium, the central bank wanted to raise rather than lower domestic interest rates. To avoid encouraging arbitrage and under a large supply of financial inflows, the system of reserve requirements was tightened and extended to other international financial transactions. In fact, beginning in January 1992, it was extended to time deposits in foreign currency; in May, the rate of the reserve requirement was raised to 30%, and the period during which the deposit had to be maintained was extended to one year, regardless of the maturity of the inflow. The spread charged over LIBOR in the option of paying the financial cost of the reserve requirement was increased from the original 2.5 to 4%.8 Later, in July 1995, its coverage was extended to purchases of Chilean stocks (“secondary ADRs”) by foreigners.9 In order to close a loophole through which the reserve requirements were being evaded (since equity investment was exempt), the authorities decided to screen FDI applications; permission to enter the country as FDI exempted from the reserve requirement was denied when it was determined that the inflow was disguised financial capital. In such a case, foreign investors had to register their funds at the central bank as financial investments subject to the reserve requirement. With the Asian crisis, and the sudden sharp scarcity of financial inflows, the reserve requirement rate was reduced to 10% and then to zero in 1998.

8 On diverse occasions, as a counter-cyclical regulation mechanism, the rate of reference and the spread considered in calculating the entrance fee were modified. 9 It is not difficult to impose reserve requirements on foreign portfolio investments. If funds that will be used for the investment are deposited with a Chilean bank, the foreign deposit is liable to reserve requirements. For those funds that do not use a Chilean bank as intermediary, the reserve requirement can be imposed when the asset is registered in the name of an agent with a foreign address. In order to be converted into ADRs, such assets must also be registered with the central bank.

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The authorities announced, however, that the policy tool would remain available in case there were new capital surges (Massad, 2000), and it was restated that the URR was a counter-cyclical macroeconomic tool. A summary of policy actions taken to tackle the excess of foreign currency during the period of abundant external financing can be found in Box VIII.1. From 1991, an attempt was made to facilitate capital outflows as a way of alleviating downward pressure on the exchange rate. In particular, gradually, pension funds (AFPs) were allowed to invest up to 12% of their total assets abroad. With a similar goal, as well as the objective of enhancing the productive development of Chilean firms, residents seeking to invest abroad were granted access to the formal foreign exchange market. The policy was effective in encouraging significant flows of FDI and purchases of foreign firms by Chilean companies in neighboring countries (the so-called chapter XII of foreign exchange regulations; see Calderón and Griffith-Jones, 1995). However, higher rates of return on financial assets in Chile than abroad and expectations of peso appreciation discouraged financial investments abroad by Chilean pension and mutual funds. These investments had been rising very slowly as the domestic firms became better informed about foreign financial assets. By mid-1997, the AFPs had only US$200 million invested abroad, which represented 0.5% of the pension funds. An immediate effect of liberalizing outflows probably was to encourage additional inflows as a result of a fall in the country risk perceived by international investors. Consequently, as argued by Williamson (1993) and Labán and Larraín (2000), the resulting effect tends to be the opposite of the desired one. The market takes advantage of opportunities to place foreign currency abroad when expectations of appreciation are replaced with expectations of depreciation.10 In the face of such a change in expectations in 1998–9, there were massive outflows in the channels opened (see Chapter IX). (b) Reforms to exchange rate policy since 1992 The large capital inflows of the early 1990s put strong pressure on the real exchange rate. In order to moderate this trend, the authorities operated through exchange rate policy, as noted earlier. However, appreciating pressures continued in the ensuing months. Many observers began to hold the view that a modification of exchange rate policy with a significant revaluation was unavoidable. Consequently, the official rate began to lose its allocative 10 Nationals of the countries concerned have been observed to behave in much the same way as foreign portfolio investors if they are allowed to do so. Thus, the ultimate cause of exchange rate and asset price volatility is associated with the openness of the capital account and the ease of moving into and out of assets denominated in foreign currency. For an analysis of Chilean institutional investors, see Ffrench-Davis and Tapia (2001) and Zahler (2006).

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Box VIII.1 Regulations on capital flows by mid-1998 • Foreign direct investment. The only restriction on FDI inflows is the requirement that investments remain in Chile for a one-year period. There are no additional restrictions on outflows, except for a tax on profit remittances. FDI must be financed with a maximum debt component of 30% (70% equity). This limit was reduced from 50% in October 1997. • Portfolio investment inflows through ADRs. The minimum amount of ADR issue is US$25 million, reduced from US$50 million in September 1994. A minimum risk rating of BBB is required for non-financial firms and BBB+ for banks issuing ADRs. A 30% reserve requirement on secondary ADRs was established in July 1995. • Other financial and portfolio inflows. Subject to the 30% reserve requirement for a one-year period. With the Asian crisis, this was reduced to 10% in June 1998 and to 0% in September. The inflows include trade credits, foreign currency deposits, foreign loans including those associated with FDI, and bond issues. Bond issuers face the same quality-enhancing restrictions as ADR issuers. From 1992 foreign loans faced a monthly tax of 0.1%, with a maximum of 1.2% on credits of one year or more. • Investment abroad by the Chilean non-financial private sector. Currency purchase in the formal market for investment abroad is authorized. Investors not wishing to have access to the official foreign exchange market need only inform the central bank of their investments abroad. Those wishing to have access to the official market need permission from the central bank. This is not difficult to obtain. Generally, the formal and free market exchange rates were similar. • Foreign investment by Chilean institutional investors. Foreign investments by pension funds, mutual funds, and life insurance companies are subject to certain limits as to the amounts and types of foreign assets that they can hold. Pension funds were allowed to hold abroad up to 12% of their total assets (raised to 16% in 1999), and investment in stocks was limited to one-half of total foreign holdings. • Foreign investment by banks. Foreign financial investments by commercial banks are limited to 25% of bank capital and reserves and are restricted to fixed income securities issued or guaranteed by foreign governments or central banks. Banks are authorized to use foreign currency deposits to finance trade among countries belonging to the Latin American Integration Association (LAIA). Commercial banks may hold equity in foreign banks provided that they have a capital adequacy index of at least 10%. Source: Central Bank reports.

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capacity between tradables and non-tradables. In January 1992, the official exchange rate was revalued by 5% and the floating band in the formal market was expanded to 10%.11 The observed rate abruptly appreciated by 9% in the market; that is, nearly the sum of the appreciation of the official rate and the lowering of the floor of the band. There followed an overwhelming wave of expectations of more revaluations, which was fed by capital inflows in the formal and informal markets. These flows were encouraged by the certainty that the central bank, under its own rules, could not intervene within the band. In fact, in a market persistently situated near the floor, it intervened only by buying at the bottom price. The market’s expectation was that, if something changed, the floor exchange rate would be revalued, as in fact it had been in January 1992. For a long time, a proposal circulated in the central bank that a “dirty” or regulated float should be initiated within the band; proponents of this view argued that the prevailing rules, with a pure band, an increasingly active informal market, and a more porous formal market, would lead to an observed exchange rate leaning towards either extreme of the band (on the ceiling in 1989–90, on the floor later). The sudden revaluation of the observed rate by nearly 10% between January and February 1992 contributed to the bank taking the decision to initiate the dirty float in March of that year. The observed rate then fluctuated for several years within a range of one to eight points above the floor (i.e. normally not on the floor itself), with the bank continuing to make active purchases but also frequent sales (though with a significant accumulation of reserves). The widening of the band had apparently signaled that the central bank had renounced attempts to deter revaluating pressures in defense of the export strategy, allowing the market, dominated by the short-termist segment, to determine the observed rate within a very wide range. To the contrary, the establishment of the dirty float gave back to the central bank a greater management capacity, enabling it to strengthen long-term variables in determining the exchange rate for producers of exportable and importable goods and services. Finally, in July of the same year, the dollar peg of the official rate was replaced with a peg to a basket of currencies (of which the dollar represented 50%, the deutschmark 30%, and the yen 20%) as the new benchmark 11 It must be noted that Chile was coming out of a profound debt crisis, which was accompanied by a sharp exchange rate depreciation. Consequently, there was space for some appreciation. However, as Chile was moving from a restricted to an overabundant supply of external savings, the authorities wanted to avoid an overadjustment of the exchange rate. One specifically troublesome feature is that, as the expectations of foreign agents change from pessimism to optimism, they seek a higher desired stock of investment in the “emerging market” over a short period of time. This implies excessively large inflows for a while. Obviously, these are transitory rather than permanently higher levels of periodical inflows.

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223

exchange rate.12 The purpose of these measures was to make the dollar–peso arbitrage of interest rates less profitable by introducing greater short-term exchange rate uncertainty, given the daily instability of international prices among these three currencies. The replacement of a peg to the dollar with a basket of currencies also tended to give greater average stability to the peso values of proceeds from exports. Indeed, unlike financial operations, which are largely dollar-denominated, trade is fairly diversified in geographic terms – with the United States representing then only one-fifth of the total – and it also operates with a more diversified basket of currencies. As a result of the policy mix implemented in 1990–4 (plus some “good luck,” the improvement in the terms of trade in 1994–5), Chile was enjoying a solid external sector with sustainable macroeconomic “fundamentals” (a small deficit on the current account, a sustainable exchange rate, and a limited amount of external short-term liabilities) when the tequila crisis exploded in late 1994 and its contagion effect reached Argentina in 1995. Therefore, the across-the-board cutoff in liquid resources for Latin America did not dampen the Chilean economy. As said, the main (but minor) shock was observed in the outflows of foreign capital from the stock market. However, due to the financing of the external deficit with long-term funds, this shock did not cause a recessive situation. In fact, 1995 saw an excellent performance in terms of economic growth, productive investment, and employment, in acute contrast with the depressed situation of Argentina and Mexico in that year. Towards mid-1995, speculative capital flows began to return to the region and with special intensity to Chile. Given overwhelming expectations of currency appreciation, after Chile had shown itself to be immune to the Tequila shock, the large interest rate differential between the peso and the dollar (together with good prospects for the Chilean economy) gave foreign portfolio and short-term investors what amounted to a very profitable one-way bet; expected profits far exceeded the toll they had to pay because of the reserve requirement for entering domestic financial markets. This trend towards appreciation could have been softened by intensifying price restrictions on inflows (i.e. by increasing the rate, term, and/or extent of the reserve requirement; see Le Fort and Lehmann, 2003); the countercyclicality of policy lost consistency. The generalized over-optimism that financial crises had been left behind by the world and the risky temptation to speed the reduction of domestic inflation with a significant exchange 12 The basket of currencies and its matrix of real exchange rates were already operating implicitly through an index of external inflation (see Ffrench-Davis, 1984). This index was used to determine the official exchange rate month to month. The new policy adjustment implied capturing daily those variations in the peso/dollar rate, following the evolution of exchange rates between the rest of currencies of the basket and the dollar.

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rate appreciation weakened the previous highly successful macroeconomic policy. In fact, the external deficit increased pari passu with exchange rate appreciation and rapid aggregate demand growth, which were stimulated by the capital inflows of 1996–7. Exchange rate management encouraged speculative inflows after 1995. In spite of its formal adherence to a crawling band, in 1996–7 the central bank was in fact maintaining an almost fixed nominal exchange rate. There are two factors contributing to the peso pressures since 1995: (i) the establishment of an annual exchange rate appreciation of 2%, on the basis of the assumption of greater productivity growth in Chile with respect to its main trading partners, and (ii) overestimates of the external inflation used for the adjustments of the exchange rate band. Moreover, in order to lower the floor of the band, in 1997 the authorities tinkered with the weights assigned to each currency in the basket, making less credible the peg to a currency basket rather than to the dollar.13 Consequently, it was a failure not of the policy tools (the band of a basket of currencies with intra-margin interventions and the encaje) but of (i) their contradictory implementation and (ii) the lack of a decision to strengthen the URR. The effects of the Asian crisis, including worsened terms of trade in 1998 (thus, now combined with some “bad luck”) and a slower pace of exports expansion, found Chile with an appreciated exchange rate (which had not happened prior to mid-1995) and a deficit on the current account now twice as large as the average for 1990–5 (see Figure VIII.1 and Table VIII.2).14 It took quite a long time for the bank to correct the outlier RER after the contagion of the Asian crisis arrived. It argued that in an economy near to the productive frontier and with a high external deficit, to allow a strong devaluation would have substantial inflationary effects. Undoubtedly, the pass-through effect on inflation is normally greater in an economy operating close to its productive frontier. However, this is also a powerful argument for counter-cyclical action during booms by avoiding the exchange rate misalignment before the critical situation arises. Increasingly, from the mid-1990s, the anti-inflationary objective had become an overwhelming priority for the central bank, at the expense of the RER and, consequently, at the expense of efficient resource allocation and real macroeconomic 13 In November 1994, the weight of the US dollar was reduced from 50 to 45%, reflecting the falling incidence of that currency in Chilean trade. In January 1997, it was arbitrarily raised to 80%. For a comparative analysis of bands in Chile, Israel, and Mexico, see Helpman et al. (1994). For an excellent analysis of intermediate regimes, with references to Chile, see Williamson (2000). 14 An enlarged deficit on current account (even after being adjusted by the trend terms of trade) is a revealed proof of an overly appreciated exchange rate, which was moving faster than net productivity improvements. I contend that in 1990–5 there was a stabilizing appreciation, while in 1996–7 there was an outlier overvaluation that exceeded by far actual net increases in TFP in Chile, thus destabilizing the external balance.

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115 110 105

108*

106

104 6%

100

12%

99

95 19%

90

91*

91

85

80

80

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

75

Figure VIII.1 Evolution of the real exchange rate, 1986–2009 (1986 100). Source: The real exchange rate is the amount of real pesos per one unit of a real weighted basket of currencies of trade partners. Index based on official figures from the central bank. The numbers correspond to annual averages of sub-periods delimited by horizontal lines. The arrows show the appreciation percentages between the respective peaks or sub-periods of annual averages. *The values for 2008 and 2009 correspond to monthly peak and valley values of each year, respectively; both values correspond to December of each year.

Table VIII.2 Net capital inflows and deficit on the current account, 1980–2008 (% of GDP) Net capital inflows 1980–4 1985–9 1990–5 1996–7 1998–2003 2004–7 2008

12.6 4.6 6.3 7.8 0.8 –3.2 5.7

Deficit on the current account 13.7 4.1 2.3 4.8 1.6 –3.4 1.6

Source: Balance of payments data from the central bank for capital inflows and current account, in US dollars. National Accounts from the central bank and Marcel and Meller (1986) for GDP, in pesos. The GDP figures in current prices were normalized with a trend series for the nominal exchange rate estimated with a Hodrick–Prescott filter in order to avoid the misleading bias introduced by a volatile RER.

balances. In the end, it was a policy reversal at the expense of sustainable growth as well as of equity. (c) Strengthening banking regulation and supervision As noted, tough bank regulation and supervision prevented the excess liquidity of banks from fueling a consumption boom and deterioration in the quality of bank assets. This was a legacy of the banking crisis of 1981–6 in the

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aftermath of the preceding foreign capital surge, which led to a virtual collapse of the entire banking system (see Díaz-Alejandro, 1985). The prudential regulation and supervision adopted since then includes: (i) continuous monitoring of the quality of bank assets; (ii) strict limits on lending by banks to related firms; (iii) automatic mechanisms of bank risk capital adjustment when its market value falls below the limits required by the regulators; and (iv) faculties to freeze banking operations, forbid fund transfers outside of troubled banks, and restrict the payment of dividends by institutions that fail to comply with capital adequacy requirements. Chilean financial markets have also acquired a depth that allowed for the orderly infusion of new funds, and for their withdrawal, without significantly affecting the quality of bank portfolios (Aninat and Larraín, 1996; Held and Jiménez, 2001). Capital adequacy ratios along the lines of the 1988 Basle Accord were introduced into the new banking law approved by Congress in 1997. But banks’ capital, in practice, was well above the Basle norm of 8%. In addition, the central bank imposed limits on banks’ open positions in foreign exchange, although these were still fairly crude in that they did not differentiate between loans made in foreign currency to firms that earn foreign currency and to firms whose earnings are in domestic currency. Neither do these limits differentiate between different currencies. Currency risk is only one aspect of credit risk evaluation, which as a whole is quite good in Chile. Therefore, this compensates for the weaknesses in the norms on open positions in foreign exchange.

3 The effectiveness of macro-stabilizing measures Macroeconomic counter-cyclical, prudential, regulations also have microeconomic effects. Both are associated with the financial costs imposed by the system of reserve requirements and taxes on foreign lending. The implicit total tax consists of the extra interest costs imposed by the reserve requirement and the tax on foreign credits. The calculations can be seen in Table VIII.3. As a result of the lengthening (in 1992) of the reserve requirement holding period to a full year, and regardless of the maturity of the financial transaction, the implicit annualized tax rate on foreign borrowing increased dramatically as maturities shortened. Before the term of the reserve requirement was extended, the implicit annualized tax rate was identical on transactions as short as a quarter (the minimum holding period up to May 1992) or as long as a year. These very large estimates of the implicit tax rate on short-term operations suggest that, if the regulations were not evaded, they must have implied strong discouragement of short-term and portfolio flows. How effective has the reserve requirement (together with interest and exchange rate management) been in deterring short-term flows and preventing excessive external deficit and exchange rate appreciation? How does it affect different kinds of agents and, therefore, what is the impact on

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Table VIII.3 Implicit cost of reserve requirement on foreign borrowing, 1991–8 (annualized rates) 1991 II Reserve requirement (%) Minimum holding period (months) LIBOR (%) Implicit cost (%) 12 months 6 months 3 months

1992 I

1992 II

1996

1997

1998 I 1998 Q3

20

20

30

30

30

30

10

3

3

12

12

12

12

12

5.5

4.3

3.6

5.6

5.8

5.7

5.6

2.8 2.8 2.8

2.8 3.2 4.0

3.3 5.5 9.7

4.2 7.2 13.3

4.1 6.9 12.7

4.3 7.3 13.4

1.8 2.4 3.7

Source: Author’s calculations, based on information from the central bank. Implicit cost includes the 0.1% monthly tax, with an annual ceiling of 1.2%.

equity? How does it alter the macroeconomic environment for investment and productive development? All these questions have been in the theoretical, empirical, and political debate. Here, I deal with them. (a) Arguments against capital account management A traditional argument is that (i) the regulation does not have effects because in the present economic world (and the one of the nineties) it stimulates evasion, offsetting all impact from the start or, gradually, soon after. A variant states that (ii) the regulation affects the composition of flows, but this does not have any economic impact. A third variant (iii) accepts that there are positive effects but, at the same time, it worsens regressively the access of small companies to financing. Some observers have claimed that the efficacy of measures intended to discourage capital inflows is only temporary, since they assume that private operators usually find ways to fully evade them (see Valdés-Prieto and Soto, 2000). In principle, this can be done through several mechanisms. Here I mention five of them. One is the under-invoicing of imports or the over-invoicing of exports. The second is to delay payment for imports or accelerate export receipts. Third, funds can be brought through the informal foreign exchange market. Fourth, short-term funds can be disguised as FDI. Fifth, agents can arrange back-to-back operations in which, for example, an agent pays for imports with a bank deposit in Chile rather than with foreign exchange; at the same time, the exporter is paid in foreign exchange by a bank in his or her country. All of these (and other forms of evasion as well) are possible, but they are not costless, some have a one-shot impact and only cause delay of the effects, and some may have undesirable effects on the tax liabilities of the avoiders of regulation. The authorities were conscious of the risks and the dynamics of the market, which, by its nature, looks for evasion channels. For that reason, up

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to 1995 they maintained a permanent monitoring, closing loopholes that were appearing. Here I mention two. First, the financial flows that banks or investment funds disguise as risk capital or productive investment; when this was becoming an important loophole, the authorities moved to close it by means of the case-by-case analysis of those flows, and by placing under the reserve requirement those that corresponded to financial investments. While some evasion is inevitable, there is no hard evidence that the measures targeted to discourage short-term capital inflows had been massively evaded, as is verified below. Second is the case of investment funds purchasing secondary ADRs. By 1993, the secondary issue of ADRs started to rise as a source of short-term inflows with particularly volatile characteristics. Thus, the extension of reserve requirements to these inflows in 1995 was an effective attempt to deal with an incipient problem that was already causing difficulties in policy management. However, after a temporary lull in 1995, they again surged in 1996, though now paying the corresponding cost of the reserve requirement. The evidence suggests that the entry fee came to be perceived as cheap in the face of positive fundamentals, optimistic expectations, and a strong likelihood of further RER appreciation. I repeat that, evidently, the policy answer then should have been a strengthening of the restrictive power of the reserve requirement, in order to adapt to the increased liquidity of international financial markets. In contrast to several studies that show a significant effect over short-term inflows, a common line of attack against the use of disincentives has been to claim that, with regard to their behavior, it is impossible to distinguish between capital inflows such as FDI or long-term lending, on the one hand, and short-term or liquid flows on the other. In an influential study (widely promoted by the supporters of the “Washington Consensus”) Claessens et al. (1995) claimed that balance of payments categories have nothing to do with the stability of flows themselves, long-term flows being just as likely to be unstable as short-term flows.15 It is interesting to note that after many empirical works that verified the lack of consistency of those critics, more recently another one arose. This one accepts that the regulations had desirable effects on the composition of flows in the case of Chile, but that they were regressive. In that sense, Forbes 15 Part of the explanation of the finding that FDI is as likely to be volatile as shortterm flows may stem from the fact that, for the countries that they selected, FDI flows were a small percentage of total foreign financing, as reported by IMF statistics. Fluctuations in small numbers tend to be greater than fluctuations in large ones. On the other hand, the period covered excludes the tequila crisis, when portfolio flows played a significant destabilizing role. It is evident that instability must be tested in critical situations rather than during booms. Finally, we repeat the relevance of distinguishing between FDI and mergers and acquisitions. FDI is mainly carried out in fixed assets (it is “irreversible” investment), whereas M&A involves “liquid” inflows.

