Fri, 01/06/2007 - 02:00 | by admin
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Inflationary pressures, currency appreciation and a drop in share prices are the possible consequences of policy measures unveiled recently by the Chilean government.
On May 21, in her second state-of-the-nation address, President Michelle Bachelet announced a relaxation of the structural fiscal surplus rule, cutting the annual surplus from 1% of GDP to 0.5% as from 2008. In changing this key plank of Chile’s macroeconomic policy, the President noted that “conditions have changed…we have reduced public debt and accumulated funds to guarantee the stability of future social spending.”
This decision was not a surprise since the government had been facing growing pressures to cut the surplus and free up more funds to spend on education, and research and development. In addition, it came on the heels of poll data showing that the President’s approval ratings had bottomed to approximately 40%. However, the magnitude of the reduction (50 basis points) was more than we expected as we had anticipated a more gradual approach (i.e. 25 basis-point annual reductions), particularly considering that the new estimate for the reference copper price, used to draw up the budget, has yet to be announced by the committee of experts charged with this task.
This move will boost government spending and could be inflationary. Much will depend on what happens to the government’s copper price assumptions and on how the new monies are spent.
Given the more aggressive surplus cut, we could see a smaller change to the reference long-term copper price as compared to the US$1.21/lb used for the 2007 budget. Based on our calculations, the extra 0.5% of GDP should amount to roughly US$660-700 million, a 2.4% increase relative to budgetary spending in 2008 as calculated using the 1% of GDP structural surplus fiscal rule and the assumptions of a reference copper price of US$1.21/lb, GDP growth of 5.7% in 2007 and 5.5% in 2008, and consumer price inflation of 3% in 2007 and 2008.
In other words, under these core assumptions, the added spending does not appear significant. However, more aggressive assumptions as to the reference copper price could significantly magnify the impact of this more flexible fiscal stance.
The destination of the resources is also of great importance in terms of potential inflationary and currency appreciation effects. This will depend on whether these new monies are allocated to current spending, which would take place on a recurring basis, or go into capital spending, which would not necessarily need to be repeated, giving the administration more flexibility down the road.
Furthermore, in the case of Chile, capital spending is more likely to finance imports given that domestic production of machinery and equipment tends not to be significant. In other words, if the added fiscal resources are used to finance investments, both the inflationary and exchange rate appreciation effects should be lower than if devoted to current spending since the monies would be mostly re-routed abroad (to purchase imports) while the country increases its productive capacity to meet the increase in consumer demand that arises in line with a more expansionary fiscal policy, thereby mitigating inflationary pressures.
President Bachelet also announced a potentially important change in the investment limits of the country’s private pension funds (AFPs), which currently manage assets worth some US$97 billion, promising to send to Congress a bill that would raise the cap on their overseas investments from 30% to 45% of total assets under management. This comes significantly earlier than expected (expectations had been for 2008) and will have some negative impact on the equity market and the currency.
We would expect the AFPs to move to the new limit quickly, given greater foreign liquidity, diversification possibilities and the local low interest rate environment, and to fund the shift from their large positions in local time deposits. We also expect to see some stock market impact with retail investor fund flows seeing a reversal from recent trend as AFP pressure comes off fixed income rates. We could also see secondary impacts as contributors may switch to more conservative funds (with lower equity weights) within the AFP multi-fund system.
Ben Laidler Director of Southern Cone & Andean Research, Associate Latin American Strategist, UBS.
Relaxing Fiscal Policy
By By Ben LaidlerPrintSend to friend
Inflationary pressures, currency appreciation and a drop in share prices are the possible consequences of policy measures unveiled recently by the Chilean government.
On May 21, in her second state-of-the-nation address, President Michelle Bachelet announced a relaxation of the structural fiscal surplus rule, cutting the annual surplus from 1% of GDP to 0.5% as from 2008. In changing this key plank of Chile’s macroeconomic policy, the President noted that “conditions have changed…we have reduced public debt and accumulated funds to guarantee the stability of future social spending.”
This decision was not a surprise since the government had been facing growing pressures to cut the surplus and free up more funds to spend on education, and research and development. In addition, it came on the heels of poll data showing that the President’s approval ratings had bottomed to approximately 40%. However, the magnitude of the reduction (50 basis points) was more than we expected as we had anticipated a more gradual approach (i.e. 25 basis-point annual reductions), particularly considering that the new estimate for the reference copper price, used to draw up the budget, has yet to be announced by the committee of experts charged with this task.
This move will boost government spending and could be inflationary. Much will depend on what happens to the government’s copper price assumptions and on how the new monies are spent.
Given the more aggressive surplus cut, we could see a smaller change to the reference long-term copper price as compared to the US$1.21/lb used for the 2007 budget. Based on our calculations, the extra 0.5% of GDP should amount to roughly US$660-700 million, a 2.4% increase relative to budgetary spending in 2008 as calculated using the 1% of GDP structural surplus fiscal rule and the assumptions of a reference copper price of US$1.21/lb, GDP growth of 5.7% in 2007 and 5.5% in 2008, and consumer price inflation of 3% in 2007 and 2008.
In other words, under these core assumptions, the added spending does not appear significant. However, more aggressive assumptions as to the reference copper price could significantly magnify the impact of this more flexible fiscal stance.
The destination of the resources is also of great importance in terms of potential inflationary and currency appreciation effects. This will depend on whether these new monies are allocated to current spending, which would take place on a recurring basis, or go into capital spending, which would not necessarily need to be repeated, giving the administration more flexibility down the road.
Furthermore, in the case of Chile, capital spending is more likely to finance imports given that domestic production of machinery and equipment tends not to be significant. In other words, if the added fiscal resources are used to finance investments, both the inflationary and exchange rate appreciation effects should be lower than if devoted to current spending since the monies would be mostly re-routed abroad (to purchase imports) while the country increases its productive capacity to meet the increase in consumer demand that arises in line with a more expansionary fiscal policy, thereby mitigating inflationary pressures.
President Bachelet also announced a potentially important change in the investment limits of the country’s private pension funds (AFPs), which currently manage assets worth some US$97 billion, promising to send to Congress a bill that would raise the cap on their overseas investments from 30% to 45% of total assets under management. This comes significantly earlier than expected (expectations had been for 2008) and will have some negative impact on the equity market and the currency.
We would expect the AFPs to move to the new limit quickly, given greater foreign liquidity, diversification possibilities and the local low interest rate environment, and to fund the shift from their large positions in local time deposits. We also expect to see some stock market impact with retail investor fund flows seeing a reversal from recent trend as AFP pressure comes off fixed income rates. We could also see secondary impacts as contributors may switch to more conservative funds (with lower equity weights) within the AFP multi-fund system.
Ben Laidler Director of Southern Cone & Andean Research, Associate Latin American Strategist, UBS. 
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