Cablegate: Chile's Economy: Strong but Beginning to Feel the Impact

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TREASURY FOR MMALLOY/RJARPE
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E.O. 12958: N/A
TAGS: ECON EFIN ETRD EINV ECIN PGOV PREL CI

SUBJECT: CHILE'S ECONOMY: STRONG BUT BEGINNING TO FEEL THE IMPACT
OF THE GLOBAL FINANCIAL CRISIS

1. (SBU) SUMMARY: Chile's economic fundamentals remain strong, but
economic growth will likely slow, negatively impacted by declining
trade and investment, relatively high inflation, falling commodity
prices, especially copper, and tightening liquidity. The peso's
fall against the dollar, low foreign debt, fiscal discipline, and
Chile's Sovereign Wealth Funds can help cushion negative economic
effects. END SUMMARY.

Declines In Copper, Currency, And The Stock Market
--------------------------------------------- -----

2. (SBU) Chile has seen a week of precipitous drops in the price of
copper, the exchange rate, and the stock market. The price of three
month copper contracts on the London Metal Exchange has dropped 11%
this week, and copper has hit is lowest price since February 2007
(dropping from a record high of $4.07 per pound in July 2008 to
$2.45 per pound this week). The value of the U.S. Dollar has
increased against the Chilean Peso by 43 Pesos in the last week (a
depreciation of almost 8% for the Peso). The Peso has also dropped
to its lowest level against the Dollar in four years. The IPSA
index (Chile's equivalent of the Dow Jones Industrial Average) has
lost over one fifth of its value in the last five days, falling
almost 5% in one day alone, and reaching its lowest point since
2006.

Economic Growth Will Probably Slow But Remain Positive
--------------------------------------------- ---------

3. (SBU) GDP grew 3.3% in the first quarter of 2008 and 4.3% in the
second. The Monthly Index of Economic Activity, which compares
variations in economic activity for the same month from year to
year, increased 6.2% in July 2008, but only 2.4% in August (much
lower than expected). The Ministry of Finance had forecast 5.4%
growth in the third quarter, with annual growth at close to 4.2% for
2008 and 4% in 2009. However, the global financial crisis has
caused many independent experts (and even some in the GOC) to revise
their forecasts downward. Morgan Stanley recently decreased its
estimate for Chile's 2008 GDP growth to 3.8%. Some analysts have
said Chile will be lucky to grow by 3% in 2009.

A Global Economic Downturn Would Hurt Chilean Trade
--------------------------------------------- ------

4. (SBU) Trade has been one of the prime engines of growth for
Chile, particularly given the huge role of copper exports (copper
accounted for almost 64% of exports in 2007, equivalent to roughly
25% of GDP). The vertiginous rise of copper prices in recent years
has helped Chile run consistent trade surpluses until last month,
which registered the first trade deficit since 2002. This was
likely due to lower levels of copper production and high oil prices
(Chile imports almost all of its oil). Chile's export sector is
continuing to diversify, as trade volumes in non-copper products
increase, but mostly in other commodities (e.g., woodpulp). Experts
believe Chile must begin exporting more value-added products, which
are starting to appear (e.g., firearms) but remain insignificant
when compared with commodities.

5. (SBU) Many Chileans fear the current crisis will lead to a global
economic downturn, which would reduce demand for Chilean exports.
In 2007, 41% of Chile's exports went to Asia and 15% went to China
alone (Chile's leading export destination). Copper products
accounted for almost 90% of all exports to China. If Chinese growth
alone were to slow, it would have a significant, negative impact on
Chilean exports. Lower commodity prices could reinforce the impact
(copper dropped to a 30 month low this month). Banks in Chile have
reportedly calculated that a change of one cent in the price of
copper will increase or decrease Chile's trade by approximately $70
million.

Depreciation Of The Peso Could Cushion Negative Effects
--------------------------------------------- ----------

6. (SBU) Since March 2008, the Chilean Peso has steadily fallen
against the U.S. Dollar, accelerating during the financial crisis,
to reach a 4 year low this month (a depreciation of nearly 20% in
2008). The Central Bank had embarked in April on an $8 billion
program to purchase dollar reserves, which it halted when the

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financial rescue package was unveiled in the U.S. The lower
exchange rate will be a boon to exporters and may help cushion some
of the effects of lower demand for Chilean products overseas.