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(2003) finds that the reserve requirement affected “small” firms more intensively by imposing financial constraints on them.16 Gallego and Hernández (2003) conclude that the reserve requirement affected the financial structures of Chilean firms, reducing their leverage, increasing their reliance on selfgenerated funds (retained earnings), and increasing the maturity profile of their debt. Both microeconomic works use as their sample a group of listed companies in stock markets.17 It is evident that any tax imposes some monetary cost to taxpayers and, in doing so, changes relative prices. The crucial point is what the net effect of capital controls is on overall welfare, after a double test: (i) to contrast their eventual microeconomic costs and their macroeconomic benefits; and (ii) to assess the effects throughout the economic cycle; that is, not only during the boom but also during the fall that usually follows. There is strong evidence that a bust has a significant bias against SMEs, as shown by the regressive impact of the recession of 1999 against SMEs and labor of lower qualification. (b) Arguments in favor of the regulation of inflows and empirical tests There are two kinds of evidence that one can use to assess the net effect of regulations. The first is qualitative. There is broad consensus that, in the first half of the nineties, Chile faced a larger supply of external finance (relative to its GDP) than other countries in the region, because of its better economic performance and greater political stability. However, during those years the exchange rate appreciation and the current account deficit (as a share of GDP) were smaller than in other countries in the region that were major recipients of foreign capital (see Ffrench-Davis, 2006, Chapter VII). In addition, FDI represented a much larger share of inflows in Chile than in other countries;18 in those years of re-establishment of democracy, besides restricting capital inflows, Chile restored labor rights and some taxes on profits. We can assume that the reason why greenfield FDI responded positively was not these variables but other policies, such as the better macroeconomic environment that counter-cyclical policies generated. These provided a better 16 Meanwhile, the positive macroeconomic effects of the reserve requirement had been acknowledged by academic circles and authorities of institutions such as the BIS, the IMF, and the World Bank. 17 Most companies listed on Chilean stock markets are among the biggest in the domestic economy. Therefore, evidently, conclusions from these works cannot apply directly to the overwhelming majority of SMEs, which are not listed on the stock market and have limited access to capital markets. 18 It should be noted that the loans associated with FDI were subject to the reserve requirement. Since the average maturity of these loans averaged about seven years, the incidence of the restriction merely for their first year was low. However, this avoided the danger of short-term credit being disguised as long-term credit.

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environment for productive investment, which attracted FDI and, what is about “four times as relevant,” also spurred domestic investment.19 The second is quantitative. Significant econometric evidence shows that policies directed towards the capital account did work rather well for about five full years. These studies indicate that the combination of disincentives to short-term inflows together with the other reforms in the macroeconomic approach, at least up to 1995, had been able to reduce short-term and liquid inflows and to avoid an unsustainable deficit on current account (Agosin, 1998; Larraín et al., 2000). As discussed below, the policy approach of Chile changed markedly in the following years in the face of a new generalized capital surge towards emerging economies, when restrictions on inflows were, paradoxically, left unchanged by the autonomous central bank rather than being increased in response to the huge capital surge of 1996–7. Consequently, the destabilizing effects in that biennium cannot be attributed to the counter-cyclical policies of the first half of the nineties. In fact, there is robust evidence that the capital controls applied in Chile modified the maturity structure of inflows, reducing the share of the short term component.20 Indeed, actual short-term and liquid flows were limited and a significant share of them entered paying the reserve requirement. The magnitude of the financial revenue from the toll reached around 1% of GDP during all the years it was in force: a positive by-product. In order to check the hypothesis that the composition of the flows does not make a difference, a series of econometric tests were run to determine the degree of persistence of different types of private flows (see Agosin and Ffrench-Davis, 2001). These tests lead to the conclusion that FDI is considerably less volatile than short-term borrowing and portfolio flows, and that it is advisable to target policies of prudential macroeconomic management (such as the reserve requirement) on short-term or liquid inflows. Moreover, persistent flows tend to be associated with productive investment and not consumption. This is what the Chilean authorities successfully reached when they took the decision to apply a comprehensive counter-cyclical policy. Undoubtedly, during the first half of the 1990s, short-term and portfolio inflows would have been much larger in the absence of the reserve requirement. Together with sterilized intervention in foreign exchange and monetary markets, the policy approach adopted prevented undue exchange rate appreciation and a consumption boom, thus keeping the current account deficit within reasonable bounds up to the mid-1990s. The policy mix also had financial costs for the authorities during the boom period. The accumulation of large volumes of foreign exchange reserves 19

The ratio of investment by nationals to FDI has been around four to one. See Edwards (1999), De Gregorio et al. (2000), Gallego et al. (2002), and Le Fort and Lehmann (2003). See also the comments about the reserve requirement’s significant effectiveness in Williamson (2003). 20

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imposed a financial cost, since the returns on these assets abroad were lower than the interest payments on the central bank liabilities issued to sterilize the monetary effects of reserve accumulation; the losses for the central bank were estimated at about 0.5% of GDP per annum. That is the cost of “insurance” for economic stability; the initial accumulation implied a movement towards “equilibrium” since in 1990 net liquid international reserves were notably low (actually, negative if measured comprehensively), but probably became unnecessarily large by 1994 (though most welcome during the sudden stop of inflows of 1995). Undoubtedly, a more flexible and restrictive management of the reserve requirement and other prudential macroeconomic policy tools by the authorities would have moderated that cost. From the point of view of investment and growth, the impressive growth performance of the 1990s supports the hypothesis that the positive effect of the whole macroeconomic approach (including the management of capital inflows) was much stronger than any associated microeconomic costs. Actually, the investment ratio of Chile in the 1990s was the highest recorded in its past history. In this sense, “financial constraints” as defined and reported by Forbes (2003) were not an impediment to expanding productive capacity.21 Moreover, the microeconomic switch from debt to retained earnings in the financial structure, as well as the shift towards longer-term liabilities of “small” firms recorded by Gallego and Hernández (2003), can be considered as a positive by-product of Chilean capital controls. Indeed, the main sources of private savings are non-distributed profits and depreciation reserves of firms; the improved macroeconomic environment implied a higher rate of use of installed capacity, higher effective productivity, larger profits, better expectations, and higher reinvestment of profits. That is not a negative outcome, but a highly positive one. This is consistent with a severe incompleteness in the Chilean capital markets with respect to long-term financing for SMEs and non-wealthy new entrepreneurs. In the macroeconomic dimension, there is robust evidence that the access to financing and spreads of SMEs are more intensively affected than those of large firms during crises. Avoiding crises by discouraging capital inflows during the boom stage naturally involves SMEs paying higher interest rates than otherwise during the boom. However, in the bust phase of the cycle, the policy contributes to avoiding both sharp increases in costs during the avoided bust and the corresponding binding financial constraints that they usually face during recessions; these restrictions could be avoided in 1995 and attenuated as in 1999, thanks to the prior prudential regulations on inflows. 21 Forbes (2003) defines “financially constrained” firms as those that depend on their own sources of financing to invest. In fact, most SMEs do not have access to the formal financial market, and therefore the macroeconomic environment they faced is a key variable determining its liquidity.

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But, though I must point out that it is my interested view as a participant in the design and implementation of this set of policies, the overall balance provides a case of very effective and efficient counter-cyclical policies. In summary, (i) there is strong evidence that the capital controls applied in Chile modified the maturity structure of inflows, reducing the share of shortterm components. This conclusion emphasizes a very positive characteristic of this policy tool, because the probability and severity of crisis appear to be closely associated with a greater liquidity of external liabilities. Empirical studies also recognize that the URR (ii) allowed a variable gap between domestic and external interest rates to be maintained, thus providing space for an active monetary policy. This was of great importance for the sustained growth process recorded during almost all the decade; in fact, frequent mini-adjustments from the central bank allowed the avoidance of maxi-adjustments, resulting in an economy working persistently on or near the production frontier. On the other hand, (iii) the effect of the URR on both total flows and real exchange rate appreciation has been found (see Le Fort and Lehmann, 2003; Ffrench-Davis and Tapia, 2005). In all, (iv) the reserve requirement contributed to moderate the stock of liabilities and to improve its profile (from both micro and macro perspectives). According to most international evidence these two factors strongly determine both the probability of crises and its associated costs. There is another dimension that is dynamic, linking with the future: (v) an economy with a high rate of use of productive capacity and stable longterm flows, usually exhibits higher rates of productive investment. This generates two positive effects that increase the efficient absorption capacity of external savings: first, gross capital formation is intensive in imported inputs, which is the reason why a given amount of capital inflows causes less exchange rate pressure when it is channeled to investment than when it goes to consumption; second, a high investment ratio generates a larger output in the future, with its respective demand for imports, creating an efficient and sustainable higher absorption capacity, without a misalignment of the exchange rate.22

4 Savings, investment, and growth in the 1990s The remarkable increase in the productive investment ratio, and the fact that the ratio kept rising up to 1998, is of great importance. In most of the period 1991–8, there was no recessive gap (gap between actual GDP and potential GDP). It has been shown that the recessive gap is a significant explanatory variable of the investment ratio (see Agosin, 1998; Ffrench22 This relevant effect on absorptive capacity, associated with the composition of inflows, is usually omitted from econometric research.

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Davis, 2006, Chapter III). It also happens that a larger investment ratio, in response to a negligible recessive gap, tends to be associated with stronger SMEs and overall better employment. The gap remained negligible until 1998, encouraging productive investment, even though other macroeconomic disequilibria were being built: a rising external deficit and an appreciated exchange rate. These two explain why Chile was hit by the Asian crisis from 1998 and it did not remain immune as it had been in the Mexican crisis of 1994–5. For that matter, it is important to make a sharp distinction between the period in which the counter-cyclical approach was implemented in a coherent way (1990–5), and the period of increasing abandonment of the active counter-cyclical strategy (1996–7). In the first period, the Chilean economy became one of the less vulnerable in a region facing financial and exchange rate crises, escaping from the contagion of the Mexican crisis. In the case of the Asian crisis, the negative effect was rather moderated and, as discussed, was mostly linked to policy failures like allowing the accumulation of macroeconomic imbalances and the careless liberalization of outflows by residents during the boom phase in 1996–7. When the Asian contagion arrived and a significant recessive gap emerged, the investment ratio fell sharply in 1999. Undoubtedly, the 1990s marks a clear-cut improvement in the growth of productive capacity, in comparison with 1974–89. The gross fixed investment to GDP ratio rose steadily: from 13.6% in 1974–89 to 20.2% in 1990–8 (in constant 2003 prices; see Chapter IX, Table IX.1). This increased ratio allowed Chile to sustain a GDP growth averaging over 7% per annum in that same period. In those nine years, actual and potential GDP grew at similar and sustainable rates, with the economy operating regularly close to the productive frontier. That is one of the main conditions that must be fulfilled by an efficient macroeconomic policy. As already stressed, that positive feature of a macroeconomics-for-development was determinant of the high rate of productive investment recorded in the nineties, and therefore of the increasing potential GDP growth. In fact, this is strongly associated with the correction of the macroeconomic environment, with high rates of use of productive capacity (and well aligned macroprices for the sake of sustainability). Naturally, this high investment ratio contributed to the generation of productive jobs and to the adoption of technological advances imbedded in imported capital goods. The increase in the gross savings ratio was also strong, rising from 12% during the Pinochet regime to 22% in 1990–8 (in current prices). This reveals that, in the nineties, national and foreign savings worked as complements, as opposed to the substitution that took place in Argentina and Mexico before 1995 and in Chile before 1982 (see Uthoff and Titelman, 1998). As shown in section 1, capital inflows averaged 5.8% of GDP in 1990–5, whereas the use of foreign savings was reduced to 2.3%, with the difference being accumu-

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lated in the international reserves. This reveals that the sterilization policies of capital inflows, by preventing excessive exchange rate appreciation and avoiding a high external debt, allowed the economy to absorb less foreign capital than the amount offered, regulating it to amounts consistent with an efficient absorption capacity. This was enhanced by the fact that most flows were associated directly with productive investment. The Chilean policies directed towards restraining capital surges and moderating exchange rate appreciation can be credited with a significant share of the success achieved with regard to investment, savings, and economic growth. On the one hand, the management of inflows has had a positive impact on real macroeconomic stability, and has contributed to keeping effective demand close to productive capacity, which is essential for investment expenditure to rise. On the other hand, when capital arrives in surges rather than trends, and takes the form of volatile financial flows rather than FDI or financing of imports of capital goods, it tends to crowd-out national savings. Foreign savings stimulate consumption through their effects on domestic liquidity, the exchange rate, and asset prices. Thus, success in moderating capital surges and modifying its composition contributed to a sharp increase in national savings ratios (Solimano, 1990; Agosin, 2001).

5 Some policy lessons from this experience The Chilean experience of prudential macroeconomic management of capital inflows provides several relevant lessons. For developing countries, the swings in capital flows can be of extraordinary magnitude relative to the size of their economies. Totally passive policy stances will inevitably generate external vulnerabilities, resulting in enormous volatility in key domestic macroprices (exchange and interest rates) and economic aggregates (aggregate demand, output gap and external balance). By depressing investment, these fluctuations have adverse effects on long-term growth, productive employment and social equity. Contrary to the neoliberal view, it is possible to discriminate between (i) flows that are stable, of a long-term nature, and contribute to the country’s growth (such as greenfield FDI that directly create new capacity) and (ii) those that are basically speculative and lead to excessive domestic volatility. In the Chilean case, the market-based discouragement applied to speculative flows had no adverse effects on FDI, which, on the contrary, reached unprecedented levels during the decade. Some evasion is inevitable: any system of discouragement makes it attractive for some operators to attempt to circumvent it. In the Chilean case, it was necessary to close loopholes when it became obvious that agents were creating them. In fact, circumvention can be kept to a minimum with a well designed and transparent system such as the reserve requirement on capital inflows (encaje), and continued monitoring by authorities.

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The objective of sustaining economic growth in the face of volatile capital flows (or volatile export prices, as in Chile) requires the use of a battery of counter-cyclical policy instruments. In the Chilean case, the combination of tax-like instruments meant to deter speculative inflows, a crawling band with intra-marginal intervention (which in my view, was utilized too sparingly), and sterilization of the monetary effects of capital inflows worked well for over half a decade. It contributed to the creation of a friendly macroeconomic environment for productive investment, job creation, and economic growth, keeping under control the external sources of vulnerabilities that caused severe crises in Argentina and Mexico in 1995.

IX Economic Policy after the 1999 Recession

In 1998 the Chilean economy ended a period of exceptional (actual and potential) GDP growth. A high ratio of productive investment gave support to that dynamism, which allowed improvement in the quality of employment, and contributed to partially reverting the regressive outcomes of the economic reforms of the 1970s and 1980s. However, since 1998, the economic dynamism and some key features of economic policy have shown significant changes. Consequently, from the perspective of the economic performance of the Concertación governments, there is a need to distinguish subperiods with different emphases and priorities. While per capita GDP climbed by 5.4% per year in 1990–8, the rate of increase dropped to 2.6% in 1999–2008; actually, it was a sharp slowdown, even though it was still above the 2% average of LACs and the 1.6% of the United States. The first half of the nineties (1990–5) had especially positive features. On the domestic front, actual GDP grew at an outstanding annual rate of 7.8% (similar to the potential GDP expansion), led by growing investment ratios, and sustaining significant real increases in wages and employment. Additionally, the worsened income distribution trend inherited from the dictatorship not only stopped, but recorded some improvement. On the external front, in spite of a massive supply of capital inflows, the government was successful in maintaining a sustainable external deficit with moderate real exchange rate appreciation in a way consistent with economic fundamentals (see Chapter VIII and Balassa, 1981). In the 1996–7 biennium, both output and investment stayed high; nevertheless, there was a weakening of distributive improvements (with some worsening in the inequality indicators), at the same time that risky external imbalances emerged, which, soon, implied high economic and social costs associated with the contagion of external negative shocks derived from the Asian crisis in 1998–9. As a result, in 1999–2003, the economy remained depressed, with a sizable gap between actual and potential GDP; only in 2004–5 did it experience a significant recovery, averaging 5.8% actual GDP growth, now led by a quite positive external shock via the terms of trade. 236

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However, notwithstanding that the positive external shock persisted well into 2008, the speed of GDP growth diminished in the next triennium.1 This performance implied a significant average output gap as compared with the negligible gap outstanding in 1990–8, with the economy now generally operating significantly below its potential capacity. This real macroeconomic imbalance was present during most of the period 1999–2008, and naturally aggravated in 2009. Actual GDP and potential GDP did not resume a sustained dynamism, evolving far below the record achieved in the 1990s (see Table IX.1). It is relevant to stress that, in spite of the persistent recessive output gap, the government continued to develop social reforms of great significance: for instance, the Chile Solidario and Chile Barrio programs, the new AUGE health program, and a deep reform of retirement pensions. In order to face the mismatch between the required resources to fulfill the social program and the depressed tax revenues in recessive situations, a structural fiscal policy was implemented, which consists of maintaining an expenditure level consistent with (estimates of) permanent or medium-term sustainable fiscal revenue. This instrument not only represents a great formal advance to guide fiscal policy, but also has desirable macroeconomic properties, in as much as it allows the authorities to avoid public expenditure curtailments in depressed periods and to avoid increases when the economy is overheated and tax revenue exceeds its normal or structural level. The present global crisis finds Chile with a Treasury that is a net creditor and with a notably Table IX.1 Investment, savings and growth, 1974–2009 (annual growth rates, % of GDP) GDP growth

1974–89 1990–5 1996–8 1999–2003 2004–5 2006–9

(1)

Potential GDP growth (2)

2.9 7.8 5.7 2.6 5.8 2.8

2.5 7.6 6.4 4.0 3.9 4.2

Output gap

Gross fixed investment

(3)

(4)

10.4 –0.3 –0.9 6.5 4.3 4.9

13.6 18.9 22.9 19.7 22.7 26.2

Current account deficit (5) 6.9 2.3 5.0 0.8 –1.7 –2.8

Gross national savings (6) 12.0 22.1 22.7 20.6 22.8 23.7

Source: Based on Chapter I and on National Accounts from the central bank. Columns (1)–(4) are in 2003 constant prices. Columns (5) and (6) are based on current prices, with the same adjustment made in Table VIII.2. Data for 2006–9 in columns (2) and (3) were taken from potential GDP growth, estimated by the Ministry of Finance, with inputs from the Trend GDP Committee. Column (6) includes fiscal savings, particularly large in 2004–8. 1 While GDP rose by 28% between 2003 and 2008, gross national income jumped 43%, pulled up by the sharp improvement in the terms of trade.

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high liquid stock in stabilization funds, crucial positive features in this critical situation for international financial and trade markets. Here I examine the origin of the break in the growth trend located in 1996–7 (section 1), the breaking point in 1998–9 (section 2), the depressed years 1999–2003 (section 3), the recovery of 2004–5 (section 4), and its weakening in 2006–9 (section 5). Section 6 analyzes some key issues for macroeconomic policy: the structural fiscal balance and its relation with trend GDP, and the exchange rate and counter-cyclical policies. Section 7 presents some conclusions.

