In This Issue

Chile Not Looking Back Colombia The Challenges Ahead View GEF Archive

		The Global Economics Team

		Read about other GEF team members

Despite the recent global market turmoil, Chile's central bank seems to be heading for the exit - delivering its first interest rate hike as early as this month - in line with the mid-May guidance that the start of the policy normalization process "is approaching".  Since the central bank first delivered its hawkish guidance in early April, incoming data indicated that the economy has proved to be exceptionally resilient.  Combined with a progressive normalization in inflation, the encouraging growth news of late confirm what we considered to be a fundamental shift as the underlying (very stimulative) monetary policy stance had begun to move out of synch with the cyclical backdrop (see "Chile: Heading for the Exit", This Week in Latin America, April 12, 2010).  Last, just as it was the case during the turmoil of late 2008 and 2009, Chile is very well positioned to respond to a potential escalation of market jitters.  Importantly, since the more immediate contagion channels from Europe's woes are likely to be financial in nature, the central bank is more likely to respond with a set of high-powered, liquidity-boosting measures as it effectively implemented in late 2008 and into 2009, rather than by keeping interest rates at the current historically low levels.  In addition, Chile's comfortable fiscal position - with public sector savings worth near 9% of GDP and gross government debt at just 6% of GDP - gives the government ample maneuvering room to kick-start the rebuilding efforts and even deliver additional fiscal stimulus, thus limiting the negative impact of a potential global slowdown. 

Economic Growth Resilience 

Despite lingering earthquake-related dislocations to economic activity, the most recent batch of data clearly indicates that the economy has proved extremely resilient.  Importantly, the ongoing rebound has been more than just a reflection of the impact of better global demand on export activity or a swing in inventories after massive destocking last year; instead, it has been characterized by strong consumption and improving fixed investment as well.   Indeed, after a temporary 2.9% annual drop in March activity, we expect the monthly GDP proxy IMACEC - released on June 7 - to return to positive growth readings in April. 

While industry has yet to fully normalize from the earthquake, output is quickly improving.  With around a fifth of Chile's manufacturing complex in the hard-hit areas in the south-central parts of the country, industrial output plummeted 17.4% in March compared to a year earlier.  In April, however, output was down just 1.3%, even as activity in some sectors was still partially paralyzed: for example, pulp production was down 53.7% in April, while refining and metals output plunged 61.4% and 30.9%, respectively.  Once seasonally adjusted, industry recovered in April nearly all the ground lost during March, according to our calculations.  Electricity generation, meanwhile, jumped 2.7% in April from a year earlier after collapsing by 10.5% in March. 

Consumption and investment, meanwhile, have been exceptionally resilient, maintaining the strong momentum shown in the first two months of the year.  Indeed, while GDP posted a sharp sequential 5.9% annualized contraction in 1Q10, details show that domestic demand continued to grow strongly.  Private consumption jumped 6.3% annualized, according to our calculations, after expanding at an annualized pace close to 10% in 2H09.  And led by soaring machinery outlays, fixed investment grew over 25% annualized in 1Q, following an average expansion of around 7% in 2H09.  Compared to 1Q09, domestic demand soared 11.1%, the fastest annual rate in almost two years.  

April indicators of consumption and investment, like imports of capital and consumer goods, continued to move higher.  Indeed, consumer goods imports, once seasonally adjusted, are running near historically high levels.  And growth in retail sales has been off the charts with particular strength in durables, whether we look at the survey by Chile's statistical institute INE (+22.4%) or by retail chamber CNC (+17.1%).  While a series of factors exaggerated April's gain - including earthquake-related purchases to replace damaged goods and early promotions linked to Mother's Day and the World Cup - even considering these ‘one-off' issues, recent sales have been remarkably strong. 

