Republic of Chile #A+/A-1# Foreign Currency Ratings Outlook Remains Stable

Stocks and Financial Services Press Releases Friday June 29, 2018 10:39
S&P Global Ratings--29 Jun--S&P Global Ratings
RATING ACTION

On June 28, 2018, S&P Global Ratings affirmed its 'A+' long-term foreign currency sovereign credit rating and 'AA-' long-term local currency sovereign credit rating on Chile. The outlook on the long-term ratings remains stable.

At the same time, we affirmed our short-term foreign currency rating of 'A-1' and our 'A-1+' short-term local currency rating. In addition, we affirmed our 'AA' transfer and convertibility (T&C) assessment for Chile.

OUTLOOK

The stable outlook reflects our expectation of continuity in economic policy over the coming three years. We expect Chile will maintain the distinctive pillars of its market economy (fiscal and monetary rules, openness to trade and investment, judicial security, and predictability) while it strengthens social policies. At the same time, we expect continued GDP growth, moderate current account deficits (CADs), and low inflation will stabilize Chile's public finances and its external profile.

We could lower the rating in the next couple of years if a combination of unexpectedly loose fiscal policy and economic growth lower than our expectations results in larger-than-expected fiscal deficits. That could contribute to annual increases in general government debt beyond our projections. A substantial and prolonged weakening of public finances could result in a downgrade. Similarly, an unexpected deterioration in Chile's net external position or a substantial increase in its gross external financing needs could weaken its external profile, also leading to a lower rating.

Conversely, a sustained recovery in GDP growth along with prudent fiscal and monetary policies would gradually strengthen Chile's economic base. That, together with continued diversification of the economy that strengthens its resilience, could gradually reduce Chile's external vulnerabilities. An improved external profile could lead us to raise the rating in the next two to three years.

RATIONALE

Our ratings on Chile reflect its ample monetary, exchange-rate, and fiscal flexibility, as well as its low debt burden, growing prosperity, and a favorable assessment of its institutional effectiveness and governance. The ratings also reflect a comparatively weak external position and vulnerabilities inherent in a small, open economy exposed to external shocks.

Chile has a long track record of sound macroeconomic policies and a vibrant democracy and good rule of law. It has maintained continuity in key economic policies despite changing governments. We expect that the consensus on macroeconomic policies and on maintaining an open economy will persist for many years. We estimate Chile's GDP per capita at nearly $17,000 in 2018, among the highest in Latin America.

Chile has been following a fiscal rule for its annual budgets since 2001, targeting an underlying structural balance over the course of a business cycle. This policy has helped boost the predictability of fiscal policy and anchor investor confidence. Despite a steady increase in net general government debt in recent years, we expect it will remain below 14% of GDP this year. Most of the sovereign's debt is issued domestically in local currency. Chile enjoys monetary flexibility thanks to a credible monetary policy that has targeted inflation while maintaining a flexible exchange rate. The flexibility of the exchange rate has helped to reduce the volatility of economic performance in recent years.

Institutional and economic profile: Continuity in key economic policies based on a strong political consensus
  • Stable democracy with strong rule of law anchors economic policies and investor confidence.
  • We expect Chile will maintain its rules-based fiscal and monetary policies while gradually expanding social services to cater to a better-educated and wealthier population.
  • Chile's small, open economy remains vulnerable to global trends but with greater resilience than before.

Chile's stable democracy and rule of law, enhanced by growing prosperity and social development, sustains our favorable assessment of its institutional and governance effectiveness. President Sebastian Pinera (of the center-right Chile Vamos coalition) won a decisive victory in the second round of presidential elections in December 2017, succeeding former President Michelle Bachelet of the center-left Nueva Mayoria coalition. Pinera, a successful businessman, had been president during 2010-2014.

The two main political coalitions that have dominated Chilean politics for decades are almost evenly represented in Congress, but the president's coalition lacks a majority in either chamber. However, we expect the government will be able to largely advance with its legislative agenda, working with moderate elements of the opposition. The need to gain support from opposition parties will also lead the government to seek compromise on contentious issues, pursuing a moderate course.

The recent elections saw the emergence of a populist "Frente Amplio," a coalition of groups to the political left of the Nueva Mayoria. Such trends reflect growing pluralism and somewhat more political fragmentation in Chile. However, increasing disagreements on social policies across the political spectrum have not weakened the public consensus on rules-based fiscal and monetary policies, which continue to enjoy widespread public support.

The Pinera Administration has focused on economic growth, job creation, and infrastructure modernization. It has responded to public pressure by proposing modifications to Chile's individual account pension system, preserving its basic features but gradually raising the level of employer contributions. Moreover, it plans to modify corporate taxes (largely by simplifying the laws, which became very cumbersome to administer after a tax reform introduced by the previous administration). The administration has also started to reform the bureaucracy to reduce delays and inefficiencies, which appear to have worsened in recent years, contributing to blocked investments and foregone projects.

Chile faces a novel challenge in managing unprecedented numbers of immigrants. A record inflow of both skilled and unskilled workers has created social tensions and political demands for better management of immigration. In response, the government has sent a new law to Congress to modernize procedures and rules for better managing immigration.

Growing levels of education and prosperity have changed Chilean politics in recent years as people have higher aspirations and changing expectations, leading to demands for a more generous social safety net and for addressing income inequality (which remains among the highest in Latin America). Traditional political parties, which have been aligned in a center-left and center-right coalition for nearly three decades, have struggled to adapt to these social and political changes. The share of the population with post-secondary education has increased greatly in recent years, gradually setting the stage for new patterns of economic growth based more on skills and education.