1 The origins of the break In general, up to 1995 the stabilizing macroeconomic policies established with the return to democracy in 1990 had discouraged the most volatile components of capital inflows and prevented an excessive real exchange rate appreciation. But, even though a larger supply of external financing to successful emerging economies was recorded after 1995, the authorities maintained the intensity of the policy instruments being used. The obvious consequence was that, in the following years, the capital inflows surpassed the capacity of domestic markets to absorb them efficiently and without generating future unsustainable imbalances. Indeed, the central bank was unable to prevent a sharp real appreciation of the peso; in fact, the RER average of 1996–8 was 19% below the average of 1990–5 (see Chapter VIII, Figure VIII.1). This appreciation, as well as high liquidity, strongly stimulated aggregate demand; that stimulus, given the appreciation, was biased in favor of the demand for tradables, which contributed to expand the current account deficit that peaked at 4.8% of GDP in 1996–7. Evident signals of key macroprice misalignments emerged, and it became necessary to fortify the instruments in order to face the excessively abundant supply of financial inflows; but the central bank did not show sufficient commitment to the defense of a competitive real exchange rate. In fact, the monetary authority increasingly privileged the anti-inflationary target (obviously facilitated by real appreciation), underestimating the increasing external vulnerability that was being generated. Recall that then there was a contagion of extreme optimism in international financial markets with respect to the emerging economies. The opinion prevailed that after the effective control of the spread of the contagion of the tequila crisis, the probability of financial crisis was vanishing, being replaced by the great contagion of overoptimism in financial quarters. Additionally, a series of measures by the central bank liberalizing outflows, specifically related to pension and mutual funds, accentuated the vulnerabilities, as strongly verified in 1998–9. However, it must be pointed out that the bank had not yet dismantled its policies with respect to the capital account, in contrast to several other LACs and Asian countries that had

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already done so prematurely; but it lacked the decisiveness to strengthen the comprehensive macroeconomic approach prevailing in the first half of the decade. A controversial issue has been the fiscal responsibility for the excess of aggregate demand of 1996–7. Neoliberal advocates attribute the later fall of GDP to the fiscal performance before the crisis, a hypothesis that is contradicted by robust data. It is true that a rise in fiscal expenditure was recorded in that biennium (nearly 7% annually). Nevertheless, (i) the fiscal expenditure that had a macroeconomic impact represented less than one-fifth of the economy; therefore, a fiscal contribution to moderate the excess of global absorption would have been evidently insufficient by itself. (ii) Second, the main components explaining the growth in public expenditure were education, justice, and infrastructure: all fields where transformations were forcefully demanded by society, with a political consensus on a greater increase in their budget, pari passu with tax increases to finance them. (iii) Third, the fiscal budget showed an increasing surplus (2.1% of GDP in 1996–7), whereas the private sector exhibited an increasing deficit (6.4% of GDP; see Chapter I, Table I.3); consequently, fiscal policy was not the leading source of the imbalance. Moreover, the government had restrained its access to credits of the World Bank and the IADB and had prepaid debt. Thus, once again as in the 1970s, the imbalances originated in external shocks and were located, predominantly, in liabilities of the private sector (see Marfán, 2005). The responsibility of the government, at most, was the lack of greater efforts to enforce coordination with the autonomous central bank.2 These problems, related to the independence of the central bank, were taboo subjects. The fear of debate ignores the fact that there is no unique form of autonomy in the world. In fact, many alternative variants exist. Although the renunciation of active handling of the reserve requirement and other prudential measures attracted the imbalances, the intermediate option to maintain the status quo, instead of the extreme option of full capital account liberalization, significantly contributed to moderate the macroeconomic disequilibria being built. On the one hand, the external deficit was limited until 1995, thanks to which the stock of external liabilities had a moderate level in that year and subsequent imbalances were limited to the rather brief period until the arrival of the Asian crisis. Furthermore, the URR had some restrictive effect in 1996–7. Therefore, if those policies had not been applied, the vulnerability of the Chilean economy and the resulting costs of the Asian crisis would have been much greater. 2 The lack of coordination between the government and the central bank was evident. As said, the monetary authorities did not show that they cared about the imbalances in the external sector; however, on several occasions, the government made explicit the need to strengthen the URR in order to moderate exchange rate appreciation.

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2 The impact of the crisis, 1998–9 The Asian crisis interrupted the period of the greatest economic boom in the history of Chile. The economy had to adjust in response to the two negative external shocks faced from 1998 – the deterioration of the terms of trade and a drop in capital inflows. As said, the contagion from Asia found the economy in a vulnerable position, with a sharp real appreciation, a dangerous climbing in the current account deficit, and facilities for capital outflows by residents. The excessive external deficit implied, by definition, an excess of aggregate demand over potential GDP. Moreover, actual GDP exceeded to some degree potential GDP, with economic activity operating at a speed somewhat faster than the sustainable one. Therefore, it became necessary to reduce the rate of expansion of aggregate demand and, to a more moderate degree, economic activity, in order to diminish the external deficit by about two points of GDP and to close the “positive” output gap (excess of actual GDP over potential GDP, which naturally is not sustainable). Even without the contagion of the Asian crisis, some adjustment in the speed of those variables was needed. The symptoms of the crisis emerged in Chile by mid 1998, and they were felt with force during 1999. The contagion occurred through two channels. On the one hand, there was a trade shock with worsening terms of trade and falling rates of export expansion. On the other hand, the large inflows of 1996–7 gave way to outflows of both domestic and external funds. As a consequence, and given an outlier exchange rate, strong depreciation expectations arose; the central bank decisively resisted them during 1998, due to its fear of inflationary pressures in a still overheated economy, and with the explicit purpose of facilitating the amortization of the dollar-denominated debt of domestic economic groups. In order to resist devaluation pressures, the bank resorted to drastic rises in real interest rates. Nevertheless, it was evident that the exchange rate was too appreciated. In that context, a rise in the interest rate contributes to restraining aggregate demand, but it hardly restrains the demand for dollars. For example, if we assume an expected 20% devaluation, then economic agents can borrow even at a high annual interest rate of 20%, buy dollars, and obtain a positive return, even if the devaluation is delayed for nearly twelve months. Undoubtedly, in 1998, both the devaluation horizon and the interest rate were below those assumed in this simple exercise. Since the strong rise of the interest rate was insufficient, the bank was forced to make massive foreign currency sales at the artificially low market price. Soon, the bank drastically reduced the width of the exchange rate band, together with an intensification of the domestic adjustment led by increases in the policy real interest rate to 14.5%; this was done to stress that the central bank would not give in to market devaluation pressures. After

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expansion of the band width by the end of 1998, its use was suspended in September 1999, starting a free floating regime, now in a context of very depressed domestic expenditure and strong peso depreciation.3 The recessive environment prevailing from late 1998 performed as an effective control on inflationary expectations; it allowed sizable depreciation without threatening the inflation target. On the other hand, since then the exchange rate has exhibited significant volatility; for example, successively guided by news on the economies of Argentina (the economic and political collapse in the early 2000s) and Brazil (the election of President Lula, a leftist leader, in 2002), the price of copper, and global uncertainties (the attacks on New York on September 11, 2001, and the wars in Afghanistan and Iraq). In this critical context, not only was there a sudden stop of foreign loans, but also massive capital outflows by residents took place. In fact, from the outset of 1998 a voluminous exit of flows was recorded, mainly from pension funds (AFPs), which could speculate against the peso when expectations shifted from appreciation to depreciation. The previous liberalizations and the liquidity of their funds facilitated that pro-cyclical action (see Figure IX.1). AFP outflows between January 1998 and June 1999 climbed to the equivalent of 4.8% of GDP and to 12% of their total funds.4 That, 18

Appreciation zone

Depreciation zone

100 95

14 12 10 8 6 4

RER Investment abroad limit

90 85 80

Investment abroad

RER (1986 = 100)

Outflows (% of total funds)

16

75

0

Dec-93 Mar-94 Jun-94 Sep-94 Dec-94 Mar-95 Jun-95 Sep-95 Dec-95 Mar-96 Jun-96 Sep-96 Dec-96 Mar-97 Jun-97 Sep-97 Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00

2 70

Figure IX.1 Pension fund outflows and RER, 1993–2000 (% of total funds, 1986 ⫽ 100). Source: Based on central bank and Pension Fund Superintendence figures. 3

The real exchange rate depreciated by 22% between September 1999 and the annual average of 2003. 4 A premature financial liberalization runs the risk of leaving too many open doors for outflows, which usually become massive in the case of financial distress and increasing depreciation expectations (see Ffrench-Davis et al., 1995). Indiscriminate liberalization of the capital account usually tends to bring exchange rate and macroeconomic instability; it makes more painful the international financial crises.

242 Economic Policy after the 1999 Recession

naturally, had an intense recessive impact on monetary liquidity and aggregate demand. The economic and social costs were significant. Domestic output adjusted downwards from the sustained 7% annual growth trend to an actual GDP drop of 0.8% in 1999. The investment ratio fell strongly (by 18% in 1999), and open unemployment climbed to 10% of the labor force. Thus, once again, after the macroeconomic imbalance led by excessive capital flows in 1996–7, a recessive adjustment, costly in terms of growth and equity, took place. During a decade, the economic agents had observed annual real increases of aggregate demand around 7–9%, and suddenly they were facing a 6% drop in 1999, with output decreasing by the mentioned 0.8%. In the meantime, productive capacity continued expanding, due to the still high investment of 1998. Consequently, given the fall of actual GDP and the rise of potential GDP, a strong recessive output gap emerged. After that, a significant output gap prevailed for many years, reflecting a severe flaw in macroeconomic policies. The neoliberal two-pillar macroeconomics, based on the control of inflation and a fiscal surplus, was fully at work, but the third pillar, of a sustainable exchange rate and an effective demand consistent with productive capacity, failed.5 In 1996–7 that capacity was exceeded moderately; to the contrary, there was a significantly depressed effective demand in 1999–2003, revealing a standard asymmetry of effects, with a net recessive balance even persisting in the subsequent years (see the output gap in Table IX.1). It is relevant to emphasize that, after 1998, the domestic financial system did not radically worsen its situation: the non-performing portfolio of banks as a percentage of total lending increased from 0.97% in December 1997 to 1.8% at its worse moment in April 1999, which is similar to the level recorded in 1992, a year without crisis as reported by the Superintendence of Financial Institutions (SBIF). This is remarkable, in the context of a 6% drop in aggregate demand, and reflects the stability dividend of the rather strict prudential regulation and supervision in force from 1986; it shows how beneficial has been the capacity of the authorities to resist the forceful and repeated demands to relax regulations. However, the Chilean experience shows that prudential counter-cyclical regulation is essential, but not enough to avoid the recessive impact of external shocks. First, there is usually a sudden stop of access to credit for In 1998–9, pension funds and residents investing abroad (the so-called chapter XII) were the main determinants of international reserve losses, and of the sharp recessive adjustment of domestic demand (Ffrench-Davis and Tapia, 2001). See Zahler (2006) for an excellent analysis of pension funds’ macroeconomic implications. 5 Effective demand is understood as that part of aggregate or domestic demand that falls on domestic output plus the demand for domestic output by foreigners (the value-added to GDP by exports).

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small and medium enterprises; second, a growing share of resources are channeled outside the formal financial system; third, beyond the quality of prudential supervision, macroeconomic imbalances that abruptly end in massive devaluations, the emergence of very high interest rates, and bubbles in stock markets and real estate can suddenly deteriorate the banking portfolio. Sustainable macroeconomic balances are an unavoidable partner of sustainable (counter-cyclical) prudential regulation and supervision. In the particular analysis of the 1999 recession, there is a series of variables that explain the benign evolution of non-performing portfolios in domestic banks, beyond the new regulation and supervision established after the 1982–3 crisis. Additionally, the management of capital flows had contributed to moderate indebtedness of banks and firms up to the mid-1990s. The effect of excessive inflows in 1996–7 was compensated by the central bank’s delay in correcting the exchange rate, because it gave time to large debtors to reduce their dollar liabilities with a cheap dollar; naturally, at the expense of the central bank balance. SMEs (which operate mainly in national currency) suffered a drier financial market, being proportionally more affected by the 1999 recessive gap; the negative impact on SMEs explains part of the weaker GDP performance from 1999.

3 The recessive phase, 1999–2003 During 1998 a long recessive adjustment began. Although from a short-run perspective the adjustment was very expensive, in a historical context the fall of 0.8% in 1999 was remarkably modest in comparison with 17 and 14% GDP drops in 1975 and 1982, respectively. Therefore, given the domestic and external conjuncture, what we have to explain is not why GDP fell in 1999, but why it decreased so mildly. The solid position of the domestic financial system has already been stressed. Despite the real macroeconom ic worsening recorded in 1996–8, the benefits of the active capital account regulation implemented in previous years had left high international reserves, reduced external liabilities, and a less volatile composition; moreover, the strict fiscal discipline implied a decreasing national debt and a strong fiscal surplus (2.1% of GDP) in the biennium before the Asian contagion. Consequently, now Chile was in a comparatively better situation to face the contagion of the Asian crisis. It can be argued, forcefully, that the sound fiscal performance helped to moderate the bust at the outset of the recession. Undoubtedly, that fiscal position contributes to moderate any financial crisis. Nevertheless, in 1981 the Treasury also had an exceptionally positive financial situation, and GDP fell by 14% in 1982. It follows that the depth of the recession, in both cases, was strongly associated with the macroeconomic environment and the accumulated imbalance in the private sector (see Marfán, 2005).

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Even though Chile underwent a comparatively smooth recession on this occasion, the economic and social costs were significant, with output losses around US$7 billion in 1999 (the gap between actual GDP and the productive frontier) and a persistent output gap during 1999–2003. Two consequences were (i) a high open unemployment rate (around 10% of the labor force) and (ii) a drop in the gross investment ratio averaging 3.2 points of GDP throughout those years with respect to 1996–8. Why was that moderate fall in 1999, in an economy with really sound fundamentals, followed by such a long recessive situation? Contrary to more fashionable views, a significant share of the explanation rests on step-backs in the quality of the macroeconomic approach. In fact, macroeconomic policies experienced significant reforms in subsequent years. By the early 2000s, the government and the authorities of the central bank decided on the conformation of a new macroeconomic framework including (i) a fiscal policy guided by a structural surplus rule (see section 6), which reinforced the responsible behavior of fiscal policy in the 1990s and a stable trend for public expenditure; in the opposite direction, the three other components shared pro-cyclical implications for economic activity: (ii) a monetary policy focused exclusively onn fulfilling the inflationary target (a range from 2 to 4% annually, though in a “long” horizon of 24 months), eliminating price indexing in monetary policy;6 (iii) full exchange rate flexibility; and (iv) full capital account liberalization. Consequently, most of the remaining capital account regulations were eliminated. In April 2001, the use of the URR (then with a 0% rate) was suspended, declaring that the full financial opening of the economy had been achieved.7 It is relevant to emphasize that a large recessive output gap then prevailed, resulting from a binding external constraint. Additionally, the regulations on pension fund outflows were increasingly relaxed. After the ceiling on investment abroad was raised, from 12 to 16% of total funds in January 1999 (in the middle of the crisis; see above Figure IX.1), it was augmented further to 20% in February 2002, to 25% in May 2003, and, in several other steps, had jumped to 60% by late 2009. Authorities stated that raising the ceiling would significantly increase the return for contributing workers. There was no concern, not even in 2008, about the disequilibria that were being built in international financial markets; neither was it considered that, if the channels were created in the 6 The bank had been using as monetary policy tool a rate indexed to the CPI (actually, to the Unidad de Fomento, UF). In 1999 it was replaced by a nominal interest rate, in the search for further reductions in inflation. In my view, the UF had been an extremely effective tool for generating some segments of long-term savings and lending. See Shiller (2008) for a strong similar view. 7 It must be noted that the policy tool of the reserve requirement is still available in the face of future capital surges if the authorities decide to make use of this countercyclical regulation.

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domestic capital market, those savings could generate higher returns in Chile than in more capital-intensive mature economies. In parallel with these policy changes, a large output gap still persisted in 2004–8.8 In 2000–3 potential GDP increased by about 4% annually, whereas actual GDP growth averaged 3.5%. Evidently, on every day that actual output grew less than 4%, it accumulated a larger gap; the opposite to what the policy sought, as real macroeconomic equilibrium mandated. Consequently, there arose two negative market adjustments: (i) part of the underutilized productive capacity became progressively destroyed and (ii) the generation of new capacity was weakened by depressed investment and innovation; in both adjustments, the SMEs and less trained workers were the greatest losers. As I have shown repeatedly, a significant gap between actual GDP and the production frontier is usually followed by a drop in productive investment. As in Mexico and Argentina in 1995, and Korea in 1998, in Chile the investment ratio diminished substantially, and in 2003 it was still three points below the 23% recorded in 1998. That was a consequence of an economy that, in spite of facing historically low real interest rates in 1999–2003, was working with a high output gap, averaging some 6% of GDP in 1999–2003 (see Table IX.1). That gap reflects a real imbalance, because the economy underutilized a significant share of the available productive resources. As shown, the larger the recessive gap, the larger the drop experienced by investment ratios. Further, a lower investment ratio affects the future growth of potential GDP and the quality of the labor market. In fact, the output gap together with the depressed investment ratio also had a deepening impact on labor markets. In the five and a half years in the period from mid-1998 to 2003, employment (including special programs financed by the government) grew by barely 3.3%, while the population aged eighteen or over increased by 9%. A main determining variable of the labor market worsening was the macroeconomic imbalance as I have defined it here: the high gap between actual and potential GDP, which implied underutilization of labor and capital in that recessive period, and discouragement of additions to the stock of capital. These factors moved the Chilean economy away from the 7% annual rate of expansion in the nineties (for both actual and potential GDP), downgrading it to the 4% plateau during the first half of the 2000s. Nevertheless, the sound macroeconomic foundations of previous years allowed the authorities, with political decisiveness, to intensify advances in 8 Vulnerability to external shocks remains a severe problem for emerging economies. The drop in 1998–9 as well as the ephemeral recovery of 2000 and the recession in 2001–3 involved the majority of LACs population. As is well known, there has been a significant convergence of policy approaches in Latin America towards the macroeconomics of “two pillars,” successful in obtaining low inflation and fiscal responsibility, but failing with respect to growth and equity.

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social expenditure during the recessive years. A comprehensive program to support the poorest households (Chile Solidario) was created, and an ambitious health reform (AUGE) started up. This was possible, partly, thanks to the new scheme of structural fiscal budget, which avoided pro-cyclical fiscal reactions in those recessive years. In this way, the government could implement new focused social programs that allowed a continuation of poverty reduction (the number of poor people fell to 19% of the population in 2003) in spite of the recessive environment. Since in 1999 it became increasingly evident that the macroeconomic pull from abroad, expected by the authorities, would be delayed, I argued that a domestic shock should be implemented, taking advantage of all the accumulated strengths of the Chilean economy: (i) a fiscal rule of structural balance, which implies restraining expenditure increases in boom periods, and should be able to accelerate them during busts; (ii) a moderate total external debt, with a low share of short-term liabilities; (iii) a central bank without external liabilities and with high international reserves (free of mortgages); (iv) a government with a minimum debt and ordered fiscal accounts, with an actual surplus of 1.9% of GDP (average 1990–8); (v) a low actual and underlying inflation rate, persistently below the center of the inflation band;9 and (vi) a private sector able to produce around 5–7% more than it was producing in those years. Thus, there were enough conditions to generate a reactivating domestic shock in the private sector, since, additionally, the real exchange rate appreciation and the excessive external deficit of 1998 had already been corrected in 1999. In fact, it was already known that a positive domestic shock, spurred by the government through monetary and fiscal policies, had been highly successful in Korea and Malaysia, under a similar recessive situation and rather similar macroeconomic features (see Mahani et al., 2006): after the abrupt GDP fall in 1998, both Asian nations experienced a sharp recovery in 1999, led by their decision to correct the real macroeconomic imbalance. In contrast, national economic authorities rejected the proposal of a reactivating domestic shock, arguing that financial markets would negatively evaluate that action and, therefore, would worsen risk ratings and raise the spreads charged to Chile. The negative impact of this, they argued, would be greater than the positive effect of the reactivating domestic shock. Most business press and opposition politicians supported and praised the official approach. Moreover, they criticized, though mildly, the actual fiscal deficit resulting from the implementation of the structural 1% surplus. Fortunately, the government was able to sustain the structural principle adopted formally in 2001, and thus progressed from a pro-cyclical fiscal policy to a neutral 9

Annual CPI inflation averaged 2.2% in 2001–4, below the 3% center of the 2–4% band.

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one, by maintaining the trend of expenditure notwithstanding drops in revenue during recessive situations. It failed to move beyond this, towards a strong counter-cyclical increase in expenditure.10 While it was estimated by a committee of experts that potential GDP was increasing by around 4% (see section 6), actual GDP rose by just 2.6% during the quinquenium 1999–2003; a poor performance, but better than the 1.3% recorded by Latin America overall. Unfortunately, the fact is that recovery only arrived in 2004, led by a positive external shock via export prices. The evident lesson was that the stepback experienced in the quality of macroeconomic policy must be corrected to achieve sustained growth with equity. The uncorrected policy failures once again exerted negative effects from 2006 (see section 5).