Heading for the Exit

Against a backdrop of solid growth momentum and a gradual normalization in inflation, Chile's central bank is likely to start its tightening cycle as early as this month, in our view.  While the deterioration in Europe's outlook and associated financial jitters played a role in May's decision to keep rates unchanged at 0.50%, we suspect that the central bank's primary role is to begin a process of normalization as the underlying monetary policy stance had begun to move out of synch with the cyclical backdrop.  With the temporary bout of deflation ending in February, real rates - measured as the policy rate deflated by headline inflation - have been moving back to levels consistent with a stimulative stance: while our work suggests that the neutral real rate may be in a range of 1-3.5%, the actual real rate was slightly negative in both April and May.  In this context, central bank authorities may have become uncomfortable, even as surveys and breakeven measures suggested that medium-term inflation expectations remained well-anchored near the 3.0% central target.  In turn, this suggested that, absent more aggressive near-term tightening, the real interest rate would have been on its way towards deeply stimulative levels.  Such a move, in our view, would have put the authorities in the uncomfortable position of allowing an effective ratcheting up in monetary stimulus even as the economy's cyclical rebound continued to gain ground. 

The Right Medicine

While the recent market jitters are playing a role in the central bank's decision-making process, they are unlikely to influence the near-term trajectory of interest rates, in our view.  With the more immediate contagion channel from Europe's woes likely to be financial in nature, the central bank is more likely to respond to a potential escalation of market turmoil with similar measures like the ones it effectively implemented in late 2008 and into 2009, rather than by keeping interest rates at current, very stimulative levels. 

In the aftermath of the Lehman event, the central bank implemented firm and successful actions to deal with the funding pressures in the domestic market.  First, the central bank proactively concluded its USD accumulation strategy prematurely - the program was only 70% completed - on September 29, citing a "relevant deterioration in global financial markets".  At the same time, the central bank resumed currency swap operations for one month, later extending the program to six months in the form of US$500 million in 60- to 90-day swaps up to a maximum amount of US$5.0 billion.  In addition, the central bank added an extra degree of flexibility to the banking system by allowing institutions holding USD deposits to use Chilean pesos, euros or yen for the purpose of satisfying reserve requirements.  Finally, the range of accepted collateral for repo operations was expanded.  At the time, cutting interest rates, after all, would have been the wrong medicine to address the funding pressures in the local market. 

Another lesson from the 2008 crisis was that, when faced with dislocations in foreign financial markets, Chilean companies have the alternative of a deep domestic capital market.  In part helped by the central bank's aggressive easing cycle - in the first three months of 2009, the policy rate was cut 600bp to 2.25% and then lowered to 0.50% by July - and some administrative changes like the temporary scrapping of the stamp tax, domestic corporate issuance soared to record levels, allowing companies to successfully refinance debt, fund working capital and finance new investments as well.  Demand from insurance companies and pension funds was instrumental in cushioning the external financial shock: for example, the AFP's allocation to domestic corporate bonds increased by more than 20% in nominal terms from 9.2% of total assets in September 2008 to 12.1% by March 2009, even as total assets declined by over US$10.0 billion (-11%) over the same period.  And despite the ongoing consumption boom, the country is still running a current account surplus - to the tune of 3.3% of GDP in 1Q, the fifth consecutive quarterly surplus - putting it in a solid position to withstand a potential external shock.  

Moreover, today Chile finds itself in an enviable fiscal position of very low levels of public indebtedness and sizable assets of almost 9pp of GDP at the end of March.  While, not surprisingly, the focus has been on the financing program for the rebuilding program - which includes a mix of temporary tax hikes, local and external debt issuance, sales of non-strategic assets and the use of the stabilization fund - even after this meaningful shock, the ability of the fiscal authorities to deliver stimulus, if needed, shouldn't be underestimated. 

Importantly, the recent experience suggests that the government has been able to put its ample resources to work in a pragmatic, efficient way.  In the two rounds of measures announced in 4Q08 worth roughly US$2 billion, the authorities focused on the credit crunch and the sectors that seemed most vulnerable including SMEs - via loan guarantees and other credit facilities - and housing, in addition to recapitalizing state-owned BancoEstado.  As the credit turmoil morphed into a real economy one, so did the government's measures: the US$4.0 billion package unveiled in January 2009 included business tax cuts, US$700 million for infrastructure, US$1.0 billion to fund Codelco's fixed investment and handouts for low-income families. 

