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When Air Force One touches down in Santiago in March, the world’s attention will once again shift to Chile. After last year’s 8.8 earthquake and the dramatic rescue of the 33 miners in Copiapó, Chile has had its fair share of media attention, but President Obama’s visit is more than just a photo-op – it is a sign of respect for one of the United States’ closest allies in the region.

And that respect is well earned. According to international rankings, Chile is the most competitive country in Latin America with the highest index of economic freedom. It has been one of the big winners of globalization with an extensive network of free trade agreements, and is on track to become a developed country by the end of this decade.

So what is the problem?

On the surface there isn’t one. The copper bonanza of the last five years has helped pay for the earthquake reconstruction and the country’s macroeconomic management is widely regarded as exemplary. 

Dig a little deeper, however, and the picture is not as pretty. Behind the veil of high copper prices, Chilean companies are less productive than they were a decade ago.

After growing at 2.3 percent a year between 1986 and 1997 when Chile’s economy grew at more than 7 percent annually, productivity - measured as the ratio of output to labor and capital inputs -  fell an average 1.1 percent per year between 2006 and 2009.

“We have lost productivity in the last five years which has been very damaging to our economy,” says Bruno Baranda, the undersecretary for the Labor Ministry.

President Sebastian Piñera has made reversing this trend a priority and productivity grew for the first time last year since 2005, albeit only 0.3 percent, but higher spending is the enemy of efficiency.

Last year’s earthquake, which caused US$30 billion in damages making it one of the most expensive natural disasters in the world, has forced President Piñera to drastically increase spending to pay for the reconstruction.

With copper currently running over US$4.40 a pound after fetching an average US$3.42 in 2010, up from US$0.80 in 2003, and continuing to fill the Social and Economic Stabilization Fund with dollars, financing the reconstruction has not been difficult.

Much work still remains to be done, particularly in terms of housing, but the money is there. The bad news for exporters is the depreciation of the dollar – currently 476 pesos down from 510 a few months ago - and higher inflation, which has prompted the Central Bank to raise interest rates.

Analysts expected a moderate fiscal expansion last year but were surprised when Chile’s real public expenditure jumped 7 percent, exceeding estimated GDP growth of 5.3 percent.

“The fiscal expansion was higher than expected, especially in December, which has negative consequences for the exchange rate and all Chileans end up losing,” says Ricardo Matte, Director of the Economic Program at Santiago think-tank Libertad y Desarollo.

Curbing public spending is key to Chile’s competitiveness in the long- term, he says, but fiscal restraint is difficult given the enormous reconstruction needs.

Fortunately, there are other ways to boost competitiveness and drive economic growth without slashing the budget or waiting for copper prices to fall, which they will inevitably do.

Productivity, according to Matte, needs to grow at about 1.5 percent per year to achieve the government’s goal of 6 percent average economic growth, which is much higher than last year.

“Chile is like a runner than has got out of practice, but at least we know we can do it,” he says. “It’s time we got back into training.”

Making Chile fit again requires macro and microeconomic reforms, says Matte, and with local elections coming in 2012 followed by presidential elections in 2013, this year could be the government’s window to lay the groundwork for future growth.

The productivity gap

First, however, Chile needs to reduce its productivity gap. According to a recent study by the U.S. management consultancy McKinsey & Company, Chile’s labor productivity – measured as GDP per hour worked - is just 34 percent of U.S. productivity.

Closing the gap would have a “huge impact” on economic growth, says Alejandro Krell, a partner at McKinsey & Company in Chile.

Even achieving 76 percent of U.S. productivity – the maximum Chile can hope for given structural constraints - would raise per capita GDP to US$27,000 by 2020 versus US$19,000 at current productivity levels, he says.

According to Krell, about half of the gap is due to “operational factors” such as the lack of standards in the construction sector, which prevents builders from using prefabricated materials.

In the retail sector, the numerous mom-and-pop stores tend to be less productive than larger shops, but even the hypermarkets are less productive that their U.S. equivalents, says Krell.

Then there are the regulatory barriers.

For example, Chilean stores are forbidden from charging customers different fees depending on the method of payment. “The cheque is a manual transaction that is difficult to process which affects productivity,” says Krell.

Countries like Norway have improved productivity by charging customers more for using cheques.

“If the regulations do not give you an incentive to change your behaviour then it’s hard to change cultural habits,” concludes Krell.

Obstacles to competitiveness

Boosting the competitiveness of Chile’s economy requires specific changes depending on the different barriers faced by each sector. 

The Economy Ministry, which has been tasked with boosting competitiveness, created a public-private entity called Impulso Competitivo, or Competitive Stimulus, in November to identify microeconomic obstacles to competitiveness in 10 sectors of the economy.

The report, published in January, lists 300 hurdles including some that are common across all sectors such as labor regulations, energy costs, infrastructure, access to financing, intellectual property rules and permitting costs.

“This study is the seed for an effective reform of state processes,” says Andrés Concha, president of Chile’s Manufacturers’ Association (SOFOFA), who worked with the Economy Ministry on the study’s design.

Ricardo Matte, who participated in the Metallurgy committee, says the measures taken by the Ministry to address these obstacles are aimed at small and medium-size enterprises (SMEs).