4 Dynamic recovery in 2004–5 Through 2003, international markets provided a significant improvement in commodities prices and trade volume, which implied a strong positive external shock in economies intensive in the production of natural resources. In fact, Chile benefited from a remarkable increase in its terms of trade, equivalent to roughly 10% of GDP between the recessive 1999–2003 period and the dynamic 2004–5; a significant share was retained abroad as profits of FDI exporters. But, in all, there was a sizable improvement for local exporters and the public sector. This positive exogenous shock raised aggregate demand and, with it, the average growth rate of actual GDP from 2.6% in 1999–2003 to 5.8% in 2004–5. Since potential GDP was moving around a 4% plateau in these years, with that 5.8% actual growth a significant reduction of the output gap was recorded (the gap fell by around 3–4 points of GDP). The fact that the 2004–5 actual rate of growth doubled the average of 1999–2003, without any change in structural variables, was a robust proof that the output gap prevailing since 1999 was mainly a macroeconomic failure, which was relaxed with the positive external shock. As shown, the domestic failure was not in fiscal policy, but was placed, principally, in the wrong signals provided by the central bank to the private sector. Chile had in those years, after having corrected the excessive external deficit and the appreciated exchange rate, all the objective conditions to carry out by itself the positive shocks required to offset negative external shocks suffered from 1998. That would also have changed the negative expectations. Naturally, the intensity of recovery was also based on the merits accumulated by the Chilean economy in the preceding years, but the predominant 10 There was a relevant expansive action through the emergency employment programs. This and some other counter-cyclical expenditures are reflected in the fact that the structural fiscal surplus averaged 0.65% of GDP in 2002–3, below the 1% target.

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force was the positive external shock.11 This reveals a macroeconomic weakness (in domestic policies as well as in the international financial architecture), since those merits were already present during the 1999–2003 recessive situation. Along with economic recovery, though with a lag, the investment ratio started to rise vigorously. The fiscal structural rule continued in force. The actual deficit of 0.7% in 2001–3 moved to a huge 4.6% surplus in 2005. The main determinant of such an outcome was a notable jump in the price of copper (see Figure IX.2). The outstanding increase of the actual price implied increasing profits for CODELCO (the public copper firm) and taxes paid by private copper producers, both enlarging the revenue collected by the Ministry of Finance. The Treasury continued to keep in action a Copper Stabilization Fund of proceeds from CODELCO, which was a natural counterpart of the structural fiscal rule; in 2005, the fund accumulated the equivalent of the gap between the actual average price of 167 cents per pound and the estimated trend price of 93 cents of sales by CODELCO.12 The Treasury was, rapidly, passing from debtor to creditor of the nation and of the world. 500 Actual copper price

450

Trend copper price

Committee

400 350 300 250 200 150 100 50 2009

2007

2005

2003

2001

1999

1995

1997

1993

1989

1991

1987

1985

1983

1981

1977

1979

1975

1973

1971

1969

1967

1963

1965

1961

1959

0

Figure IX.2 Real copper price, actual and trend, 1959–2009 (2009 US$/lb). Source: Calculations based on Ffrench-Davis and Tironi (1974), central bank and Budget Office figures. The long-term trend series is estimated with a Hodrick–Prescott filter (lambda ⫽ 100) until 2000; in order to avoid the end-of-sample bias of the filter, from 2001 to 2009 the annual average growth rate (4.4%) of the real price between the actual price in 2000 (2009 US$1.30 per pound) and the trend price reported by the Committee for 2009 (2009 US$1.99) is used. 11

It must be emphasized that similar positive external shocks allowed the average GDP growth rate of Latin America to jump from 1.3% (1999–2003) to 5.6% (2004–7). 12 Estimate in 2004 for the structural budget of 2005, made by the Copper Price Committee, an independent pluralistic counsel of the Minister of Finance. The estimate in 2006 for the budget of 2007 was 121 cents per pound of copper. The structural

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Naturally, generalized improved terms of trade and fast rising volumes of exports enhanced, directly, the spending capacity of the private sector, and expectations returned to optimism. Given a large output gap by the start of the positive external shock, domestic supply was able to respond with a rising GDP and low inflation pressures (within a target band of 2–4% set by the autonomous central bank). In the meantime, the bank allowed the real exchange rate to appreciate by 20% between March 2003 and December 2005, reinforcing an increase in aggregate demand, despite the gradual rise in the interest rate and the oil price. But, given a significant appreciation, aggregate demand became increasingly import-intensive.

5 Deceleration from 2006 By late 2005, a generalized optimism was reflected in expectations of continued growth of actual GDP around the 6% plateau. Estimates of potential GDP dynamism were rising, supported by a significant increase in the investment ratio. Improved expectations of businesses, after the customary lag, were responding to the relevant reduction that had been exhibited by the output gap, and the prospect that the dynamism of economic activity was to be sustained. However, after the recovery experienced in 2004–5 came a period in which actual GDP has persistently grown below the expansion of potential GDP, even placing the Chilean economy below the average speed of Latin America, thus losing the lead that it had held in the region since the late 1980s. It is true that by 2008 Chile still exhibited a much better record since 1990, with the average 5.3% vis-à-vis the 3.2% of LACs, but in the margin (2004–8) it was losing ground as documented below. Different explanations have emerged, such as (i) the arrival at maturity, (ii) the increased obstacles to growth set by the government and the lack of more neoliberal reforms, (iii) a lack of heterodox reforms, and (iv) failures in the macroeconomic approach. By late 2005, consensus expectations for growth in 2006 were perfectly feasible.13 However, after a strong start, economic activity lost momentum. In all, instead of the output gap being reduced by about 1% of GDP it was increased by a similar figure. That implied employment, wages, and profits that were lost forever; additionally, some uncertainty was reintroduced to entrepreneurs’ minds, particularly exporters and small entrepreneurs, and optimism was weakened. or trend estimate in 2008 for the 2009 budget (at the 2009 price level) was 199 cents. See Table IX.3. 13 In July 2005, within the framework of the trend GDP estimation for the structural fiscal balance, an output gap of 1.7% was reported by the Ministry of Finance for that year. If the gap is calculated under the concept of potential GDP, the recessive gap rises to around 4–5% (see Chapter I, Annex).

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It cannot be argued that the slowing could be explained by having reached maturity. Indeed, the Chilean per capita GDP (at PPP), in spite of the progress achieved in the past two decades, reached merely one-third of the level of the USA. A weak performance in recent years – especially given the spectacular terms of trade that Chile was facing – was the result of a complex combination of macroeconomic and microeconomic features, and a lack of long-term perspective. The conventional interpretation of most of the opposition was that the government had put a brake upon the economy with red-tape bureaucratism and a lack of additional privatizations; particularly, it was stressed, those of CODELCO and of Banco Estado (the commercial public bank). With respect to the privatizations requested by the opposition, CODELCO has provided huge income to the Treasury, especially in the period to be explained, while Banco Estado played, among domestic financial institutions, the main countercyclical role during the 2009 recession, particularly lending to SMEs. With respect to bureaucratism, obstacles to entrepreneurship, and so on are a real challenge on the road to the development of Chile. But (i) Chile fares reasonably well in international comparisons of developing economies, and (ii) the structural and bureaucratic environment for entrepreneurship and innovation was not notably different to 2004–5 when growth was significant, and even, I would say, rather similar to that of the golden period of the 1990s. Something rather similar or somewhat worse cannot explain a sharp worsening of the dependent variable. The available information shows that the main causes of this lost dynamism since 2006 (beyond particular situations in the mining and energy sectors)14 are not a lot of new micro-restrictions or “bottlenecks” imposed by the government, but mainly failures in two strategic areas, and a set of specific situations to which I turn later. One area refers to variables affecting the macroeconomic environment and depressing the expectations and dynamism of both private and public economic agents; actual total factor productivity (TFP) suffers with underutilization of installed capacity. The second strategic area relates to the economic development agenda, which, notwithstanding recent progress in innovation policies, has been weak and hesitant; innovation and, consequently, structural TFP suffers. (a) The macroeconomic environment I have argued that macroeconomic failures have been at the heart of the worsened performance of the economy after the golden years. The case is illustrated with an analysis of 2006. I believe that 2006 was a crucial year for consolidating creative expectations. I summarize the depressing role of four

14

Such as a strike in the copper mine La Escondida, a landslide in the main mine of CODELCO (Chuquicamata), and shortages in natural gas supply from Argentina.

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policy variables that contribute to explain why the impulse was weakened instead of strengthened: 1 A premature upward adjustment of the interest rate by the central bank, mainly during 2005 and 2006. Inflation had risen from a 1% average in 2004 (below the 2–4% band set by the central bank) to 4% in 2005 (in the upper border of the band). The bank overreacted, bringing down inflation, by late 2006, below the center of the band. Inflation (both total and core inflation) was restrained at the expense of economic recovery, with a strong imbalance between economic policy objectives.15 2 An excessive exchange rate appreciation and its negative impact on tradable production, as is demonstrated by a sizable increase in imports and a decreased demand for domestic output. As Figure IX.4 exhibits, the increase in the quantum of imports had been notably larger than that of exports since 2004. Exchange rate appreciation and the reduction of the actual tariff paid by importers explain why domestic demand became much more import-intensive in 2006;16 I re-examine this issue below. In fact, in that year domestic demand expanded by 6.4%, but since the import quantum grew by 10.5%, the local demand for domestic output only involved a 3.6% rise.17 Again, there was a severe inconsistency between the current exchange rate policy and the consensus objective of fostering exports with higher value-added. 3 The authorities sterilized a substantial share of the expansive effect of the high copper price; meanwhile most of the recessive impact of a higher oil price was allowed to operate. Naturally, the higher oil price, which averaged US$56 and 66 per barrel in 2005 and 2006, respectively, caught an increasing share of the Chilean budgets. Part of the copper revenues should have been used to compensate for that effect; for instance, by 15 The core CPI, which excludes oil and perishable food, in December 2006 exhibited an annual inflation of 2.6%. That is, below the center of the 2–4% target. In the course of 2006, nevertheless, the core CPI moved close to the ceiling of the band, but during 1999–2004 it was usually below the center. 16 In 2002, imports from Korea, Europe, and the United States faced a uniform tariff of 7%. The actual average tariff paid by all imports was reduced from 3.8% in January 2003 to 1.6% in 2006. The positive counterpart for national production is that the lower tariff reduces the production costs of exports, and tariff preferences with partner countries facilitate sales abroad. Exports continued leading GDP growth with a 7.6% rate in 2004–6. Nevertheless, a decreasing trend is observed (13.3% in 2004; 4.3% in 2005; 5.1% in 2006), because of some particular problems and likely due to the cumulative exchange rate appreciation and the elimination of the subsidy to nontraditional exports (see Chapter VI). 17 Notice that, as discussed in Chapter VI, part of imports is used to produce exports, so that they are re-exported. It must be kept in mind that GDP is the sum of the value-added of exports (which of course are sold abroad), and the rest of GDP (which is sold in the domestic market).

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subsidies to the public transportation of lower income population, by making an existing Oil Stabilization Fund work more effectively, or in a simple stabilizing adjustment (a transitory, not a permanent reduction) of the oil-specific tax.18 4 The insufficient power of the interesting structural fiscal balance policy, which advanced from pro-cyclicality to nearly neutrality, but without reaching strong counter-cyclicality (as argued in section 6). The stabilization of fiscal expenditure constitutes great progress, but is still insufficient as an input of the sector for macroeconomic stability. In order to improve the macroeconomic performance, Chile needs to carry out additional corrections with a more comprehensive approach. An evident correction would have been to revise the 2006 public budget, readjusting social and productive investment; either with a drop in the target of a 1% structural surplus or by re-estimating structural tax proceeds with a copper price of 121 cents (the revised estimate, in 2006, of the trend price). The economy was operating in 2006 as if the trend copper price were only 99 cents. This set of facts contributes to explain why the domestic economy grew at a slower pace during 2006, notwithstanding the positive external situation and the domestic output gap. During the next biennium, effective demand experienced several ups and downs, affecting the stability of economic activity; the significant effects of demand on the response of real supply (that is, actual GDP) reflected the fact that the Chilean economy was operating persistently below the production frontier. Evidently, in the years before the global crisis there was a complex international scenario. There were positive features for Chile, such as the spectacular price of copper and other large exports, which allowed the Treasury, with great responsibility, to accumulate sizable funds for eventual bad years (or awful years such as 2009); fiscal surpluses jumped further to an annual average exceeding 7% of GDP in 2006–8. Moreover, the world trade volume was dynamic until the arrival of the international financial crisis. On the negative side for Chile, international prices of oil and food were climbing. From mid2007 to mid-2008, the price of food in the Chilean CPI increased by 22%, which generated significant inflationary pressures, explaining about half of the nearly 10% annual inflation recorded at the peak of the commodities boom (by the third quarter of 2008; see Ramos, 2008). It was, mainly, an imported inflation. Of course, Chile was not the only importer, since it became a public bad available to all open economies. The central bank consistently expressed 18

The oil tax is clearly a progressive one from a distributive perspective, and is environmentally friendly. I strongly support heavy taxes on fuels for environmental and distributive reasons. From a macroeconomic perspective, the negative impact of the increased price of oil should have been compensated for with additional fiscal expenditure financed with a fraction of the copper proceeds.

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its bias for the inflation target, at the expense of growth. By late 2008, when Chile was already exhibiting negative monthly inflation, the monetary policy interest rate (8.25%) exceeded by over 7 points that of the USA. When the contagion of the global crisis arrived, the government made intensive use of the tools at hand, principally the stabilization fund, which provides ample room for counter-cyclical fiscal policy. Notwithstanding a drop in tax revenue resulting from a depressed demand, some taxes were reduced transitorily (on fuels, credits, SMEs); tax revenue would have fallen 23% in 2009. In parallel, expenditure increased 18%, which implied a 4.5% actual fiscal deficit. The strong counter-cyclical fiscal policy, based on the official structural policy (see section 6a), was the main force compensating for the negative shocks, principally that on the volume of exports. In fact, the volume of Chilean exports, which had risen by 7.9% in the previous two decades, dived 5.6% in 2009. Fiscal policy softened to a significant degree the multiplication to the domestic market of the shock on exports. The domestic economy only contracted by 1.1% (see Chapter VI, Table VI.6). For the first time since the opening of the economy, which started in 1973, the recessive adjustment in the face of external shocks was stronger on exports than on the domestic economy. Counter-cyclicality of fiscal policy was effective and efficient in 2009. But returning to 2008, before the arrival of the global crisis, in all, as said, during the previous boom period growth was moderate, not bad, but came after five years of significant recession (average growth of 2.6%); then, naturally, there was a recessive gap waiting to go into production, which allowed “an easy stage for recovery.” Thus, the record is low compared with the potentiality of the domestic economy and the huge positive external shocks. Additionally, it is noticeable that the Chilean economy grew by less than the average of Latin America during the long international boom from 2004 to 2008. The economic growth of Latin America averaged 5.3% in those years, while Chile recorded a 4.9% growth. This rise of GDP was determined by a 6.6% expansion of exports and 4.2% of the rest of GDP. This moderate figure contrasts sharply with the 6.5% dynamic growth of non-exports in 1990–8 (see Chapter VI, Table VI.6). Systemic competitivity was failing. The failure was associated with the second variable underlying the weak economic performance: a weak and hesitant development agenda. The arrival of the global crisis, with its new recessive impact, reinforces the need to review past experiences and to introduce corrections to the development strategy. The 1.5% drop of economic activity in 2009, again provides room for “an easy stage for recovery” during 2010, and room for introducing pro-development reforms. (b) The development agenda Economic growth has slowed, but the social agenda has been particularly innovative and has contributed to a more inclusive development.

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Chile made ambitious social reforms in this period. As detailed in Chapter VII, pensions and health were substantially improved, unemployment insurance, initially mostly a self-insurance, was strengthened with a meaningful solidarity pillar, care of children has expanded powerfully, the extreme poor are better taken care of with Chile Solidario, the quality of housing for poor and medium-low segments has risen and the subsidies are more generous, and subsidies for the hiring of young workers have been established. The social agenda has been quite powerful, well designed, and transparent. But the strong social agenda was not well matched by the economic agenda. Evidently, there has been progress in several areas. But a rather poor economic outcome in the second decade is what needs an explanation and not the success in the first decade. The poor outcome is mostly explained, I believe, by significant shortcomings. My view is that these shortcomings had a relevant influence in the defeat of Concertación Democrática in the recent presidential (January 2010) and parliamentarian elections. But political analysis is beyond the reach of this book. There is consensus that fiscal responsibility was outstanding, but structural progressive reforms (as well as macroeconomic management, as shown) were weak and somewhat contradictory to the introduction of equitability in the market behavior. The latter required deep reforms in the capital markets, away from the priority for the overnight markets and moving decidedly towards enhancing the long-term market segment; developing segments for SMEs and for entrepreneurs without wealth or history.19 Further, incentives to innovation were weak, even though they have been taking relevant shape only recently.20 Labor training for untrained workers has been improving but too mildly. The sharp increase in the number of years of education have been associated with lowered quality, which demands even more effective labor training for the workers that have suffered that faltering quality. There appears to be a growing shortage of more trained workers and entrepreneurs, in an economy that has doubled GDP per capita, and whose requirements for growth are now more demanding. In brief, Chile missed, to a significant degree after the promising start in the early 1990s, what I call taking the road that leads from financierism to productivism.

19

There have been several reforms of the capital markets, which have improved access to financing for SMEs and microcredit. However, the market is still intensive in shortterm and liquid dealings and remains quite limited for SMEs. The Counsel on Equity designated by President Bachelet (Consejo Trabajo y Equidad, 2008) stressed its concern for the incompleteness of capital markets and their regressive biases. 20 In 2008 it was decided to focus the allocation of the proceeds of a royalty recently established on mining to a selected group of clusters. It represented a sharp, and encouraging, deviation from allocative neutrality. See Benavente (2005) and Consejo Nacional para la Innovación (2007) for substantive analyses of the challenges faced by Chile and alternatives for action.

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Table IX.2 Gross investment and depreciation, 1995–2009 (% of GDP at constant 2003 prices)

1995–8 2006–9

Gross fixed investment (1)

Depreciation (2)

Net capital formation (3) ⴝ (1) ⴚ (2)

22.8 26.0

7.2 10.6

15.6 15.4

Sources: Based on National Accounts of the central bank and Data Base for the Trend GDP Committee, Ministry of Finance, August 2009.

(c) Some specific situations It is interesting that gross capital formation, as measured in constant prices by the National Accounts, had risen substantially. National accounts identified a sizable drop in the price in pesos of capital goods that are mostly imported; exchange rate appreciation plus drops in international prices underlie that performance. Consequently, a given level of domestic savings could purchase a sizably larger volume of capital goods. The gross investment ratio reached record levels in 2005–9. Why was the higher ratio generating lower potential GDP growth? There are some robust and some tentative explanations. First, it is customary to look at gross investment figures, while what are relevant are the net figures. Table IX.2 presents data on gross fixed investment, depreciation of capital, and net fixed investment, in constant prices, as a share of GDP. Two subperiods with peak gross ratios are compared: 1995–8 and 2006–9, with a rise in the gross ratio of over 3 points of GDP. However, depreciation of capital also experienced a sharp rise, from 7.2% of GDP to 10.6%. Thus, in net terms, the rise of the ratio becomes negligible. But, still, why is a similar ratio associated with a lower GDP growth? Additional explanatory variables are the sudden problems experienced in the supply of energy that affected the productivity of some energy-intensive installed capacity (see Central Bank, 2009), an increase in “green” environmentally friendly investment that tends to increase the cost of projects, and investment in protection from personal insecurity (an unfortunate world trend related to inequality and reduced space for social integration).

6 Two relevant issues: the structural fiscal balance and the exchange rate (a) Improving the structural fiscal balance21 As part of a counter-cyclical policy package, the concept of structural fiscal balance (SFB) is an outstanding fiscal component. There are different varieties 21 In Marcel et al. (2001) the basic features of the Chilean rule are exposed. Tapia (2003) develops an analysis of the macroeconomic implications and proposes a

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of SFB, but the essential component is the measurement of the balance across the business cycle, estimating at each point of time what would be the public income and spending in a framework of sustainable full employment of human and physical capital; that is, in simple terms, an economy making full use of potential GDP (GDP*). If terms of trade fluctuations are relevant for fiscal proceeds – via profits of public companies or taxes paid by private exporters – the purchasing power of GDP* should be estimated at the trend terms of trade. Given a tax burden, those two trends must guide the sustainable path of public expenditure. The fiscal instruments used to implement counter-cyclical policies must be pragmatically chosen (see Stiglitz et al., 2006). During booms, for example, a reduction in public expenditure will probably be insufficient to compensate for an excess of of the private sector expenditure led by capital inflows. An increase in taxes, instead, can directly affect agents with a higher propensity to spend and spread its effects across the different sectors of the economy. During an economic downturn, a tax relief may be ineffective under a depressed macroeconomic environment and a private sector reluctant to consume and invest. Public expenditures in non-exportables can, in this latter case, be a more effective instrument – for instance, by accelerating public works if unemployment in the sector is high. Fiscal policy ought to be part of a flexible policy package. Given that emerging economies are especially vulnerable to global economic downturns, overreliance on monetary policy may bring poorer macro results, as compared to a more balanced framework of counter-cyclical fiscal, exchange rate, and monetary policy, as well as prudential regulation of capital flows. The use of counter-cyclical fiscal policy needs as a convenient precondition to be on a path of solvent and sustainable fiscal accounts. The government of President Lagos implemented, in 2001, a formal fiscal rule that operates within the concept of structural balance. Conceptually, the structural balance methodology isolates the impact of the business cycle on public finances, providing a long-term picture of the fiscal situation in terms of both income and spending. It consists of maintaining in each annual budget a level of fiscal expenditure consistent with revenues collected as if the economy were making “normal” use of the productive capacity (an estimate of a “trend” GDP) and the copper price were at its long-term level. Therefore, when the economy is overheated, the government naturally collects a larger than “normal” (to be defined below) tax revenue, but it does not increase expenditure, thus accumulating savings; and in periods of bust, the government uses those savings (or borrows) to cover depressed series of adjustments to improve its effective counter-cyclicality. Recent important adjustments are presented in DIPRES (2007) and Velasco et al. (2010). The issue is further discussed in Ffrench-Davis (2010); the research support of Rodrigo Heresi was crucial in this publication.