Bottom Line

Despite the recent global market jitters, Chile's central bank seems to be heading for the exit.  Against a backdrop of solid growth momentum and a gradual normalization in inflation, Chile's central bank is likely to start its tightening cycle as early as this month.  After all, if global financial conditions deteriorate further, keeping interest rates at record-low levels seems like the wrong medicine; instead, Chile once again finds itself very well positioned to respond to the external shock via monetary and fiscal measures, as it effectively did in late 2008 and 2009.   

Colombia
The Challenges Ahead
June 02, 2010

By Daniel Volberg | New York

Whatever the outcome of Colombia's presidential election - it now goes to a second round of voting on June 20 after Juan Manuel Santos fell just short of an absolute majority - the next administration faces three challenges.  First, Colombia is at the early stages of a significant mining, particularly oil, boom that raises the threat of Dutch disease.  Second, Colombia needs to strengthen its fiscal accounts.  Finally, Colombia needs to tackle the high degree of informality in the labor force.

The Oil Boom

Colombia is in the early stages of an oil boom.  While Colombia, wedged between oil-rich Ecuador and Venezuela, has not been a major oil producer, this appears to be changing thanks to the government's ability to regain control over territory formerly held by insurgents.  The authorities have been working hard over much of the last decade to put in place a framework that would spur the development of the mining, and especially the oil, sector.  The authorities revamped the regulatory framework, creating an independent oil regulator - the National Hydrocarbons Association (ANH) - in 2003.  The authorities are attracting international oil companies via multi-decade concessions to explore and develop mostly onshore oil fields, as well as via tax incentives in the shape of sliding scale royalties that start low and rise with the production level of new fields.  And the deterioration in the business environment in neighboring Venezuela has led much of PDVSA's talent to migrate to geographically and geologically similar Colombia.  As a result, oil output has been climbing rapidly over the past few years: from near 500,000 barrels per day in 2007 to near 770,000 in the three months through April.  And the authorities expect that production will near double over the next five years to 1.5 million barrels per day by 2015.

The oil boom means stronger activity in the oil sector.  While the oil sector's share of overall activity is relatively small - oil and mining accounted for near 7% of GDP in 4Q09 - its growth rate has been significantly above average.  Indeed, the oil sector, which had grown at just below 1% on average over the past decade, has accelerated to 11.3% annual growth in 4Q09.

The oil boom means rising foreign direct investment (FDI).  Colombia has been one of the most important FDI destinations in Latin America - relative to the size of the economy Colombia was second only to Chile in attracting foreign investment in recent years.  And oil and mining is claiming a growing share of Colombia's FDI - last year the oil sector accounted for near 63% of net FDI inflow.

The risk of an uncontrolled oil boom is Dutch disease: an adverse scenario where the non-oil economy atrophies.  Some early signs of this risk are in evidence already.  After all, the strong FDI inflow has already pressured Colombia's currency stronger in recent years, leading to complaints from the manufacturing sector that industrial exports are becoming uncompetitive.  But if the oil boom really takes off, the risk is that the Colombian peso could appreciate dramatically over the next few years.  One challenge is that the oil sector does not generate much employment - in the three months through April the oil and mining sector's share of total employment was a puny 0.3%.  By contrast, the largest employment generators are restaurants and hotels (30% of total), personal and social services (23%) and manufacturing (17%).  A rapid appreciation of the currency on the back of a booming oil sector could make much of the manufacturing sector uncompetitive, leading to significant unemployment, social tension and productivity decline.  An additional risk is that the oil boom may result in a significant upturn in fiscal revenues that, if not controlled, can fuel inflationary fiscal spending as well as an overall reduction in the government's efficiency.

The good news is that the authorities in Colombia are planning ahead and preparing the right steps.  There are several cases of countries, such as Norway or Chile, successfully managing an oil or mining boom while avoiding Dutch disease.  The key appears to have been a regime where much of the extra revenue is saved in a stabilization fund or a sovereign wealth fund. 

