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As 2011 draws to a close there are substantial risks in the global economy that Chile cannot afford to ignore. These are focused in Europe, but the fallout from the debt crisis in that continent could have important repercussions for emerging economies next year and beyond.

 “The world has changed significantly during 2011,” said José de Gregorio, president of Chile’s Central Bank, at an AmCham breakfast in September.

The current global economic situation was virtually unthinkable six months ago. At that time the major risks facing Chile’s economy were overheating and higher inflation due to soaring commodities prices. Developed economies were recovering more slowly, but emerging economies including Chile were surging.

“The right thing to do in that situation in terms of monetary policy is raise rates in line with inflation,” said de Gregorio.

But by the end of August, that scenario had changed dramatically. Standard & Poor’s downgraded the US debt and at the same time the EU debt crisis, which until then had been contained in Portugal, Greece and Ireland, began to spread to Italy, Spain and other countries.

The result in Chile and the world has been slower economic growth, lower commodities prices and lower inflation. Nevertheless, the Central Bank has maintained the benchmark rate steady at 5.25% since June. And, according to the bank’s latest monetary policy report (IPOM), it plans to leave the rate unchanged until at least the end of this year.

“One thing is monetary policy and another thing is what actually happens in the real economy,” said de Gregorio, adding that Chile’s economy is expected to grow around 6% in 2011. However, the Central Bank has downgraded its economic growth forecast for 2012 to between 4.5% and 5%.

This reflects the risk of contagion of the Euro crisis. With Greece and Italy facing risk premiums up to ten times higher than Germany, it is becoming increasingly expensive for these countries to finance their debt. “There is a tremendous crisis of confidence in Europe which is contaminating the banking system,” said de Gregorio.

But unlike the dramatic collapse of Lehman Brothers in 2008, the European crisis has evolved “in slow motion” with days of optimism and others of pessimism, said de Gregorio, who has governed the Central Bank since 2007.

“Lehman was like a car going at 100 kilometers in the rain when it suddenly jumps the barrier and crashes,” he said. “Today, it’s like the same car going into a tunnel without its lights on where none of the other cars have their lights on either and you can’t see the end.”

Of course, in this situation drivers are going slowly and some European economies have stalled. “We can’t rule out that the situation will get even worse next year,” said de Gregorio.

The EU has approved a significant bailout package for Greece, but now Italy looks like it may also need a hand. “European leaders can’t find a way out of this crisis,” admitted de Gregorio.

Part of the problem is that the institutions don’t exist that could solve the crisis. But the world is better prepared today than it was in 2008. This time governments and central banks have had plenty of time to prepare and implement necessary safeguards.

“There are many more mechanisms to mitigate a potential recession or prolonged slowdown,” said the Central Bank president.

But further weakening of the US economy is likely. Business confidence in the United States, which has rocked by the Japanese earthquake in March, continues to slide. Unemployment is rising and household debt has reached exorbitant levels. Meanwhile, the Federal Reserve benchmark interest rate remains near 0%, leaving little room for expansive monetary policy.

Even so, US stock markets have not fallen as much as Latin American markets, noted de Gregorio. The reason is that in times of uncertainty investors take refuge in US treasury bills and the dollar. This has had an important impact on the exchange rate, with the dollar rising from 460 pesos at the beginning of August to over 500 pesos in November.

Even more worrying for Chile than the peso’s depreciation, has been the sudden drop in prices for commodities including copper, which has fallen from a record high of US$4.60 per pound in February to less than US$3.50/lb.

The world economic outlook for 2012 is uncertain with recession a strong possibility, said de Gregorio. In this scenario, Chile must drive with caution but as long as it keeps its eye on other drivers and brakes when necessary, it should make it out the other side of the tunnel.

“We have shown our ability to adjust monetary policy when necessary,” de Gregorio said, adding that, thanks to its low risk premium – lower than two thirds of European countries – Chile has all financing options open. “We will keep monitoring the external situation but Chile remains in a very strong economic position,” he concluded.

Julian Dowling is Editor of bUSiness CHILE