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tax revenue resulting from the slower economic activity; thus it maintains the trend of expenditure. This rule implies relevant conceptual progress in fiscal and macroeconomic management, with respect to the standard policy recipe in which expenditure follows economic cycles. It is a significant improvement with respect to the pro-cyclical traditional norm that seeks to balance the actual fiscal budget each year. Given the strong volatility of international trade and financial markets, the standard neoliberal recipe is highly pro-cyclical. The use of the new fiscal framework requires estimating several key structural variables, among them (i) the trend GDP growth rate and (ii) the longterm price of copper. The estimation of both parameters is made with inputs provided by two independent committees of experts on an annual basis. The definitions of the key parameters and assumptions have been made increasingly transparent, the disclosure of information to the public has been improved, and the methodology has been refined. Table IX.3 shows the evolution of key fiscal indicators. Evidently, fiscal responsibility was not a novelty in Chile when this framework was started in 2001. The nearly 2% average surplus in the 1990s, following the return to democracy in 1990, testify to it. The concept of trend copper price was also already operative, with a copper stabilization fund at work for over a decade, and a significant precedent established successfully in the 1960s, though dismissed since the 1970s. But, in this case, the formal launching of the stabilization approach was quite useful for the quality of policy, including interesting features, such as the creation of committees of independent experts to estimate the trend price of copper and inputs for trend GDP, when Chile was facing a recessive gap from 1999. In fact, the formal adoption of the structural balance took place in a context of a depressed economy, the macroeconomic need for an actual fiscal deficit, and the assumption of a new president from a leftist party. The formal and well advertised launching was an opportune and efficient step from an economic and political perspective. In August 2006, the structural rule and fiscal policy that previously depended exclusively on administrative decisions and political will were institutionalized. The new law, the Fiscal Responsibility Law, reinforced both the credibility and the transparency of fiscal policy. This positive fiscal rule was accompanied by certain features that are not intrinsic to it, but options in its implementation. Here, I mention three: (i) the level at which the structural balance is targeted; (ii) the degree of counter-cyclicality; and (iii) the definition of potential GDP (GDP*) or trend GDP. First, a key feature was the level at which the structural balance is targeted. During the first years, a structural surplus target equivalent to 1% of GDP was set with the aim of ensuring the accumulation of assets with which to reduce the liabilities inherited from the debt crisis in the 1980s, and meet future public sector commitments, including particularly the contingent

258

Table IX.3 Fiscal indicators, 2001–9

GDP growth (%) Trend GDP growth (%) Current copper price (US$/Lb) Trend copper price (US$/Lb) Fiscal balance (% of GDP) current Structural fiscal balance (% of GDP) current Fiscal income growth (%) constant 2008a Fiscal expenditure growth (%) constant 2008a Fiscal income (% of GDP) current Fiscal income (% of trend GDP) current Fiscal expenditure (% of GDP) current Fiscal expenditure (% of trend GDP) current

2001

2002

2003

2004

2005

2006

2007

2008

2009

3.4 4.1 71.5 90.3 –0.5 1.0 4.1 3.6 21.7 21.2 22.2 21.7

2.2 3.9 70.7 91.2 –1.2 0.6 0.8 4.2 21.1 20.2 22.3 21.4

3.9 4.0 80.7 88.0 –0.4 0.7 5.3 1.6 20.7 19.8 21.2 20.3

6.0 4.2 130.0 88.0 2.1 1.0 20.0 6.1 22.0 21.5 19.9 19.4

5.6 4.9 166.9 93.0 4.6 1.0 19.1 6.6 23.8 23.4 19.3 18.9

4.6 5.0 304.9 99.0 7.7 1.0 23.1 6.9 25.9 25.3 18.2 17.8

4.6 5.3 322.9 121.0 8.8 1.0 12.3 8.7 27.5 26.7 18.7 18.2

3.7 5.0 315.5 137.0 5.3 0.7 –8.3 8.0 26.5 25.3 21.2 20.3

–1.5 4.9 232.4 199.0 –4.5 –0.9 –23.2 17.8 20.5 18.2 25.1 22.2

Sources: DIPRES ( January 29, 2010) and Velasco et al. (2010). The estimates in each year of the trend variables for the next budget year have been used here. For 2005 the official estimate of the output gap was 1.7% of trend GDP. Potential GDP implied an output gap of 4.6% a Deflated by the CPI which, sometimes, notably differs from the implicit deflator of GDP.

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liabilities generated by the public guarantee for a minimum pension. In addition, another argument for maintaining a structural surplus was the structural operating deficit of the central bank of Chile, as a result of losses arising from the bailout of the private banking system during the 1980s. After some years of strong fiscal savings owing to the persistent boom in commodity prices, the Treasury became a net creditor to the rest of the world, with growing stabilization funds. By late 2008, the Economic and Social Stabilization Fund (the successor of the Copper Buffer Fund) and the Pension Reserve Fund had accumulated the equivalent of 18% of GDP, while fiscal liabilities were negligible, after the significant amortizations made with the previous surpluses of the fiscal balance. The socially profitable allocation for that 1% of GDP was to finance social investments and productive development, such as better quality education, training for workers and small entrepreneurs, innovation support, regional infrastructure improvements, and incentives for long-term financing of SMEs and new entrepreneurs. All these items were needed to secure faster development convergence with rich nations. Thus, it did not made sense any more to continue accumulating money year after year in a country with social needs that were still high.22 Consistently, the structural surplus target for 2008 was reduced to 0.5% of GDP. The contagion of the global crisis led to further reduce the balance targeted to 0% in 2009. In parallel, Chile moved sharply from the rather cyclically neutral approach to a strong counter-cyclical one. In 2009, it reached a 0.9% structural fiscal deficit and a 4.5% measured deficit, with an 18% rise in expenditure. Second, the structural rule allowed the maintenance of a level of expenditure consistent with medium-term trends (estimated or, as to be shown, rather underestimated) of GDP. This was very positive in the context of the recessive gap in 2001–3 and 2009, under depressed fiscal revenue. A structural surplus was consistent with an actual deficit in those years. In contrast to the neoliberal recipe, it implied sustaining fiscal expenditure in spite of a depressed GDP, but it did not consider increasing expenditure to offset recession. Consequently, it implied a fiscal policy that was rather neutral with respect to the economic cycle, but fell short of being properly countercyclical. Nonetheless, some counter-cyclical spending was carried out, principally in the form of emergency employment programs. The Anti-unemployment Contingency Program, which previously required annual approval under the 22 Given that terms of trade shocks have been strong, the stabilization fund should take care of stabilizing fiscal expenditure as well as the supply of foreign currency. To achieve the twin counter-cyclical targets, the effective coordination of the Ministry of Finance and the central bank becomes essential. While the stability of fiscal expenditure has been exemplary, that of the exchange rate has failed.

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budget law, became permanent, with the Fiscal Responsibility Law establishing its objective, conditions and financing. The instrument is available at national, regional, or local levels. The program can be activated whenever the conditions established by the law are met: in this case, when the national three-month rolling average unemployment rate, measured by the National Statistics Institute (INE), exceeds its average for the previous five months, or when it reaches at least 10% of the labor force (DIPRES, 2007). In order to progress towards a more efficient macroeconomic policy, it is necessary to go further beyond neutrality. It must advance decisively towards a counter-cyclical approach, what has been done in 2009, under the challenge of the global crisis in process (in fact, the estimated structural balance for 2009 is a deficit of 0.9% of GDP; see DIPRES, 2010). An effective counter-cyclical fiscal approach would involve anticipating public expenses in recessive situations such as that in 1999–2003, and transitorily reducing some taxes, such as VAT or social security contributions. And vice versa, in overheated situations such as in 1989. This would imply a move towards effectively counter-cyclical taxes and expenditure. The doses of each component should be associated with the expected effectiveness of tax changes vis-à-vis expenditure changes, and perceived shortages or excesses in each of them. Given the low tax burden in Chile (18% of GDP) and the insufficiency of investment in public works, education, and innovation, an asymmetrical treatment would be recommended: increase public investment in recessions and raise taxes in booms.23 Third, the definition of the concept of “potential GDP” is essential for implementing an approach of structural fiscal balance. It can be defined as a production frontier or GDP* or as trend GDP (GDPt). The former is defined as the maximum sustainable level of production by the economy; in volatile economies there usually is a significant average output gap between GDP* and actual GDP, where the latter is usually below GDP*. In fact, in unstable economies, actual GDP can be sharply below GDP*, while only exceptionally can it be above it; this is quite a relevant asymmetry for macroeconomic policies. GDPt can be defined as the level of production consistent with a “normal” use (in statistical terms) of productive inputs; that is, the trend value or permanent component of actual GDP, which implies symmetrical positive and negative gaps. Then, the central question is what concept is the relevant one for calculating the structural fiscal accounts: maximum attainable or trend output? The methodology of the Ministry of Finance made an explicit option in favor of the trend GDP concept. The arguments are, first, that GDPt is the most 23

A related subject is that of the tax burden and its composition. On this matter, two high-priority problems, presently, are the need to dismantle regressive tax exemptions and combat tax evasion and avoidance; this requires clear messages to taxpayers that there is a growingly transparent and efficient use of tax revenue.

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standard methodology used by “the profession,” and the feature of symmetry between positive and negative gaps is assumed to maximize transparency and diminish risks of lack of credibility.24 Estimates of GDPt evidently, usually, include the sharp recessions suffered by the Chilean economy. As a consequence, it is obvious that, in this economy, average GDPt moves well below GDP* or productive frontier, thus providing biased information for counter-cyclical macroeconomic policies. Consequently, the main disadvantage of using the trend measure is the weakening of counter-cyclical policies. In practice, economic cycles are not symmetrical from the point of view of the duration and intensity of booms and busts; moreover, as said, they are not symmetrical with respect to the production frontier. Thus, although statistically a trend of recent history can be obtained, it frequently does not reflect a state of “normality.” Actually, if macroeconomic policy seeks to reach GDPt and to stop there, that involves maintaining an output gap with respect to GDP* that discourages capital formation. On the other hand, if the economy falls below the estimated trend for a relatively long period, the trend growth rate itself would tend to fall further, implying a spurious reduction in the output gap (a “lowering the bar” effect), and, therefore, a weakening of overall counter-cyclical policies. Thus, guiding monetary and fiscal policies according to GDPt instead of GDP* results in a “selffulfilled prophecy” that depresses the future productive frontier; Figure IX.3 shows clearly the downward adjustment in the trend GDP growth rate made by the committee, even before the global crisis, maintaining an output gap with respect to GDP* that discourages capital formation. But, naturally, it contributes to controlling inflation with greater force. Those policies should be reformed, in order to place economic activity closer to the level of potential GDP. Interestingly, year after year the authorities have made changes in the methodology used which have reduced partly the differences with GDP*. In summary, the Chilean fiscal policy has evolved in the past two decades to combine discipline, transparency, and macroeconomic management. Since 2001 there has been a rule that, in spite of several shortcomings (such as the insufficient intensity of counter-cyclical effects throughout its life), has served to avoid the standard pro-cyclical bias and give stability to public expenditure. As the concept of structural budget has gained credibility, it has been easier to introduce improvements and windows of discretion; for example, allowing for an unprecedented expansive, counter-cyclical, reaction to the 2009 crisis in a context of fiscal sustainability. Overall the Chilean experience shows the importance of the introduction of structural budgeting as a principle, and the value of learning in policymaking, 24

It is interesting that modal methodologies, with standard filters, like that of Hodrick–Prescott, use estimates for several future years in order to avoid the bias introduced by the “final years” of the historical series. Naturally, the future years are not responding to “purely objective” estimates.

262 Economic Policy after the 1999 Recession 5.4 5.2

2006 2007

5.0 4.8

2008

4.6 4.4

2009

4.2 4.0 3.8 3.6 2006

2007

2008

2009

3.4 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Figure IX.3 Trend GDP: annual review by Committee of Experts, 2006–9 (annual growth rate, %). Source: Based on Ministry of Finance data. Each year, with the new historical data and the forecasts for the following years by the Committee, the Ministry re-estimates the trend GDP for past and future years.

paying attention to local structural specificities. Key challenges for the future are a greater understanding and guiding principles to deal with the macroeconomic effect of fiscal policy on economic activity, prices, and the exchange rate determination. A particular problem is how to achieve a management of public savings that efficiently serves both short-term macroeconomic policy and long-term economic development. Progress in fiscal policy must be matched by enhanced counter-cyclical capacity in the management of aggregate demand and the exchange rate, which in recent years have become quite unstable in response to pro-cyclical capital flows. Chile had, in the 1990s, an outstanding and successful experience with counter-cyclical regulation of financial inflows and achievement of comprehensive real macroeconomic balances. It is time to consider its reinstallation for the sake of stronger sustained growth-with-equity. (b) Correcting the exchange rate policy The exchange rate is a macroprice whose evolution is extremely relevant for the efficient allocation of resources. The exchange rate regime, particularly after trade liberalization, has become an increasingly influential variable in emerging economies, for both trade and finance. It is subject to two conflicting demands. The first demand comes from trade: with the dismantling of traditional trade policies (tariff and non-tariff restrictions), the real exchange rate has become a key determinant of international competitiveness and a crucial variable for an efficient allocation of resources into tradables.

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Indeed, a “competitive” and stable real exchange rate is an input for sound trade development. A rather depreciated real exchange rate improves export competitiveness, and its stability favors productive investment in tradables and higher value-added activities. The positive connection between a competitive level of the real exchange rate and success in economic growth of EEs has been documented by Williamson (2000) and Rodrik (2007). It is noteworthy how the two extreme proposals in fashion (corner solutions) disregard these relevant analyses based on robust facts. The second demand is derived from an open capital account. Volatility in international financial and trade markets generates a demand for large fluctuations of the exchange rate so as to equilibrate the balance of payments in response to positive and negative shocks generated during the cycle. This objective frequently cannot be reconciled with the trade-related goals of exchange rate policy, because the equilibrium of the balance of payments uses to take place at the expense of disequilibrium of the current account. It becomes particularly detrimental for a growth strategy based on export expansion and diversification. Intermediate regimes of managed exchange rate flexibility – such as crawling pegs and bands, and dirty floating – attempt to reconcile these conflicting demands (see Williamson, 2000; Ffrench-Davis and Ocampo, 2001). The kind of flexibility of the exchange rate that we do get becomes crucial. From 1999, the central bank adopted a free exchange rate regime. The RER has fluctuated widely since then, with a pro-cyclical pattern detrimental for the efficient production of tradables, particularly for those intensive in value-added. Figure IX.I depicted the behavior of the RER in the 1990s (see also Chapter VIII, Figure VIII.1). Here the focus is on the more recent period. Notwithstanding the sharp sterilizing effect of the stabilization funds, the series of jumps in the price of copper (up from 60 cents per pound at a point in 2002 to 400 cents in 2008) generated a foreign exchange bubble for an artificially, outlier, strong peso. Between 2003 and early 2008 the exchange rate appreciated 24%; in parallel tariffs were approaching zero and the subsidy for non-traditional exports had disappeared. It was such an extreme appreciation that the central bank, even though it was strongly committed to a free rate, announced a program of purchases in the foreign exchange market that were effective in stopping the destabilizing trend and reverting it, soon assisted by the arrival of the contagion of the international crisis. The bank did not argue that the rate was an outlier and needed correction, but stated that it was just seeking to fortify international reserves in the face of rising uncertainty. After a significant depreciation up to late 2008, appreciation was resumed in 2009. By December 2009 the real exchange rate had appreciated by 16% with respect to late 2008. It was close to 8% below the RER in the golden period (1990–5), with average nominal tariffs reduced to 1% from 10% as well as

264 Economic Policy after the 1999 Recession

the elimination of the 10% subsidy to non-traditional exports. In the 1990s there was room for stabilizing appreciation, but in the 2000s that room has elapsed with a much stagnated productivity changes (TFP). As compensation, the trend price of copper is today much higher, which allowed the current account to be in balance in 2009 (see Figures IX.2 and IX.3). Instability has been the dominant feature in a country that supposedly has an export strategy. If the balance is achieved by an increased price of a commodity such as cooper, the country would face the risk of a “Dutch decease”; even worse, the present estimate of the trend could be a misleading signal. I recall that, by the mid-2000s, the trend price was estimated to less than one-half the present estimate. The fact is that the copper market is notably cyclical and estimates are strongly influenced by the short run. There is a high risk that today we are on the overoptimistic side of expectations. An efficient insurance against that risk is to bet for a systematic diversification of exports, which requires reform of the exchange rate policy. Figure IX.4 is quite illustrative of the instability generated by an unstable RER. Since 2003, the volume of imports has been growing, frequently, several times faster than the volume of exports (see panel A). A surplus in the current account in 2001–4 (adjusted by the trend price of copper, in panel B), has been replaced by a fast rising deficit, peaking at 8% of GDP in 2008. In parallel, exports were losing speed (see Chapter VI). The exchange rate regime is in sharp conflict with the export strategy. This type of wide inconsistency is costly for both economic growth and equity. The characteristic volatility of freely floating exchange rate regimes does not pose significant inefficiencies when market fluctuations are short-lived random walks; in such a case they are easily faced with derivatives (see Dodd and Griffith-Jones, 2006). But fluctuations become a major concern when there are longer waves – medium-term waves – as has been typical of the access of EEs to capital markets in recent decades. In this case, persistent appreciation of the exchange rate during capital surges tends to generate perverse effects on irreversible resource allocation. Moreover, under freely floating regimes with open capital accounts, counter-cyclical monetary policy exacerbates pro-cyclical exchange rate fluctuations, with significant costs derived from an inefficient resource allocation and under-utilization of GDP*. The ability of a flexible exchange rate regime to smooth the effects of external cycles depends on the capacity to effectively manage a counter-cyclical monetary and credit policy without enhancing pro-cyclical exchange rate patterns. This is only possible under intermediate exchange rate regimes along with capital account regulations. That was, clearly, the successful case of Chile in the first half of the 1990s (see Chapter VIII). Managed flexibility – including diverse types of bands or other interventions by economic authorities – strengthens real exchange rate stability, keeping the ability to partially absorb the effects of moderate shocks.

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A 20

18.4 17.2

16

14.5 13.3

12

10.1 7.2

8

12.2 10.6

9.7

5.1

7.6

6.5

4

5.1

4.3

4.1 1.6

3.1

2.3

0 ⫺4 ⫺5.6

⫺8 ⫺12 ⫺16 ⫺20

Exports 2000

⫺14.3

Imports

2001

2002

2003

2004

2005

2006

2007

2008

2009

B 6 4.9

5

4.5

4 3

1.2

0.8

1

2.6

2.2

2.0

2

1.2

0 ⫺1 ⫺2

⫺0.3

⫺0.9

⫺1.2

⫺0.6 ⫺1.1

⫺0.5 ⫺1.5

⫺1.6

⫺2.1

⫺3

⫺2.9

⫺4

⫺2.6

⫺5 ⫺6 ⫺7 ⫺8 ⫺9

Current account 2000

2001

2002

Current account corrected by trend copper price 2003

2004

2005

2006

2007

⫺7.9

2008

2009

Figure IX.4 Panel A: evolution of exports and imports of goods and services, 2000–9 (annual real growth rates, %). Panel B: current account balances, 2000–9 (% of current GDP). Source: Based on central bank figures. Panel A shows series from National Accounts in prices of 2003. Panel B shows the ratio between the current account from the Balance of Payments and GDP in current prices. The nominal trend copper price, here, is derived from the real trend price in Figure IX.2.