“SMEs account for 80 percent of the country’s employment and raising their productivity by reducing costs is essential,” says Matte.

The Ministry has already taken steps, recently pushing through a bill that reduces the time required to form a new business from 27 to 16 days, and is working on other legislation.

McKinsey’s Alejandro Krell says the government’s measures are all “steps in the right direction,” but adds that greater public-private cooperation in areas such as agribusiness and tourism could also help productivity.

A climate that facilitates entrepreneurship and innovation is important, but the study shows that access to lower cost energy supplies, a well trained workforce, and quality public services are also areas where Chile must improve.

Labor flexibility

There were 485,000 new jobs created in Chile last year and the government plans to create another million in the next three years.

While this is good news for Chileans – especially women since they are expected to fill 70 percent of new positions - higher employment is not an indicator of productivity.

Indeed, labor inflexibility is a major constraint to competitiveness, according to the Impulso Competitivo report. The unemployment insurance system is top of the list with the cost of firing equivalent to 100% of a worker’s annual salary compared to an average 54% in the OECD.

The report also noted that the high level of informality in the small business sector is due to “lack of flexibility in the working day.”

For example, only 7% of workers in the formal workforce hold part-time jobs, compared to the OECD average of 15%. “Part time jobs benefit women and young people, but there aren’t enough opportunities in Chile,” says Krell.

Andrés Concha agrees that changes are needed to facilitate the access of women to the workforce. “There is room to improve in areas like part-time work,” he says.

However, a bill proposed by President Piñera to extend maternity leave to six months from three months may end up having the opposite effect.

“Chile already has very low participation of women in the workforce and it will be even lower with this law, what company will want to hire a woman now?” asks Larraín.

The government accepts that the labor market needs to be more flexible, but this requires a broad political consensus that has not yet materialized.

Education reform

Labor market reforms are not much use if those entering the workforce lack the skills to do their jobs efficiently.

Chile has made some improvements in education, but nearly all sectors list human capital as an obstacle to competitiveness. Specific gripes include the inability of workers to speak English, lack of technical qualifications and insufficient training.

“Training and good labor practices are crucial for productivity growth,” says Undersecretary Baranda.

The Labor Ministry is working on a new voucher system that would expand training options for employers and workers in key sectors, he says, but the root of the problem is the country’s public education system.

Chile maintained its ranking of 30th out of 139 countries in the World Economic Forum’s 2010-2011 Global Competitiveness Report and is top in South America, but this is down from 22nd in 2005 and is in the bottom third of OECD countries.

The main reason, says Felipe Larraín, a Professor of Public Policy at Adolfo Ibañez University which contributed to the study, is bad results in education and innovation.

“The negative results are understandable because today’s businessperson is less tolerant of poor human capital,” says Larraín.

It is in primary education where Chile is failing the most, ranked 101st behind countries like Gambia. Chile fairs better in higher education and training (45th), a key area of concern for companies, but still far behind most OECD countries.

The government has taken some steps to address the issue. In February a law was promulgated to improve teaching quality in the classroom by giving principals the power to fire bad teachers and reward good ones.

These measures should go some way to reducing Chile’s education deficit, but it will take time and money, admits Larraín. “It won’t happen overnight - this is a long, slow process.”

Energy costs

Another barrier to competitiveness is high energy costs. Electricity prices in Chile are among the highest in the region and more than twice as high as in the U.S., which directly impacts productivity.

To make matters worse the government recently announced electricity rationing, including a reduction in voltage, as the result of an ongoing drought in central Chile.

“We need energy to grow but rationing for industrial and residential consumption could seriously affect productivity and competitiveness,” says Larraín.

To promote energy savings, the government has extended summer daylight saving time to early April, but companies in the agriculture and manufacturing sectors say energy costs at peak hours in the early evening are disproportionately high and should be reduced. 

The problem, say distributors, is growing demand and capacity restrictions. With less hydroelectric generation, peak demand in Chile’s Central Interconnected System (SIC) is being met by diesel-fired turbines, which cost more than twice as much as coal-fired plants to run.

New coal plants, however, have been caught up in red tape and environmental lawsuits, sometimes for several years. “The investment capital exists, the projects exist, the demand is growing and yet the start of new investment projects has been repeatedly delayed,” says Concha.

No one doubts Chile needs new capacity to grow, but a consensus is urgently required on where that capacity should come from and how much Chileans are willing to pay for cleaner energy.

Clearly, there is much work to do to improve Chile’s competitiveness and close its productivity gap.

Reining in fiscal spending may be, as Concha says, the ultimate “antidote” against “Dutch disease” caused by dependence on copper exports, but it’s not the only medicine in the cabinet.

The government has made progress in promoting entrepreneurship and improving education standards, but more needs to be done to reduce energy costs and promote innovation.

Fortunately, President Piñera has the opportunity this year, barring natural disasters or global economic crises, to not only rebuild Chile but to make it more efficient.

For Chilean companies faced with a weak dollar and an uncertain world economic situation these reforms are not just cosmetic, they are a matter of survival.

Julian Dowling is editor of bUSiness CHILE