Rebalancing the Chilean Way
Feb 07, 2006
Luis Arcentales (New York)
Chile’s robust GDP growth in recent years may not qualify it as the most rapidly growing economy in the region, but it should be watched carefully, as it may tell us where the region is headed. While Argentina and Venezuela have posted even stronger growth rates in the past two years, neither can be held out as an example of sustainable growth. By contrast, Chile’s growth has contained both a healthy dose of consumption and investment producing a surge in domestic demand which is now outpacing GDP growth by a margin of nearly two to one. That domestic demand driven upswing has pushed Chile’s current account into a modest deficit and is likely to set the stage for a moderate, but growing deficit during the course of 2006.
Rather than fear the return of a current account deficit in what has long been Latin America’s model country, global watchers should rejoice. This is precisely what the globe needs: signs of vibrant growth beyond the US consumer, who has sustained global growth and helped create what many fear is a dangerous global imbalance (see for example, Steve Roach’s “Passing Ships in the Night” in GEF, February 3, 2006). Indeed, if there is a problem with the Chilean story, it is that signs of global rebalancing are taking place in a relatively small country with little space to really help offset any possible slowdown in US consumer spending.
Chile’s domestic-demand driven story may come as a surprise to many who often view the country’s economy as little more than a copper exporter. With copper alone accounting for 45% of exports last year, there is no mistaking Chile’s external sector and fiscal accounts have benefited from this abundance. Indeed, mining exports soared 31% in 2005. Meanwhile, the public sector posted a record 4.8% of GDP surplus last year, boosted in great part by record copper-related receipts. But the real Chile growth story is far from externally driven and, in fact, it is centered in domestic demand.
A favorable consumer backdrop of expanding jobs, wages and explosive credit has underpinned healthy consumption growth. On the investment front, construction activity had its best year since the Asian crisis brought Chile’s “golden” years of 7.3% average GDP growth between 1985 and 1997 to an abrupt end. Combined with a 44% surge in machinery and equipment outlays during the first nine months of last year, it is not surprising to see that domestic demand expanded at an 11.5% clip, nearly twice the rate of total GDP growth. Slowly, the domestic-demand driven upswing has pushed Chile’s current account into deficit territory, which for the year ending last September posted a modest shortfall of $185 million.
More than just a “soft patch”?
In the past months, however, mixed real-economy data has led some Chile watchers to call the resilience of the economy into question. Until the third quarter of last year most signs— from Chile’s buoyant labor market to good industrial output and the uninterrupted uptrend in imports—pointed almost unequivocally in the direction of solid growth. With 275 basis points of tightening since September 2004 and even accounting for mining-sector woes that were a drag all year, sporadic signs of some moderation gave way to concerns among some Chile watchers that a more severe slowdown was on the cards. In contrast, as the year ended we are seeing an uptick in economic activity again, suggesting that calls of a deceleration were premature.
The first focus of attention for those on the slowdown camp appears to be on the third quarter GDP figures, which rose at the slowest pace since early 2004. A slowdown in the productive sector— including an outright decline in mining output—seemed to be the key culprit. With manufacturing and construction activity losing momentum, it was just a matter of time, many argued, before the weakness would broaden. The first signs from the fourth quarter validated some of these fears as job growth began to trend lower and production failed to show renewed strength. Under such circumstances, some Chile watchers held that it wouldn’t be long before the central bank brought its tightening campaign to an end.
During this “soft patch,” however, domestic demand did not fizzle. The slowdown in construction was more than offset by booming machinery outlays, meanwhile, consumer spending carried on unscathed. Moreover, as the year came to an end production appeared to be back on a brisk growth path.
The outlook for investment spending, which had the best run in a decade last year, remains upbeat. Investment spending represented roughly a quarter of domestic demand but accounted for just over 50% of growth last year according to our estimates. To be fair, we expect such a disproportionate contribution to move towards more sustainable levels this year. However, that is hardly a reason for concern as evidence suggests that the capex upswing has more room to go. Demand for capital goods imports is at very high levels while the most recent data from the industrial complex showed an uptick in both capital goods output and sales. Looking ahead, surveys paint a particular upbeat picture on investment prospects – chiefly in the mining sector but also in commerce and manufacturing – a result that matches well with positive business expectations for demand growth.
The construction sector is also poised for another year of solid growth underpinned by expanding mortgage credit, favorable signs from building permits and inventory levels. To be sure, some leading indicators such as shipments of building materials have reflected a fair amount of volatility. But on the balance, the case for optimism in construction is compelling; indeed, Chile’s principal construction chamber expects vigorous activity during 2006.
Meanwhile, the consumer backdrop remains as supportive as ever. The Chilean job growth machine has been the most important pillar of the homegrown consumption story. Courtesy of one of the strongest job-expansion episodes in the past decade, the seasonally-adjusted rate of unemployment has steadily improved reaching the lowest levels since 1998. In the past few months, however, job growth has decelerated leading to a small hiccup in the rate of unemployment. Yet the devil is in the details: while there has been some accommodation on total jobs, their composition points to salaried positions gaining ground relative to self-employment. Indeed, once seasonally-adjusted the entire decline in total jobs of late has come courtesy of lower self-employment. Far from a sign of weakness, the sustained upturn in salaried positions is particularly encouraging because formal employment gains usually take the longest to take hold in a recovery. Not surprisingly in light of the good news from jobs and also rising real wages, consumer confidence – including future job prospects – is riding at multi-year highs.
Another positive consumer tailwind is the explosive growth in credit which has led to strong sales of durable goods and a vibrant housing market. The better news is that the banking sector’s aggressive credit expansion is set to carry on this year, according to our Latin American banks’ analyst Jorge Kuri. With asset quality well under control, the overall sentiment among major lenders is upbeat. And even as Chile boasts the deepest credit channel in the region, Jorge notes that it is far from a mature market: penetration in checking accounts, credit and debit cards is limited. Therefore, opportunities for further expansion abound. From the cost side and in contrast to the trend in business credit, monetary tightening by the central bank has not prompted a commensurate adjustment in the cost of credit to consumers.
Our outlook for another year of abundance in Chile suggests that monetary tightening is far from over. Indeed, in the January minutes, the central bank once again reiterated its view that monetary conditions remain lax. Though inflation expectations remain well anchored near the 3% central target and concerns over the strength of the peso are still alive, our view that the economy is back on a solid growth path after the 3Q “soft patch” points to a 25 basis point move this week with a likely follow up move during the second quarter. We still expect to see the benchmark interest rate set by the central bank to move above 5% this year, likely on its way to 5.5%.
In an increasingly unbalanced world, Chile is doing its own rebalancing act by moving towards spending beyond its means. But this is hardly a reason for concern. The current bout of abundance is not creating the sort of spending binges that have sowed the seeds of one too many past crises in Latin America. Instead, Chile’s strong domestic-demand led upswing and the concomitant move of its current account into negative territory rest on good fundamentals. A favorable consumer backdrop of good jobs, wages and credit growth has prompted healthy spending, windfall tax revenues have boosted public spending but also promoted record fiscal savings. Above all, Chile is showing high levels of investment spending accompanying the upturn in consumer spending. That, in turn, should help to improve its competitiveness even as it begins once again to draw on external financing to fund some of its growth.
The question for Latin America’s largest economies is not will they ultimately move down the path of current account deficits replacing today’s surpluses: that in our view is a given assuming a benign global backdrop continues. The question is whether external financing will be tapped to boost investment spending or simply finance the classic consumption-led binges of the past. Chile’s lead on this front is positive. Will the rest of the region follow?
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