266 Economic Policy after the 1999 Recession

Consequently, the exchange rate fulfils more efficiently its allocative role between tradables and non-tradables. If we pretend to give priority to the exchange rate as a resource allocator in the trade strategy embraced by Chile – multiple trade associations with different blocks and competitive nations – it is imperative to give signals of certain medium-term real stability to both investors and producers. There is a need not only for present producers of tradables to remain competitive and increasingly linked with the rest of the domestic economy, but also for many other producers to be born in the future. The dynamic role of SMEs in this process must be stressed. Obviously, intermediate regimes may also exhibit shortcomings (see Ffrench-Davis et al., 2003). First, intermediate regimes are subject to speculative pressures if they do not achieve credibility in markets; in critical conjunctures, particularly after the exchange rate has become an outlier price, the costs of defending a given rate are huge. Then, it may be wise to temporarily move to full flexibility. Second, reserve accumulation during long booms may become financially costly. Lastly, the capital account regulations needed to manage intermediate regimes efficiently reduce those costs, but are only partially effective. However, all things considered, intermediate regimes offer a healthy alternative to certainly costly outlier macroprices frequently resulting from the corner solutions. In the neoliberal approach a statement has emerged that the economic authorities are unable to affect the “market exchange rate,” because that would imply the intention of defeating fundamental market forces. However, the relevant point is that the intermediate approach is intended not to move “against the market” of producers of tradables, but to avoid shorttermist agents or transitory terms of trade fluctuations dominating the foreign exchange market. When one or the two latter dominate, this tends to lead to rates that are not sustainable in the mid-term, with huge costs to the agents that really are at the core of the fundamentals; that is, the producers of tradables. This pervasive outcome has been extremely frequent, in recent decades, in several emerging economies. Thus, the issue is which role to be assigned to the exchange rate, and my view is that it must be the allocation of irreversible resources between tradables and non-tradables. In brief, a totally free exchange rate policy implies accepting an inability to achieve a sustainable real macroeconomic policy, as I have defined it in Ffrench-Davis (2006, Chapter I), and an export strategy with strong pull effects on the rest of the economy. In a context of massive and volatile capital flows and erratic terms of trade, a totally free rate fluctuates remarkably. In fact, since the late 1990s, the exchange rate has shown great volatility. That volatility discourages (i) the generation of value-added on natural resources, (ii) new exports by SMEs, (iii) subsistence of the national industry competing with imports and the employment it generates, (iv) productive investment in tradables sectors, and (v) exploiting new opportunities presented by trade agreements – it

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also enhances their risks and costs. In order to renew a growth-with-equity path, Chile needs to recover its ability to maintain real macroeconomics balances, as an essential condition. The central bank would have to return, explicitly or implicitly, to an intermediate policy between both extremes in fashion.

7 Concluding remarks In an open economy like the Chilean one, high growth depends on the world economic situation, but also on “sound” domestic macroeconomic management and microeconomic reforms. This implies an active macroeconomic policy, focused on the real economy (“productivism”), involving an economy working near to the productive frontier. Lengthy recessive cycles generate structural damage for labor generation, depressed fiscal revenue, and losses and bankruptcies of enterprises. In summary, the great GDP instability reflects a failure of macroeconomic policies, as illustrated by the recessive gap of 1999–2003 and the rather slow growth of 2006–8. In order to avoid or to moderate the intensity of these situations, an improvement is required towards a more comprehensive counter-cyclical approach, (i) so that the authorities can focus, free of urgency, on the design of a development strategy that involves complex reforms and microeconomic policies, and (ii) so that producers can focus on investment and productivity improvements, with right macroprices and a potential GDP consistent with effective demand. Once the macroeconomic framework is corrected, the road towards pending deep microeconomic reforms is cleared. These reforms are associated with labor and entrepreneurial training, innovation support, capital market reforms with priority for long-term financing, and a comprehensive SMEs program. In all these issues there has been progress, but insufficient, sometimes hesitant, and with contradictions. A growth-with-equity strategy requires coherent action and to be placed systematically at the core of the national agenda.

X Concluding Remarks and Challenges

The Concertación Democrática completed two decades in command of the Chilean economy, through four presidential regimes. The first three democratic regimes covered a period of time as long as the sixteen years of dictatorship, when neoliberal reforms were implemented. In this closing chapter, first, a brief summary of the sixteen years of dictatorship versus the first sixteen years of democracy is made, focused on economic growth and income distribution outcomes; summary outcomes for the full two decades of Concertación regimes are also presented. Then, four general conclusions that I consider must be present in the analyses of Chilean development are reported. Finally, I raise ten challenges, in a non-exhaustive listing, that I have selected as of high-priority action for Chile at the opening of the 2010s.

1 An account of sixteen years of dictatorship versus sixteen years of democracy When I was starting the preparation of this edition, sixteen years had elapsed from the return to democracy; a period as long as the prolonged dictatorship. Thus, it was an opportune time for making a global assessment of both experiences, at a time when Chile was to start its third century as an independent nation. Notwithstanding the development gaps in both GDP and equity that reemerged from 1999, great social and economic progress had characterized the sixteen years of democratic development. There are evident, huge, contrasts with the sixteen years of dictatorship. Economic growth in the neoliberal regime of Pinochet, between 1973 and 1989, averaged only 2.9%, and income distribution deteriorated remarkably. That outcome was associated with the deep fundamentalism of reforms and reformers, implying numerous policy failures that severely affected economic growth and social welfare. 268

Concluding Remarks and Challenges

269

During the dictatorship of Pinochet diverse modernization took place in Chile. Undoubtedly, several of them have constituted a permanent basis for democratic development strategies, but others constitute a sharp negative burden for economic development. The four Concertación governments, a center-left coalition of Christian Democrats and Social Democrats, in a strategy of continuity with change, did seek reforms to the reforms, in order to correct the inherited model. The objective was to introduce pragmatism and progressiveness. In particular, they tried to diminish the vulnerability to external shocks in a context of increasing volatility in international markets, and to advance in correcting the inequality featured by the economic model. The outcome of the set of changes was that during the 1990s there was a vigorous expansion of productive capacity without precedent in Chile (averaging 7.1% annually in 1990–8), along with significant reduction of the number of people in poverty (from 45 to 21% of the population in the same period) and some improvement in income distribution. Nevertheless, a recessive output gap in 1999–2003 revealed flaws and contradictions, and the lack of deeper reforms to the reforms. With the Asian crisis contagion, the final year of President Frei’s government (1999) and the first part of President Lagos’s (2000–3) evolved in a recessive economic environment. The sharp fall of 1999, and the subsequent stagnation of economic activity, was concentrated in non-tradable sectors, which represented around 70% of GDP; that stagnation involved a negative impact, mainly on SMEs and employment. A slower expansion of the volume of exports was accompanied by a terms of trade deterioration. However, its impact was multiplied in the rest of the economy through the capital account and the monetary and exchange rate policies. That recessive impact prevailed until 2003, constituting a substantive failure of Chilean macroeconomic policies. If Chile had had an indebted economy, short of international reserves, without access to external credit, and a fiscal deficit, it could have justified a domestic multiplication of the external shocks as extended as it was in 1999–2003. But no such conditions occurred in Chile in these years. The result of such a long and severe recessive period was a policy option of not facing the negative external shock with a positive domestic reactivating shock. The external shocks were multiplied due to the adoption of a “financieristic” macroeconomics, at the expense of sustained growth and equity. I have stressed this issue throughout the book because of its high relevancy for the future. The arrival of the present world crisis reinforces my criticism and the direction of my proposals. The contrast between 7.1% growth in 1990–8 and 3.7% in 1999–2008 reflects significant weaknesses in the design of economic policy. In all, in the sixteen years between 1990 and 2005, GDP growth averaged 5.5%, in contrast to 2.9% in 1974–89, and per capita GDP expanded by 4.1%

270 Concluding Remarks and Challenges

in comparison with 1.3% in 1974–89 (see Table X.1).1 As said, the economic performance of the Concertación Democrática regimes was weaker in its second half. The presidential election of 2009, in which the center-left coalition was defeated, took place when the contagion of the financial crisis was at work and the weakening of economic policy was reflected in poorer economic growth and a worsened trend in the labor market. Nonetheless, even including this latter period, the overall annual average of the four democratic governments is notably superior to that of the dictatorship: per capita GDP growth was 3.6 and 1.3%, respectively. Additionally, by 2009 social policy had acquired a solidly stronger power as shown in chapter VII, which is reflected in the improved distributive figures by 2009 as compared to 1999–2005, in spite of the weaknesses of the labor market and of economic growth. The differences in the annual averages imply a notorious cummulative gap between the two as time goes by. Figure X.1 is illustrative. By the end of its sixteen years the Pinochet regime had achieved (in 1989) a GDP per capita merely 23.6% higher than in 1973; the Concertación Democrática recorded an 88.8% increase between 1989 and 2005. That remarkable difference has been associated with the improvement in the quality of macroeconomic policies since 1990 (in particular, I repeat it, mostly in the first Table X.1 GDP, GDP per capita and income distribution, 1974–2009 (annual growth rates, %) GDP growth (%) GDP per capita Q5/Q1 ratio growth (%) (1) (2) (3) 1974–1981 1982–1989 1990–1998 1999–2009 1974–1989 1990–2005 1990–2009

3.0 2.9 7.1 3.3 2.9 5.5 5.0

1.5 1.2 5.4 2.1 1.3 4.1 3.6

15.1 20.2 15.5 15.2 17.7 15.7 15.3

GINI coefficient (4) 51.9 56.7 52.9 52.6 54.3 53.1 52.7

Source: Author’s calculations based on Chapter I and National Accounts from the central bank. Columns (1) and (2) are based on 2003 constant prices. Columns (3) and (4) are based on the University of Chile Employment Survey for Santiago. 1 If the comparison includes the twenty years of democracy up to 2009, the record of GDP growth is slightly lower: 5.0%. The comparison underestimates the performance of the Bachelet presidency because it ends in a year of recession, 2009, which implies that potential GDP was significantly above actual GDP. Actual GDP is the data used in the comparison, but the higher potential GDP implies that the economy, in subsequent years, can grow much faster than the generation of new capacity. It is a positive inheritance, in contrast with that of 1989, which made unavoidable a downward adjustment in 1990.

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220.0 Per capita GDP 1973–1989

Per capita GDP 1989–2009

200.0

188.8

180.0 160.0 140.0 123.6

120.0 100.0

2009

2008

2007

2006

1988–2004

1989–2005

1987–2003

1986–2002

1985–2001

1984–2000

1983–1999

1982–1998

1981–1997

1980–1996

1979–1995

1978–1994

1977–1993

1976–1992

1975–1991

1974–1990

1973–1989

80.0

Figure X.1 Per capita GDP growth, 1973–89 versus 1990–2009 (real indexes, 1973 and 1989 ⫽ 100). Source: Based on data from Marcel and Meller (1986) and central bank for GDP, and National Bureau of Statistics for population.

years of democracy), with the sustained increase in social expenditure that has provided better opportunities for more people, and with efforts aimed at correcting micro- and mesoeconomic market and policy failures. These last efforts, in fact quite insufficient, consisted of trying to free themselves from neoliberal fundamentalism, and to progress, too mildly, towards “completing” long-term capital markets, labor training, and technological innovation.

2 Four general conclusions Classifications and categories tend to be arbitrary, but if they are coherent they provide a guiding framework for analysis and policy actions. Four groups of economic lessons or conclusions follow. They are drawn from the recent decades of Chilean economic history. (a) Equity is crucial for sustained growth The challenge of making growth consistent with distributive equity is ever more important, especially in light of the sharp drop in the standard of living of a wide segment of the population in the 1970s and 1980s, and the fact that democratic governments have only partially met the expectations they aroused in the 1990s. It is clear that substantial political consensus among the main social and political groups will be required to meet the challenge. Only in this way can the country implement action over time that will distribute the costs and benefits of economic growth in a more equitable fashion, with progressive improvement in the distribution of opportunities,

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productivity, and income. Democracy requires that growth and equity progress together. (b) The need to recover a macroeconomics for development There is overwhelming evidence that macroeconomic balances are crucial to the success of any development strategy. One component that tends to be omitted from the catalog of macroeconomic factors, and should always be in the foreground, is the relationship between new productive capacity creation and actual increases in production (or utilization of capacity). As has been documented, there were deep imbalances in the relationship between the two variables during the Pinochet regime. Underutilization was notably high in both 1975–9 and 1982–7. In both periods average capital formation plunged, reducing sharply the creation of new capacity, productive employment, and equity. In fact, the consequences of that macroeconomic disequilibrium were long-lasting. A similar sort of disequilibrium emerged in 1999–2003, though quite moderately. Consequently, the effects were of the same negative sign – lower capital formation, higher unemployment, more inequality – but were notably milder than in the two older recessions. It must be stressed that the most significant macroeconomic balance is the sustainable use of economically productive capacity. An economy working on the production frontier, with correct or right macroprices (particularly exchange rates), achieves higher productivity, encourages larger capital formation, and fosters the demand for labor. This is what I have called real macroeconomics or productivistic macroeconomics, in contrast to the financieristic macroeconomics (with an unbalanced focus on inflation and disregard for variables such as the stability of the exchange rate and domestic demand). The cost of real macroeconomic imbalances is high indeed. Beside the fact that such a situation leads to a reversal of the initial success that may have been achieved in growth and redistribution, experience shows that it entails costly political losses for governments that succumb to populist temptations, whether from the left (as with unfunded social spending) or the right (e.g. with tax cuts that make it unfeasible to finance the investment in human capital that is essential for growth-with-equity, or with the excessive financial deregulation and capital account opening that paves the way for macroeconomic imbalances). The ways of achieving macroeconomic balances can be quite diverse. They may have progressive or regressive effects; they may be pro-cyclical or counter-cyclical depending, among other things, on the relative weight given, by policymakers, to variables such as inflation, employment, economic activity, the composition of public spending and revenue, the nature and regulation of financial institutions, and public actions that contribute to building the capacity and organization of low-income segments of population. In all, they may be biased towards fostering financierism or towards productivism; the former tends to be regressive and volatile, while the

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latter provides the bases for growth-with-equity. Sustainable comprehensive macroeconomic balances are essential, and they must be designed consistently with macrosocial balances. (c) Inheritances, positive and negative, make a significant difference In the 1970s and 1980s there were several reforms directed to modernize the country’s economic organization. Undoubtedly, many constituted permanent and valuable bases for future development strategies. The changes included significant growth and diversification of exports, the achievement of a more efficient fiscal budgeting process and organization of the internal revenue service, and the development of a new generation of entrepreneurs who were more dynamic and modern than the traditional business class. This progress contributed considerably to the outstanding performance of the 1990s. However, there is a serious lack of pluralism and pragmatism in the sector holding the highly concentrated economic power, mass media, and wealth. This lack of pragmatism, or deep neoliberalism, has been a heavy handicap to implementing policies effectively accelerating growth-withequity. In the other corner of society, the Concertación Democrática had to work in a social environment with weak social organizations, few and divided unions, and an extreme imbalance of voices made heard in Chilean society. There have been corrections, but also significant contradictions (see Garretón, 2003). A rebalancing of voices and power is crucial for achieving the reforms geared towards comprehensive social and economic development. (d) A deficit of development-friendly reforms Structural reforms suffered from various failures that had severe repercussions for potential economic growth and the population’s welfare. The 1990s saw significant reforms to the reforms of previous decades, with the specific objective of introducing a progressive pragmatism. These reforms reflected a great concern to reduce the vulnerability of the Chilean economy to the international environment, with its increased volatility, while stressing policies contributing to greater equity in the distribution of opportunities, productivity, and income. The results of this change of focus, despite a number of contradictions, have been notable. The recession of 1999–2003, nevertheless, highlighted failures and insufficiencies, the lack of greater reforms of the reforms, and a step-back in macroeconomic policies. There have been relevant social reforms launched recently, such as Chile Solidario for the extreme poor, the AUGE program for health, unemployment insurance and its new reform, and the ambitious social security reform. Nonetheless, I emphasize again that in an economy that is not rich and exhibits shameful inequality, outcomes are principally determined in the mal-working of markets. There is an absolute need to make sharp corrections in the working of markets: corrections pro-labor and jobs, pro-SMEs,

274 Concluding Remarks and Challenges

and pro-real macroeconomic stability. This is what leaders of the official coalition have called deepening reforms of the model.2 From an optimistic perspective, the positive side of the recessive situation has been a growing recognition of the problems and the search for ways to solve them. Public opinion has been expressing its discomfort, despite the progress achieved; this is partly reflected in the fast growing number of people not participating in political elections. Even people, paradoxically, can react to reward the regressive forces. Chile has all the conditions needed for moving forward, with strengthened dynamism, in the direction of sustainable development. With this book, I hope to contribute to the thoughtful dialogue needed if we are to achieve growth with equity – a dialogue for constructive and progressive action.

3 Ten specific challenges How can vigorous growth be achieved while advancing towards equity? First, there must be an understanding of how this can be achieved and what the country’s real record is so far. Development occurs when growth is sustainable over long periods of time. If progress in Chile is measured by the decade, counting both good and bad years, only the 1990s recorded a figure of 7% for (actual and potential) GDP growth. In the 1960s, GDP growth averaged 4.3% and in the 1970s and 1980s less than 3%. Some outstanding priorities that need to be kept up-front in order to replicate the exceptional record of the 1990s and grow with more equity are grouped here under the ten points that follow. (1) Chile must regain a macroeconomic environment of sustainable development with three features. The first is to achieve, as in most of the 1990s, a level of effective demand close to the productive capacity of the Chilean economy – always a key objective for efficient macroeconomic balances and vigorous productive investment. This implies avoiding unsustainable booms and applying vigorous and consistent counter-cyclical actions during recessions. Second, it will be necessary to maintain a competitive and stable real exchange rate, which is not feasible with corner solutions (neither a fully free rate nor dollarization). Third, interest rates must be kept within a moderate range. These three objectives require a more flexible fiscal policy, with effective anti-cyclical measures (in the fiscal budget, monetary policy, and banking supervision), and an increased ability to discourage excesses in speculative capital inflows. The great danger is a “populist” attitude that fails to weigh the broad negative effects on the economy of excessive capital flows that are speculative, short-term, merely financial, or aimed at purchasing 2 Acentuar las correcciones del modelo. See Manifiesto de los Partidos de la Concertación (2005), prepared during the presidential campaign of President Michelle Bachelet (2006–10).

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what already exists without creating new productive capacity. In fact, the main cause of the recession of 1999 was the huge capital inflow recorded in 1996–7, as shown in Chapter IX. The long recessive gap up to 2003 was associated with the explicit dependency from the voices of short-termist agents who specialized, in simple terms, on overnight finance. What a misuse of the potentiality of the Chilean economy this was. (2) Export dynamism is a determining factor for the ability to grow. Chile cannot afford to continue simply doing more of what it has always done. Markets become saturated and resources are exhausted or become less productive. Non-traditional exports must be developed, without losing what has been gained with traditional items. This means (i) moving forward strongly to add value and technology to the traditional natural resources and developing the production of intermediate goods and services as well as capital goods linked to the productive process in those traditional areas (the recent decision to move ahead with selected clusters is encouraging); (ii) developing non-traditional natural resources; and (iii) finding niches for the ability and experience of national entrepreneurs and technicians in order to acquire competitive advantages in services and manufactures. This will require an intense national effort to complete markets for technology, labor training, and long-term capital. A dynamic export drive cannot be achieved with the present wide exchange rate instability. Notwithstanding the counter-cyclical stabilization funds of the government, the foreign exchange market has been dominated, since the mid-1990s, by volatile financial flows and terms of trade swings. There is a need to recover the exchange rate as a powerful and efficient resource allocator. (3) With respect to export markets, Chile has signed free trade agreements with most of the world, including, among others, the USA, the European Union, Japan, the Republic of Korea and China in this decade. Chile needs to better use the broad opportunities offered by its partners; as seen, exports expanded more slowly in the 2000s than in the 1990s. As far as non-traditional exports are concerned, negotiating access to Latin American markets, taking advantage of geographic proximity, will be crucial.3 New obstacles will probably emerge – among them, macroeconomic instability in some neighbors and historical or political conflicts – but they must be confronted constructively. A well designed regional integration is one way to make, rather than take, globalization. (4) Development always leaves some productive sectors behind. It is better to anticipate malaise than to ignore it and have to deal with a moribund patient later. Comprehensive macroeconomic stability can make a 3 Geography still counts for a lot, as testified by the North Americans, who sell half of their exports to their two neighbor partners in NAFTA, or the Europeans, for whom the intra-regional share is close to two-thirds.