As early as this week, the authorities in Colombia may unveil a structural fiscal rule that would generate significant savings in case the mining boom takes off.  The authorities have signaled the broad parameters of the proposals already: a structural primary surplus that is phased in over the next five years, a stabilization fund for excess revenues that would be used first to reduce Colombia's debt and then largely saved, though part could be used for investments in education and infrastructure.  Thus, the fiscal rule would in theory force the authorities to restrain spending and save excess revenues.  The alternative would be to raise taxes on the oil and mining sector if commodity prices surpass a certain threshold.  This alternative, however, may be functionally inferior since it would reduce the incentive to develop Colombia's natural resources while doing little to reduce a potentially distortionary fiscal spending binge.  Therefore, shepherding the right sort of fiscal rule through Congress may be a key decision for the next administration.

The Fiscal Deficit

While the oil boom may boost Colombia's fiscal accounts in the medium term, the next administration will need to engineer a fiscal adjustment much sooner.  After all, last year Colombia's central government fiscal deficit reached -4.2% of GDP and the consolidated fiscal deficit was at -2.8%.  That contrasts with the -2.3% central government and the -0.1% consolidated fiscal deficits posted in 2008.  True, last year many countries around the globe saw significant fiscal deterioration in an attempt to counteract the global downturn.  But as sovereign stress in Europe may be signaling, with the globe now in recovery mode, fiscal sustainability has come back into focus.  And given that the authorities expect a central government deficit near -4.5% again this year, it will be the task of the next administration to steer Colombia's fiscal accounts back to health.

Part of the fiscal challenge in Colombia is that the tax take is already high.  There are some who suggest that Colombia needs higher taxes.  They point out that the central government's tax revenue over the last five years was near 13% of GDP, on the low end in the region.  Of course, the consolidated tax revenues were much higher, closer to 30% of GDP.  That is largely explained by significant surpluses in the social security system and the regional fiscal accounts.  Both of these surpluses are funded by taxes.  Given the high level of taxation, it is difficult to envision a fiscal adjustment via higher taxes that does not have significant growth costs.

In order to strengthen the fiscal accounts, given the constraint that taxes are already high, the next administration will need to cut spending.  The authorities have rightly focused attention on raising investment in infrastructure, which soared 34% last year.  But given budget constraints, the next administration would need to shift the financing of infrastructure projects more towards the private sector if it hopes to rein in fiscal spending pressure.

Informal Economy

In addition to dealing with the coming oil boom and putting the fiscal house back in order, the next administration will need to find a way to reduce the size of the informal economy.  Most of Colombia's labor force is informal (that is, not taxed or monitored by the government).  Measuring informality is difficult, but the Colombian statistical agency has several ways to track it.  One way is a survey of small businesses (the bulk of Colombian employment): it shows that near 52% of all those employed in the three months through March were employed in the informal sector.  Another gauge is that near 57% of all those employed did not have social security.  The biggest source of informal employment is the restaurant and hotel sector, where near 40% of all informal workers are employed.

The large informal sector presents two problems: fiscal and social.  On the fiscal side, informal employees pay less tax, making it more difficult for the state to keep its fiscal house in order.  Indeed, the presidential front-runner has signaled that he may cut taxes, counting on the consequently faster economic growth and greater formalization of employment to shore up fiscal revenues.  But the greater issue with formalization is social - the larger the number of formal employees, the larger the number of voters who have a stake in the current economic model.  That, in turn, reduces the event risk around elections, which in Latin America have historically been a source of significant uncertainty about the direction of economic policy.

Bottom Line

While the pundits may assume that the election is largely decided after Juan Manuel Santos produced a much wider lead over his principal opponent than polls had suggested, the challenges for Colombia remain much the same whoever wins on June 20 and takes office on August 7: the incipient oil boom, the need to strengthen the fiscal accounts and the need for structural reform to reduce the size of the informal economy.  The good news is that if the oil boom is indeed at hand, dealing with the adverse effects of it would likely provide Colombia with the resources to deal with the other challenges.  Given that policymakers have been largely proactive in managing the long-term economic priorities, we remain constructive that, absent a significant adverse external shock, Colombia should enjoy strong and sustained growth in the years ahead.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.