Investment Has Been Healthy, While Consumption Slows
--------------------------------------------- -------

7. (SBU) Investment has been steadily rising in Chile. In the
second quarter of 2007, gross fixed capital formation grew 13% on
the previous year, whereas the second quarter of 2008 showed a 23%
increase for the same period. Consumption has slowed down. In the
second quarter of 2007, total consumption registered an 8% increase
on the previous year, but in the second quarter of 2008 it increased
less than 6%. Sales of consumer goods also slowed, expanding 8% in
the first half of 2007, but increasing only 4% during the same
period in 2008. Rising inflation, tightening credit standards, and
slower job creation were the main causes. In the second quarter of
2008, gross capital formation exceeded domestic savings for the
first time in many quarters, possibly pointing to a move toward
foreign savings as a source for investment. However, most analysts
fear Chile will see a decrease in investment due to less domestic
liquidity (more below) and a possible global economic downturn.

Inflation Is High, Monetary Policy Is Tightening
--------------------------------------------- ---

8. (SBU) Relatively high inflation continues to dog the Chilean
economy. In September 2008, inflation was 9.2% (as measured by the
consumer price index) triple the Central Bank target rate. Core
inflation reached 0.7 percent in August totaling a 9 percent
increase in 12-months. In September, the Central Bank continued to
tighten monetary policy, raising the interest rate to 8.25 percent,
the highest rate since 1998. According to the President of the
Central Bank, the increase was necessary to ensure convergence of
inflation toward 3% over the policy horizon. Inflation expectations
point to a slow decline in inflation over the next year. The
Central Bank has repeatedly called inflation an "imported problem"
linking it to persistent, high commodity prices (especially oil and
agricultural products imported by Chile). A global downturn may
help ease price pressures, but a continued depreciation of the
Chilean Peso will also affect prices. Maintaining a contractionary
monetary policy may prove difficult if the negative impact on the
real economy is significant.

Less Liquidity In Banks May Hurt Domestic Companies
--------------------------------------------- ------

9. (SBU) Although there have been no reports of exposure to
mortgage-backed securities, liquidity has become a concern for
Chilean banks. Before the crisis, the spread on international loans
to Chilean institutions was relatively small (LIBOR + 10 basis
points). Many international banks began to lend less or pull out of
Chile in search of better returns. The spreads have increased
(currently LIBOR + 27 basis points), but foreign banks have been
slow to return. Anecdotal evidence indicates international lines of
credit to Chilean institutions are drying up now. Chilean banks
have tightened credit and raised interest rates on deposits to
attract more capital. The week of October 6, the Central Bank
announced a $500 million currency swap program to improve dollar
liquidity and the Finance Ministry injected $1 billion into Chile's
four largest banks.

10. (SBU) Large companies (especially multinationals) are reportedly
taking out loans simply to ensure they have extra liquidity on hand
in case it becomes necessary. This make liquidity even tighter for
small- to medium-size enterprises (the majority of Chile's private
sector), many of which depend on the loans for operating capital.
Analysts fear this effect may accelerate, causing some Chilean
businesses to curtail operations or even close, likely impacting
unemployment. Chilean industrial production fell 3.1% in August
2008 compared with the same period in 2007 (mostly due to lower
copper production). In August, unemployment was 8.2%, up from 7.2%
in January.

Fiscal Discipline, Sovereign Wealth Funds May Help
--------------------------------------------- -----

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11. (SBU) Chile's fiscal discipline has been an ongoing strength of
its economy. The GOC is required to run a structural fiscal surplus
of 0.5% of GDP (changed in 2007 from 1%). Chile has run budget
surpluses for most of the past two decades. In 2007, the fiscal
surplus represented 8.2 percent of GDP.

12. (SBU) The GOC has wisely chosen to keep windfall copper revenues
(from the state-owned CODELCO copper company) outside of the economy
in Sovereign Wealth Funds. In 2006, the Government created the
Pension Reserve Fund (FRP) and the Economic and Social Stabilization
Fund (FEES), estimated currently at a combined $21 billion. The GOC
has also announced plans to create a third fund for education.
Chile's fiscal discipline, relatively low foreign debt levels (35%
of GDP in the second quarter of 2008), mounting reserves (11% of GDP
in the second quarter of 2008), and Sovereign Wealth Funds, will
likely protect the country from some of the effects of an economic
slowdown.
SIMONS

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