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great contribution to development and can help to minimize the number of losers, but a pragmatic, forward-looking sectoral and regional policy is also essential. Significant sectors, such as in agriculture, are urgently in need of further thought and timely action for efficient, pro-development, reconversion. (5) Growth is not possible without physical investment. The Chilean economy needs more, not less, productive investment. First, a dangerous rent-seeking bias, intensified in recent years, must be avoided: there are too many efforts and capabilities devoted to mergers and transfers of existing assets. It is necessary to strengthen creative skills; upgrading the quality of macroeconomic policies and enhancing actions to complete markets of factors and exports are essential. Second, domestic capital formation is an overwhelming proportion of investment everywhere in the world. Only one of every ten dollars invested in the world comes from abroad. Domestic savings and investment are determinant. Policy must be designed to assure that Chile’s long-term savings – such as those of the private pension funds – are invested in domestic capital markets, and allocated to long-term lending for development. It is a gross mistake to believe that those funds are too large for Chile; actually, they are not enough, but the channels for their proper allocation are missing. The prevailing tendency in Chile to transfer the funds of the private pension system abroad presents an unfortunate contradiction with the objective of raising the domestic savings rate so as to increase capital formation in Chile. Priority should be given to improving the transmission channels between those long-term funds and productive investment – naturally, always with guarantees and prudential regulations to protect the savings of workers. This is consistent with the fact that average profitability is usually higher in Chile (still a capital-scarce country) than in developed countries. (6) Investment in human capital is a key input for stability and growthwith-equity. It must be given the priority it deserves, always keeping in mind that education is dependent on teachers; social trust and recognition of their importance must be rebuilt. Present public funding is evidently insufficient for attacking the deeply unfair inequality it holds at present. Education, however, operates over the long term. Most of the labor force of this new decade will consist of Chileans who have already finished their formal education. Chile, then, faces the great challenge of enhancing the flexibility of the supply of labor with far-sighted and well focused national labor-training programs; small and micro entrepreneurs also need effective training programs. (7) The environment has become a leading issue in modernization. Chile must make up for its lag in addressing environmental issues and in integrating them in the design of public policies. A highly pragmatic and participatory approach is needed to reconcile the development of today’s productive capacity with preventive action, sustainability over time, and

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the present welfare of citizens. Growth-with-equity for present generations must become sustainable. (8) Income distribution is highly inequitable. Chile must intensify its efforts to improve the quality and coverage of social spending, make an effective impact on hard core poverty, and eliminate the possibility that a young, intelligent person will not receive a good education because of a poor social origin. Chile Solidario, the AUGE program, and the Social Security reform are significant steps forward. Strengthening the fight against tax evasion and the regressive loopholes that still exist in the tax system would provide financing and contribute to tax equity. Once again, global consistency of policies and their interrelations is crucial. The quality of macroeconomic policies strongly affects poverty and income distribution, through its impact on productive employment. (9) The state must be reformed. The main issues here are professionalizing public administration, raising productivity systematically, improving the quality and friendliness of public service, making space for the participation of people in identifying priorities and failures (in education, health, public works, labor training, etc.), better using the public purchasing power to develop SMEs, and heightening transparency in government. Simultaneously, salaries must be gradually raised to levels consistent with those prevailing in the private sector. (10) Paradoxically, since the return to democracy the quality and intensity of thinking about the future of Chilean people has eroded. It has become too focused on the short term and concentrated on what “the market finances.” Too much confidence has been placed in what other countries think and do (some specialists even believe that other countries should drive Chile’s macroeconomic policy, e.g. through the capital account opening), and too little attention has been paid to the importance of each country’s or region’s specific characteristics and targets. For many, globalization has taken the shape of mythic immutability. However, globalization is a highly heterogeneous process, human-made, incomplete, and rather unbalanced with respect to social and economic factors. It is urgent that Chile rethink the role of globalization in its economic life, in order to understand how to move more effectively than in recent years towards sustained growth-withequity and to position itself to act cogently during this new decade.

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Index acquisitions 211, 216 ADRs (American Depositary Receipts) 213, 219, 221, 228 Afghanistan war 241 AFPs (Administradoras de Fondos Previsionales) 12, 196, 220, 241 unemployment insurance scheme 34, 200 agricultural sector 6, 7, 11–12 challenges 276 debt crisis (1982) and recovery 113, 123 exports 69 price bands 135 aid program, debt crisis (1982) and recovery 122 Alessandri, Jorge 5, 8 Allende, Salvador, and regime 7–9 agrarian reform 7, 12 foreign banks 82 inequality and poverty 179 macroeconomic variables 8 nationalization program 7, 11, 13 American Depositary Receipts (ADRs) 213, 219, 221, 228 amortization 104, 120, 213, 240, 259 Andean Pact/Community 13, 56, 60, 134, 151 anti-dumping measures 12, 135, 138 Anti-unemployment Contingency Program 259–60 Argentina capital flows 88, 209, 214, 223 currency and debt crisis (1998–2002) 17, 77, 158, 165, 241 economic complementarity agreement 151 investment ratio 32 savings 233 tequila crisis 223, 245 article 14 87, 97 Asian countries capital account 238–9

Chilean exports to 142, 143, 163–5 see also specific countries Asian crisis 4, 24, 29–31, 41, 42, 46, 269 capital flows 155, 214, 219, 221, 224, 233 exports 157, 165 inequality and poverty 174, 191, 200 recession (1999) and recovery 236, 239–40, 243 Asia-Pacific Economic Cooperation Forum (APEC) 151 AUGE health program 34, 192, 237, 246, 273, 277 automobile industry 61 Aylwin, Patricio, and regime 24, 25–9 exchange rate 140 interest rates 129 macroeconomic variables 8 Bachelet, Michelle, and regime 24, 34, 35–8 Council on Equity 254 GDP 270 macroeconomic variables 8 social policy 204 balance of payments Alessandri regime 5 Allende regime 9 capital flows 214, 217 exchange rate policy 91, 263 exports 134, 166 external indebtedness 88 financial liberalization 80 Ibáñez regime 5 import liberalization 69–71 Pinochet regime 13, 15–16, 19 balance of trade debt crisis (1982) and recovery 112, 117 export development 133, 135, 170 external indebtedness 104 Banco del Estado 81, 250 291

292

Index

banking/financial sector Allende regime 7, 13 capital flows 210, 216, 221, 225–6 debt crisis (1982) and recovery 19, 122, 123 external indebtedness 96–7 financial liberalization 81–3, 85, 87 inequality and poverty 205 interest rates 97–8, 99, 101–2 nationalization 7, 13 Pinochet regime 11, 13, 18 privatization 13, 81 regulation and supervision 81, 83, 90, 96–100, 225–6 reserves see reserves bankruptcies 14, 19, 22, 44–5 import liberalization 66, 68 Basle Accord 226 best practice, and export development 132 binding external constraint (BEC) 132, 209, 244 black market 9 Bolivia 151 Brazil 85, 88, 90, 151, 241 Budget Office 23 building sector 104 bureaucracy 250 Canada 151 capital account Asian countries 238–9 Aylwin regime 28, 29, 30 capital flows 218, 220, 226–9 exchange rate policy 263, 264, 266 exports 157 external indebtedness 96 financial liberalization 81, 82, 105 Frei Ruiz-Tagle regime 29, 30 Latin American countries 238–9 recession (1999) and recovery 238–9, 241, 243, 244 capital adequacy ratios 225, 226 capital flows 209–11 challenges 274–5 debt crisis (1982) and recovery 77, 112, 114 exchange rate policy 266 exports 155, 170 external indebtedness 103

financial liberalization 78, 79, 80, 82–8, 105–6 Frei Ruiz-Tagle regime 31–2 interest rates 99, 102 Latin American countries 88, 154, 209, 214, 216 macroeconomic effects 105 macrostabilizing measures, effectiveness of 226–32 magnitude and composition 211–16 policy counter-cyclical response 216–26 policy lessons 234–5 recession (1999) and recovery 236, 238, 240, 241, 256 savings, investment, and growth in the 1990s 232–4 structural fiscal balance 256 capital formation capital flows 232 challenges 276 debt crisis (1982) and recovery 113, 115, 125–6, 127 democracy 27, 30, 38, 170 dictatorship 22, 144 exports 144, 170 external indebtedness 103 financial liberalization 81 inequality and poverty 202–3 macroeconomics for development 272 recession (1999) and recovery 255 capital market segmentation 74 car industry 61 Cartagena Agreement 56 CASEN surveys 178–9, 185, 191 Central America, free trade agreement 151 central bank capital flows 210, 212–13, 216–21, 222–6, 230, 231, 232 debt crisis (1982) and recovery 120, 122 democracy 28, 30, 31, 33, 35, 36, 37 dictatorship 24 exchange rate policy 91, 92–3, 139–40, 155, 263 external indebtedness 96 import liberalization 71

Index recession (1999) and recovery 238–41, 243, 246, 247, 249, 251–3, 259 structural fiscal balance 259 Central Bank Autonomy Act 1990 140 challenges for the future 274–7 children 254 Chile Barrio program 34, 237 Chile Foundation 136 Chile Solidario program 34, 184, 191, 192, 202, 237, 246, 253, 273, 277 China 150, 151, 160, 162, 163–4 Christian Democrats 5 CODELCO (Corporación Nacional del Cobre) democracy 26, 39, 160, 166 dictatorship 11, 12 exports 160, 166 molybdenum 160 recession (1999) and recovery 248, 250 tax reform 194 Colombia 88, 92, 151 commodity boom 35, 37 comparative advantages export development 133, 151, 153, 154, 162, 173 external indebtedness 103 financial liberalization 77, 83 import liberalization 71, 72, 73 Compendium of Rules for International Exchange in Chile, Chapter XIX 119 competitivity Bachelet regime 37 challenges 275 competition policy 123 exchange rate policy 262 exports 132, 133, 172–3 import liberalization 71, 74–5 Lagos regime 37 recession (1999) and recovery 253 Concertación Democrática (CD) 24–5, 268 comparison with dictatorship 268–71 defeat in 2010 elections 254 inheritances, impact of 273 macroeconomic variables 8 outcomes 38–43

293

recessive adjustment (1999–2003) 31–4 recovery (2004–9) 35–8 reform of the reforms (1990–8) 25–31 slogan 4 social policy 204 Consejo Trabajo y Equidad 254 Constitution 26 construction sector 104 consumer goods, and import liberalization 61, 62–3, 64, 68 consumer price index (CPI) Bachelet regime 37 capital flows 217 Ibáñez regime 5 Pinochet regime 14, 16–17, 21 recession (1999) 244, 246, 251, 252 Copper Buffer Fund (CBF) 39, 40, 92, 216, 259 copper industry Allende regime 7 capital flows 218 debt crisis (1982) and recovery 110, 113, 116–17, 120, 128 democracy 26, 33, 35, 36, 39–40 exports 156, 157, 159, 160–1, 166–7, 169 dictatorship 12, 13, 14, 20–1, 23 exports 134, 141, 142 exchange rate policy 90, 91, 95, 140, 263, 264 exports democracy 156, 157, 159, 160, 166–7, 169 dictatorship 134, 141, 142 Frei Montalva regime 6, 7 globalization of volatility 159 import liberalization 55, 66, 69 inequality and poverty 201 and molybdenum 159, 160 recession (1999) 241, 248–9, 251–2 structural fiscal balance 256, 257 tax reforms 194 see also CODELCO Copper Price Committee 248 Copper Stabilization Fund 6, 7, 248, 257 CORFO 11, 137, 167 Costa Rica 151, 180

294

Index

Council on Equity 254 crawling-peg exchange rate 90–3 Aylwin regime 27 capital flows 217–18, 224 debt crisis (1982) and recovery 116, 123 exports 134, 135, 139–40, 154 external indebtedness 90 financial liberalization 80 Frei Montalva regime 97 Frei Ruiz-Tagle regime 31, 33 Pinochet regime 54, 134, 135, 139–40 credit capital flows 218 external indebtedness 88–92, 96–7, 102 financial liberalization 81, 82, 83, 105 interest rates 97–9, 100–2 Mexican and East Asian crises 214 microcredit 254 Pinochet regime 13 recession (1999) and recovery 242–3 creditworthiness, Chile’s reputation for 82 Cuba 180 current account Aylwin regime 28 capital flows 210, 212, 215–18, 224–5, 229, 230 debt crisis (1982) and recovery 78, 114, 115 exchange rate policy 139, 155, 263, 264 external indebtedness 89, 96, 104 financial liberalization 82, 83, 84, 86, 88 Frei Ruiz-Tagle regime 30 import liberalization 68, 69–71 Mexican 214 Pinochet regime 16, 17 recession (1999) and recovery 237, 238, 240 debt crisis see under recessions and financial crises debt paper, purchase of 119–20 debt swaps 110, 117, 118–20, 121, 125

capital flows 211 export development 136–7 demand 43 Allende regime 7 Aylwin regime 26, 27, 28, 29 Bachelet regime 36 capital flows 216, 217, 234 challenges 274 debt crisis (1982) and recovery 109–10, 112–13, 116, 121–2, 124, 127, 128 export development 132, 134, 135, 144 external indebtedness 88, 103 financial liberalization 79, 104, 105 Frei Ruiz-Tagle regime 32 import composition 61 import liberalization 64, 65–6, 67–8, 72, 73 interest rates 100 Pinochet regime 13, 14, 15, 20–1, 23, 24 recession (1999) and recovery 238–40, 242, 247, 249, 251–2, 262 democracy see Concertación Democrática; specific regimes demographic changes 188, 245 development policy Bachelet regime 37 challenges 275–6 deficit of development-friendly reforms 273–4 historical perspective 5–9 macroeconomics 272–3, 274–5 recession (1999) and recovery 253–4 dictatorship see Pinochet, Augusto and regime dynamism, and import liberalization 72, 73 Economic and Social Stabilization Fund 259 economic complementarity agreements 151 economies of scale and specialization 131 Ecuador 151 education and training challenges 276, 277 democracy 34, 38, 42

Index dictatorship 10, 179, 180 export development 132 inequality and poverty 185–7, 191–3, 197–201, 203–4, 207 recession (1999) and recovery 239, 254 structural fiscal balance 259 efficiency and import liberalization 71–5 El Salvador 151 employment see labor market ENAP 11 encaje 28, 29, 105, 210, 224, 234 ENDESA 122 energy sector 255 entrepreneurs bank loans 100 capital flows 231 challenges 275, 276 debt crisis (1982) and recovery 125, 126 democracy 36, 38, 42 export development 134 inequality and poverty 203 recession (1999) 249, 250, 254 structural fiscal balance 259 environmental issues 255, 276–7 equity, as crucial to sustained growth 271–2 European Union (EU)/European Economic Community Chilean exports to 142, 143, 152, 162–4 exports from 251 tariffs 57 trade agreement with Chile 151 exchange rates 43 Alessandri regime 5 Allende regime 7 capital flows 210–11, 215–18, 220–5, 229, 232–4 challenges 274, 275 debt crisis (1982) and recovery 77, 110, 112, 115–16, 121–2, 126–8 democracy 27–8, 30, 31, 33, 35, 36 exports 150, 152, 154–6, 157–8, 166, 167, 169, 171, 172 dictatorship 13, 14, 15–17, 20–1, 22 exports 131, 133, 134, 135, 138–40, 141

295

exports democracy 150, 152, 154–6, 166, 167, 169, 171, 172 dictatorship 131, 133, 134, 135, 138–40, 141 external indebtedness 88, 89–96, 97–8, 103, 104 financial liberalization 80, 81, 88, 105 Frei Montalva regime 7 import liberalization 55, 57–60, 71, 72 manufacturing sector 66, 68 inequality and poverty 197, 206–7 Mexico 214 potential GDP 46 recession (1999) and recovery 236, 238–44, 246–7, 249, 251, 256, 262–7 structural fiscal balance 256, 259, 262 export investment financing 137 exports 1950s 5 acceleration of receipts 227 Alessandri regime 5 Asian countries 57, 71, 75 capital flows 210, 217, 224 challenges 275 debt crisis (1982) and recovery 110, 114–17, 121–2, 125–6, 128 democracy 24–5, 40, 41, 149–73 Aylwin regime 28 Bachelet regime 36, 37 Frei Ruiz-Tagle regime 31 Lagos regime 31, 35 dictatorship 13, 17, 18, 20, 21, 22, 130–1 dynamism and diversification 141–3 economic growth 144–5 national development 131–3 trade policy 133–40 exchange rate policy 90–3, 263, 264, 265, 266 Frei Montalva regime 6, 7 and import liberalization 57, 59, 60, 69, 71–2, 73, 75 manufacturing sector 64, 66–7 inequality and poverty 197

296

Index

exports – continued non-traditional 137, 141–2, 151–2, 156–8, 161 over-invoicing of 227 recession (1999) 240, 247, 249, 251, 253 subsidies see subsidies export warehouses 137 external debt see foreign indebtedness external inflation 16 externalities, export development 132 external vulnerability 102–4 Exxon 12 family allowances 180, 181, 191, 192 family subsidy 191 Finance, Ministry of Bachelet regime 36 exchange rate policy 155 molybdenum 160 Pinochet regime 12 recession (1999) and recovery 248 structural fiscal balance 259, 260 financial crises see recessions and financial crises financial liberalization 104–6 debt crisis (1982) and recovery 78–83 inequality and poverty 195 financial sector see banking/financial sector financierism 38, 42, 43, 103, 127, 254, 269, 272 inequality and poverty 205–6, 207 fiscal balance Alessandri regime 5 Allende regime 7 Aylwin regime 27 Bachelet regime 36 capital flows 210 debt crisis (1982) and recovery 121–2 Frei Ruiz-Tagle regime 30 interest rates 99 structural (SFB) 33, 255–62 see also fiscal policy fiscal policy 43 capital flows 216 challenges 274 debt crisis (1982) and recovery 127–8 democracy 42

Aylwin regime 26–7 Bachelet regime 37, 38 Frei Ruiz-Tagle regime 30–1, 32–3 Lagos regime 33 dictatorship 14, 20 external indebtedness 90 inequality and poverty 192 recession (1999) 237–9, 243, 244, 246–7, 248, 252–3, 255–62 see also fiscal balance Fiscal Responsibility Law 257, 260 Fondo de Garantía para Exportaciones No-Tradicionales 137 Fondo Nacional de Salud (FONASA) 195–6 food prices 37, 252 foreign banks 82, 85 foreign currency 28, 31, 165, 209, 212, 240 foreign direct investment (FDI) capital flows 209, 211, 213–16, 219, 221, 228–30, 234 debt crisis (1982) and recovery 118 democracy 28, 30, 38, 166–7 dictatorship 11, 13 exports 166–7 financial liberalization 81, 82, 83, 105 inequality and poverty 195 recession (1999) and recovery 247 short-term funds disguised as 227, 228 foreign exchange 43 capital flows 213, 216, 217–18, 221, 226, 227, 230 chapter XII of regulations 220 debt crisis (1982) and recovery 110, 120, 123 exchange rate policy 263 exports 131, 132, 135, 165 external indebtedness 88–96, 97–8 Frei Montalva regime 6 Frei Ruiz-Tagle regime 33 Pinochet regime 19 exports 131, 132, 135 import liberalization 55, 69–71, 75 foreign indebtedness 78–8, 104–6 capital flows 218 debt crisis (1982) and recovery 111, 112–13, 117–18, 121–2, 125

Index dynamics 102–4 export development 133, 135 import liberalization 68 interest-rate differentials 97–102 macroeconomic adjustment 88–97 Pinochet regime 18, 20 foreign loans Alessandri regime 5 Allende regime 7 capital flows 218 external indebtedness 103 financial liberalization 81, 88, 105 Pinochet regime 16 recession (1999) and recovery 241 foreign reserves see reserves free trade agreements (FTAs) 150–1, 173, 275 Frei Montalva, Eduardo and regime 5–7 agrarian reform 6, 7, 12 crawling exchange rate 92 foreign banks 82 inequality and poverty 179 macroeconomic variables 8 trade reform 54 Frei Ruiz-Tagle, Eduardo and regime 24, 25, 29–33, 269 macroeconomic variables 8 General Agreement on Tariffs and Trade (GATT) 135, 153 GINI coefficient 175, 178, 189, 190, 191 dictatorship and democracy compared 270 global financial crisis 37, 237–8, 252, 253, 269 exchange rate policy 263 structural fiscal balance 259, 260 globalization/globalism challenges 275, 277 neoliberalism 10 open regionalism 151 government spending Allende regime 7 Aylwin regime 26 Bachelet regime 37 Frei Montalva regime 6 Frei Ruiz-Tagle regime 30 Ibáñez regime 5

297

inequality and poverty 192, 194 infrastructure investment 170, 239 Pinochet regime 12, 13 recession (1999) and recovery 239, 244, 246, 256–7 structural fiscal balance 256–7, 260 see also social expenditure Great Britain 202 Great Depression 5 gross domestic product (GDP) Allende regime 7, 9 capital flows 217, 218, 233 debt crisis (1982) and recovery 109–10, 112–16, 124–8 democracy 24–5, 38, 40, 41, 149–56, 167–73 Aylwin regime 25, 27, 28–9 Bachelet regime 35–6, 37 Frei Ruiz-Tagle regime 30, 31, 32, 33 Lagos regime 31, 32, 35, 37 dictatorship 13–15, 17–19, 21–3, 41 dictatorship and democracy compared 268, 269–71 estimating potential GDP 43–9 export development 130, 133, 135, 144–5 financial liberalization 78, 84 Frei Montalva regime 6 recession (1975) 64 recession (1999) and recovery 236–7, 240, 242–3, 245, 247, 249, 252–3, 255, 257, 267 structural fiscal balance 257, 260–1, 262 trend versus potential 33 see also productivity gross national product (GNP) 17, 18, 104 Guatemala 151 health sector AUGE health program 34, 192, 237, 246, 273, 277 inequality and poverty 180, 191–2, 193, 195–6 Lagos regime 34 Pinochet regime 10, 11, 180 recession (1999) and recovery 237, 254

298

Index

Herfindahl–Hirschman Index (HHI) 161, 162 Honduras 151 housing 253 hyperinflation 9, 10, 127 Ibáñez, Carlos and regime 5 illiteracy rate 179 import deposits 55 import liberalization Alessandri regime 5 democracy 150 dictatorship 11, 13, 21, 22, 53–4, 75–6 composition of imports 61–3 evaluation 68–75 manufacturing sector 64–8 process 54–60 trade development 131, 135 external indebtedness 93, 95, 96 financial liberalization 77, 88 inequality and poverty 197 interest rates 97, 100 imports Alessandri regime 5 Allende regime 9 Bachelet regime 36 capital flows 218 debt crisis (1982) and recovery 109–10, 112, 114–17, 123, 128 delayed payment for 227 exchange rate policy 264, 265, 266 and export development 131, 133, 137 external indebtedness 103, 104 Frei Montalva regime 7 liberalization see import liberalization marketing 68, 74, 103, 115 Pinochet regime 15–16, 18, 21 recession (1999) and recovery 249, 251 substitution see import substitution under-invoicing of 227 import substitution 5, 61 and export development 133, 139, 152 income distribution 174–5, 206–8 Allende regime 9 capital flows 210 challenges 277 debt crisis (1982) and recovery 126

democracy 26, 37–8, 40–1 dictatorship 11, 20, 23, 24 dictatorship and democracy compared 268–9, 270 external indebtedness 88 financial liberalization 105 import composition 61, 62–3, 66, 75 interest rate differentials 102 recession (1999) and recovery 236 reforms 193–206 trends 176–93 income tax 194 incremental capital-output ratio (ICOR) 46–8, 49 India 151 industrial modernization program, Frei Montalva regime 6, 7 industrial relations 6, 195 see also labor unions and organizations inequality see income distribution infant mortality rate 180 inflation 43 Alessandri regime 5 Allende regime 7, 9 Aylwin regime 27 Bachelet regime 36, 37 capital flows 217, 225 debt crisis (1982) and recovery 124, 127, 128 exchange rate policy 88–9, 90–2, 93–6, 98, 139, 140 external 16 financial liberalization 82 Frei Montalva regime 6, 7 Frei Ruiz-Tagle regime 30, 31 hyperinflation 9, 10, 127 Ibáñez regime 5 import liberalization 60 interest rates 99 Lagos regime 35 Pinochet regime 13–17, 21 recession (1999) and recovery 240, 241, 244, 246, 249, 251–3 structural fiscal balance 261 informal labor market 196 infrastructure capital formation 170 public spending on 170, 239 structural fiscal balance 259

Index inheritances, impact of 273 innovation democracy 38, 42 inequality and poverty 203, 205 recession (1999) and recovery 250, 254 structural fiscal balance 259 Inter-American Development Bank (IADB) 239 interest rates 43 Aylwin regime 27, 28, 129 Bachelet regime 36, 37 capital flows 210, 211–12, 217, 218, 222–3, 231, 232 challenges 274 debt crisis (1982) and recovery 77, 122, 123, 125, 128–9 export development 134, 140, 155 external indebtedness 90, 96–102, 103, 104 financial liberalization 79–83, 88 Frei Ruiz-Tagle regime 31 import liberalization 73 inequality and poverty 206–7 Pinochet regime 11, 13, 16, 17, 22 exports 134, 140 recession (1999) and recovery 240, 243, 249, 251, 253 intermediate goods 61 Internal Revenue Service 23 International Development Bank (IDB) 20, 117 international financial crisis 37, 237–8, 252, 253, 269 exchange rate policy 263 structural fiscal balance 259, 260 international financial institutions (IFIs) 103, 117–18 International Monetary Fund (IMF) 19, 20, 29, 117 international reserves see reserves investment Alessandri regime 5 Allende regime 7 capital flows 210, 213, 220–1, 229, 231, 232–4 challenges 276 debt crisis (1982) and recovery 78, 113, 114, 116, 122, 124–6

299

democracy 38 Aylwin regime 25, 27, 29 exports 157, 167 Frei Ruiz-Tagle regime 30, 32 Lagos regime 32, 35 dictatorship 18–19, 23 exports 132, 134, 144 exchange rate policy 263 exports democracy 157, 167 dictatorship 132, 134, 144 export investment financing 137 external indebtedness 88, 102, 103 FDI see foreign direct investment financial liberalization 79–80, 81, 105 capital flows 84, 88, 105–6 Frei Montalva regime 6 import composition 61 import liberalization 64, 66, 73 inequality and poverty 202–3, 204–6 interest rates 100 potential GDP 44 recession (1999) and recovery 236–7, 242, 244–5, 248–9, 255 Iraq wars 217, 241 ISAPRES 195–6 Japan Chilean exports to 142, 143, 163–4, 165 tariffs 57 trade agreement with Chile 151 justice, public expenditure on 239 Korea agreement with Chile 151 capital flows 214 domestic positive shock 35, 246 exports 161, 251 intensive development period 25 investment ratio 32, 245 macroeconomic imbalance 246 tariffs 57 trade and financial reforms 57, 207 labor force participation rate 34 women 40, 193, 199

300

Index

labor market Allende regime 9 capital flows 210, 232, 233 challenges 276 debt crisis (1982) and recovery 109, 112, 127 democracy 184, 190–3, 195–8, 200–1, 203–4 exchange rate policy 266 import liberalization 64, 65, 68, 74 inequality and poverty 40–1, 175, 202, 204 informal 196 Lagos regime 34 output gap 34 recession (1999) and recovery 245, 247, 254 training see education and training unemployment see unemployment labor relations 6, 195 see also labor unions and organizations labor rights 23, 26, 34, 195, 229 labor unions and organizations Aylwin regime 26 Frei Montalva regime 6 inequality and poverty 195 Pinochet regime 10, 11, 13, 14, 16, 20 Lagos, Ricardo and regime 24, 25, 31, 32, 33–4, 35, 37, 269 fiscal policy 256 macroeconomic variables 8 social security system 193 land reform and ownership debt crisis (1982) and recovery 126 Frei Montalva and Allende regimes 179 Pinochet regime 11, 12 Latin American countries (LACs) capital account 238–9 capital flows 88, 154, 209, 213, 215 Chilean exports to 142, 143, 151, 162–4 commodity boom 35 debt conversion 119 exchange rates 154–5 exports 149, 161, 170, 171–2 foreign capital, net use of 89 foreign debt crises 109, 120

GDP 36, 41, 149, 170–2, 236, 247–9, 253 hyperinflation 127 import liberalization 72 infant mortality rate 180 international financial institutions 117 investment ratio 88 open regionalism 151 per capita bank debt 85 regional integration 7, 275 regressive trends (1980s) 202 tariffs 138 trade liberalization 165 Latin American Integration Association (LAIA) 220 law of one price 94, 95 life expectancy 180 life insurance companies 221 literacy rate 179 Lula da Silva, Luiz Inacio 241 macroeconomic adjustment to external indebtedness 88–97, 102 macroeconomic balance 42–3, 272–3 capital flows 216–17 debt crisis (1982) and recovery 126–9 exchange rate policy 267 export development 144 inequality and poverty 175, 204–6, 207 labor market 34 private investment 27 recession (1999) and recovery 243, 245 macroeconomic effects of capital flows 105 of import liberalization 64–6 macroeconomic framework and import liberalization 71–3 macroeconomics for development 272–3, 274–5 Malaysia 35, 246 manufacturing sector debt crisis (1982) and recovery 112, 113 dictatorship 22, 136, 142, 143 effect of trade liberalization on 64–8 exchange rate policy 95

Index exports democracy 161–2, 165 dictatorship 136, 142, 143 external indebtedness 104 inequality and poverty 197 marketing imported products 68, 74, 103, 115 market segmentation 102 MERCOSUR 151, 158, 165 mergers 68 Mexico capital flows 209, 214–15 Chilean exports to 165 economic complementarity agreement 151 investment ratio 32 NAFTA 173, 215 savings 233 tequila crisis 28, 30, 77, 83, 214–15, 223, 228, 233, 245 microcredit 254 military coup 6, 9 minimum wage 180, 181, 184, 192, 195 molybdenum 69, 96, 160 monetarism 93 monetary policy Aylwin regime 28 capital flows 211–12, 232 debt crisis (1982) and recovery 115, 123, 128 exchange rate policy 264 external indebtedness 88, 89–90, 92, 104 financial liberalization 80 Pinochet regime 13–16, 22 recession (1999) and recovery 244, 246, 253, 256 structural fiscal balance 256, 261 monetary sterilization 28 money supply Allende regime 7 debt crisis (1982) and recovery 128 external indebtedness 88, 89, 103–4 financial liberalization 82, 104 Ibáñez regime 5 Pinochet regime 14, 16, 21 multinational corporations 11 mutual funds 213, 221, 238

301

NAFTA 150, 173, 215 National Bureau of Statistics (INE) 179, 188 National Common Fund 195–6 National Council for Innovation and Competitivity 170 nationalization programs 6, 7, 11, 13 National Training and Employment Service (SENCE) 197–8 neoliberalism 3, 9–10 domestic financial liberalization and external debt 77–106 import liberalization 53–76 inequality and poverty 193–8, 207 outcomes 21–4 pragmatic, with regressive bias (1982–9) 10, 20–1, 109–29 pure (1973–81) 10–19 net transfer of funds (NTF) 80 Nicaragua 151 non-tariff barriers 55, 57, 60, 133, 150 North American Free Trade Agreement (NAFTA) 150, 173, 215 oil industry democracy 35, 36, 39 dictatorship 13 globalization of volatility 159 and import composition 61 Iraq crisis 217 recession (1999) and recovery 249, 251–2 oil shocks 13, 14 one price, law of 94, 95 open regionalism 151 Organization for Economic Cooperation and Development (OECD) 29, 215 output see gross domestic product; gross national product; productivity Paraguay 151 parliamentary elections 26, 42, 254 Pension Reserve Fund 259 pensions debt crisis (1982) and recovery 122 democracy 184, 191, 196, 201 dictatorship 11, 12, 180 private funds see private pension funds

302

Index

pensions – continued recession (1999) and recovery 237, 254, 259 Peru 151 Pinochet, Augusto and regime 3, 9–10 Central Bank Autonomy Act 1990 140 comparison between dictatorship and democracy 268–71 Constitution 26 debt crisis (1982) and recovery 109–29 import liberalization 11, 13, 21, 22, 53–4, 75–6 composition of imports 61–3 evaluation 68–75 manufacturing sector 64–8 process 54–60 trade development 131, 135 inequality and poverty 174, 179–84 macroeconomic variables 8, 22 outcome of regime 21–4 plebiscite (1988) 140 pragmatic neoliberalism, with regressive bias (1982–9) 10, 20–1 pure neoliberalism (1973–81) 10–19 savings 18–19, 233 social security reform 12, 27 political parties 20, 24 portfolio investment 213, 214, 220, 243 poverty 174–5, 206–8 Aylwin regime 26 challenges 277 Chile Solidario 34, 184, 191, 192, 202, 237, 246, 253, 273, 277 definition 176 recession (1999) and recovery 246, 254 reforms 193–206 trends 176–93 poverty line 176–8, 185–7 Presidential Advisory Council for Labor and Equity 184 presidential campaigns and elections 1989 24 1999 32 2010 42, 254, 270 price controls and bands Allende regime 9

debt crisis (1982) and recovery 123 export development 135, 138 price liberalization 11, 12, 13, 57 private debt, “nationalization” of 20, 110, 117–18 private pension funds 196 capital flows 220, 221 challenges 276 Frei Ruiz-Tagle regime 31 recession (1999) and recovery 238, 241, 244 privatization debt crisis (1982) and recovery 110, 120, 122, 125–6 inequality and poverty 195 interest rates 100 Pinochet regime 11, 12, 13 recession (1999) and recovery 250 PRO-CHILE 72, 134, 138, 154 product differentiation 74 production function 48–9 productive frontier (PF) 33, 38 capital flows 224, 232, 233 debt crisis (1982) and recovery 113, 128 democracy 29, 30, 32, 36 estimation 43, 44, 46–9 exports 171 macroeconomics for development 272 recession (1999) 252 structural fiscal balance 260, 261 productivism 38, 42, 43, 254, 267, 272–3 productivity Allende regime 9 Aylwin regime 28 capital flows 210 challenges 274 debt crisis (1982) and recovery 109–10, 112–16, 124–6 exchange rate policy 95 external indebtedness 104 Frei Montalva regime 6, 7 Frei Ruiz-Tagle regime 32 import liberalization 64–8, 73 inequality and poverty 203 macroeconomics for development 272 Pinochet regime 13, 14, 21–2

Index recession (1999) 236–7, 242, 244, 251 see also gross domestic product; gross national product professional associations 10 public expenditure see government spending public purchasing mechanisms 12–13 quotas, and financial liberalization 82, 90 real estate 243 recessions and financial crises 1975 18, 19, 21, 24, 64 1982 debt crisis 3, 13, 19, 20, 21, 24 accumulation of imbalances 110–12 capital flows 213 causes 77–106 export development 131, 133 public debt 27 recovery 109–10, 117–29 shocks 112–17 1999 236–8, 267 decelerated recovery (from 2006) 249–55 dynamic recovery (2004–5) 247–9 exchange rate policy corrections 262–7 impact 240–3 origins 238–9 recessive phase (1999–2003) 243–7 structural fiscal balance 255–62 2009 37 Ibáñez regime 5 structural fiscal balance 33, 255–62 reform of the reforms 4, 25–31, 150, 269, 273 inequality and poverty 190, 192 regional integration 7, 275 regulatory framework 5 reserves 81, 83, 90, 97–9 Alessandri regime 5 Allende regime 7 capital flows 86, 210, 213, 216, 218–19, 224, 226–33 debt crisis (1982) and recovery 110, 113, 114, 115 exchange rate policy 139

303

external indebtedness 88–90, 96, 98–9 financial liberalization 81, 83, 86 Frei Montalva regime 6 import liberalization 69 Pinochet regime 16 recession (1999) and recovery 239, 243, 246 resource allocation exchange rate policy 262, 264, 266, 275 exports 171 financial liberalization 79, 104 import liberalization 72 interest rate differentials 102 risk rating of Chilean economy 27, 213, 246 sales taxes 11 salmon industry 136, 142, 159–60 SALs (Structural Adjustment Loans) 117, 216 savings capital flows 84, 105–6, 209, 231, 232–4 challenges 276 debt crisis (1982) and recovery 112, 114, 122, 125 democracy 27, 33, 38–9 dictatorship 18–19, 233 external indebtedness 88, 102, 103 financial liberalization 79–80, 81, 84, 105–6 import liberalization 75 interest rates 101–2 recession (1999) and recovery 237, 255, 262 structural fiscal balance 262 self-employment 196 SENCE (National Training and Employment Service) 197–8 seniors, inequality and poverty 201 September 11, 2001 attacks 241 shanty towns, eradication programme 34 small and medium-sized enterprises (SMEs) capital flows 229, 231, 232 democracy 36, 37, 38, 42 exchange rate policy 266

304

Index

SMEs – continued export development 137 financial liberalization 105 inequality and poverty 203, 205, 206–7, 208 recession (1999) and recovery 243, 245, 250, 254 structural fiscal balance 259 social expenditure Allende regime 7, 179 Aylwin regime 26 capital flows 216 challenges 277 democracy and dictatorship compared 271 inequality and poverty 206 democracy 184, 191–2, 193, 194–5, 201 dictatorship 180, 182 Pinochet regime 180, 182 trends 181 see also government spending social movements 24 social policy 273 dictatorship and democracy compared 270 inequality and poverty 204 recession (1999) and recovery 237, 246, 253–4 social security system capital flows 210 debt crisis (1982) and recovery 122, 126 democracy 40–1 dictatorship 12, 27, 180 inequality and poverty 193, 195 reform (2008) 184, 192, 273, 277 South Korea see Korea steel industry 160 stock markets capital flows 213, 214, 223, 229 debt crisis (1982) and recovery 120–2 interest rates 100 recession (1999) and recovery 243 strikes 6, 9 Structural Adjustment Loans (SALs) 117, 216 structural fiscal balance (SFB) 33, 255–62

subsidies 110, 116 democracy 153–4 dictatorship 20 GATT/WTO restrictions 153 inequality and poverty 195 Supintendencia de Bancos 123, 242 Taiwan 25, 57, 161, 207 tariffs Bachelet regime 36 capital flows 218 countries other than Chile 57 debt crisis (1982) and recovery 116, 123 drawback scheme 135–6, 153–4 exchange rate policy 263 exports democracy 150, 152, 157 dictatorship 133, 134, 135–6, 138–9 import liberalization 53, 54, 55–60, 72, 75 Pinochet regime 12, 133, 134, 135–6, 140 recession (1999) and recovery 251 taxation capital flows 105, 216, 218, 226, 229 challenges 277 debt crisis (1982) and recovery 122, 128 democracy 26, 27, 28, 30, 37, 39 inequality and poverty 184, 192, 194, 206, 207 dictatorship 11, 21, 23, 182 Frei Montalva regime 6, 7 income tax 194 rebates 153 recession (1999) and recovery 237, 239, 248, 253, 256–7 sales taxes 11 structural fiscal balance 256–7, 260 value-added tax (VAT) 11, 26, 137, 192, 194 technology capital flows 233 challenges 275 export development 132, 137 inequality and poverty 203, 205 terms of trade Allende regime 7 capital flows 212, 223, 224

Index

305

debt crisis (1982) and recovery 113, 114, 116–17, 120, 124, 128 democracy 29, 30, 31, 35, 39 exports 157, 158, 159–61 dictatorship 13, 14, 21, 131, 135 exchange rate policy 140, 266 exports democracy 157, 158, 159–61 dictatorship 131, 135 Frei Montalva regime 6 import liberalization 66 recession (1999) and recovery 236, 237, 240, 247, 249, 250, 256 structural fiscal balance 256, 259 time deposits 219 total factor productivity (TFP) 43, 44, 48, 203, 250, 264 trade deficit see balance of trade trade liberalization debt crisis (1982) and recovery 113 effects on manufacturing 64–8 export development 133 external indebtedness 103 Frei Montalva regime 54 Latin American countries 165 Pinochet regime 12–13, 22, 53 see also import liberalization trade policy debt crisis (1982) and recovery 123, 128 democracy 149–56, 166, 196–7 exchange rates 262–3, 266 export development 130–1, 132–40 inequality and poverty 196–7 trade surplus see balance of trade trade unions see labor unions and organizations training see education and training Treasury crawling exchange rate 90, 92–3 debt crisis (1982) and recovery 122 global financial crisis 237–8 recession (1999) 243, 252, 259

dictatorship 14, 19, 183–4 exchange rate policy 95 and import liberalization 64, 71, 72, 73, 74 insurance 34, 200–1, 206, 254, 273 recession (1999) and recovery 242, 244, 256 structural fiscal balance 256 trade policy 152 Unidad de Fomento (UF) 244 Unidad Popular (UP) 7 United Kingdom 202 United States of America ADRs 213, 219, 221, 228 capital account liberalization 29 capital flows 218, 222–3 Chilean exports to 142, 143, 152–3, 162–4 exports 251 free trade agreements 150, 151 GDP 41, 236 loans to Chile 7, 20 NAFTA 150 regressive trends (1980s) 202 tariffs 57 unremunerated reserve requirement (URR) 218–19, 224, 232, 239, 244 Uruguay 151 utility tariffs 7

unemployment Anti-unemployment Contingency Program 259–60 debt crisis (1982) and recovery 127 democracy 34, 40, 184, 190–1, 193, 200–1

wage levels Allende regime 7, 9, 179 Aylwin regime 26 capital flows 210 debt crisis (1982) and recovery 116, 122, 124, 125

value added debt crisis (1982) and recovery 115 exchange rate policy 95, 266 exports democracy 152, 154, 158, 161–2, 165, 167–9, 172 dictatorship 142 external indebtedness 103 import liberalization 64, 65, 73, 75 Pinochet regime 17, 18 tax (VAT) 11, 26, 137, 192, 194 Venezuela 88, 151

306

Index

wage levels – continued exchange rate policy 93, 95 Frei Montalva regime 6 import liberalization 64, 65, 72 inequality and poverty 177–8, 184, 190, 192–3, 197, 198–9, 204 minimum wage 180, 181, 184, 192, 195 Pinochet regime 14, 16, 23, 24, 180, 202–3

poverty line 177–8 trends 181 water subsidy 191 women labor force participation 40, 193, 199 unemployment 200 World Bank 20, 29, 117, 216, 239 world trade 156–7, 252 World Trade Organization (WTO) 150, 151, 153, 167