We view Chile's commitment to anchor fiscal and monetary policies within a transparent framework of rules as a strength to the credit rating. Its long track record of sound macroeconomic policies implemented by different political coalitions has contributed to its prosperity and high level of human development.

The Chilean economic cycle has been strongly correlated with copper prices, but the government is better able than before to smoothen the business cycle thanks to fiscal, monetary, and exchange-rate flexibility, as well as a low net general government debt burden. The combination of recent strong global copper prices and renewed business confidence after the 2017 national elections has boosted GDP growth prospects. The economy is likely to grow 4% in 2018 and decelerate to 3.3% in 2019 (and around 3% afterward). We expect per capita growth to exceed 2% in the next three years.

GDP growth should be sustained by recent energy-sector reforms, including the construction of renewable energy generation capacity and the unification of the country's transmission network, which will cut future energy costs. Lower energy costs should help sustain the competitiveness of the mining industry, which will remain a key source of economic activity for many years.

Flexibility and performance profile: Moderate increases in net general government debt and stable external profile
  • We expect that net general government debt will stabilize as a share of GDP in the coming couple of years, after rising steadily in the past decade.
  • Chile enjoys monetary flexibility thanks to a credible monetary policy that has targeted inflation while maintaining a flexible exchange rate.
  • Chile's external profile is likely to remain stable or to strengthen marginally in the next couple of years.

Chile's external profile, while moderate compared with most sovereigns, is a comparative weakness in its rating profile. A sustained improvement in its external indicators would reduce its vulnerability to external shocks, strengthening sovereign creditworthiness.

We project gross external financing requirements to exceed 100% of current account receipts (CAR) and usable foreign exchange for the next three years and narrow net external debt (gross debt net of liquid external assets) to CAR to hover just below 50% in 2018. The projected stability in external metrics reflects our view that the CAD will fall toward 0.5% of GDP in 2018, from 1.5% last year, and hover around 1%-2% over the next two years. These projections are based on a recovery in exports, including copper and other mining exports, that could raise the trade surplus toward 3.5% of GDP in 2018 (up from 2.9% in 2017). We expect the trade surplus to decline moderately to 2.7% of GDP in 2019 and toward 2% in the following year, reflecting rapid import growth.

Copper exports accounted for about 50% of total exports in 2017. About 51% of total exports went to Asia in 2017, and more than half of that amount went to China. Our copper price assumptions are based on our publication entitled " Metals Stay Strong: S&P Global Ratings Raises Its Price Assumptions For Metals Again," published March 18, 2018.

Foreign direct investment (FDI) should fully fund the CAD in the next couple of years. A major part of FDI is reinvestment of earnings from mining companies. Higher copper prices could attract higher levels of FDI inflows to Chile. Net FDI is likely to be below 2% of GDP in 2018 and rise moderately in the next two years. Chile has 26 trade agreements with countries that receive more than 90% of its exports.

We project that net general government debt will stabilize below 14% of GDP in 2018, after rising rapidly since 2014 because of large fiscal deficits (we deduct general government assets--equal to 10.9% of GDP in 2017--including government deposits in the central bank and in other financial institutions and its external liquid assets). The combination of modest fiscal deficits and better GDP growth in the next three years should keep the debt burden stable. Interest payments are likely to consume less than 4% of general government revenues during this period. Around 80% of the central government's debt is in local currency.

Chile's fiscal outturn is likely to improve in 2018, with the general government deficit approaching 1% of GDP from 2.6% last year. Revenues will likely exceed budget targets thanks to better-than-expected GDP growth and because copper prices have been on average above the budgeted level. The combination of good economic growth, better control over discretionary spending, and potentially minor revenue measures is likely to keep the general government deficit below 1% of GDP in the next two years. As a result, we project the average change in net general government debt to GDP to be just above 1% of GDP for the next three years. The "structural" central government fiscal deficit, calculated using the parameters of Chile's fiscal rule, was 2% of GDP in 2017. The government plans to reduce it by 0.2% of GDP annually to reach 1% in 2022.

The application of Chile's fiscal rule had been loosened in recent years, with recourse to greater discretion, weakening its value. A recent disclosure of an error in calculating the structural fiscal outcome for 2017 created public pressure to update the rule and strengthen its implementation and monitoring. The Pinera Administration has introduced a law to Congress designed to tighten the procedure for applying the rule, reduce discretion, improve independent monitoring of fiscal policy, and raise its transparency. We expect the law to be approved this year.

We expect continuity in Chile's inflation-targeting monetary policy and in the flexible exchange rate. Long-term inflation expectations remain within the central bank's target range of 3% plus or minus 1%. Inflation is likely to remain below target in 2018 at 2.5% and could rise to around 3% in the next couple of years. Inflation has remained in the single digits for many years.

The transmission mechanism of monetary policy is likely to remain effective. The Chilean financial system is deeper than that of almost all Latin American countries. Domestic credit to the private sector and nonfinancial public sector exceeded 80% of GDP in 2017, and total banking system assets exceeded 120% of GDP. The total value of private-sector pension fund assets was around 74% of GDP in 2017 (and their external assets exceeded 31% of GDP). The bulk of their domestic investment was in fixed-income instruments, including sovereign and central bank debt.

We estimate that contingent liabilities from the banking system are limited. We classify Chile's banking sector in group '3' under our Banking Industry Country Risk Assessment (on a scale from '1' to '10', ranging from what we view as the lowest-risk banking systems, or group '1', to the highest-risk, or group '10'). The government estimates that its guarantees amounted to 1.6% of GDP in 2017--mainly internal debt guarantees to the national railway and the Santiago metro (Empresa de los Ferrocarriles del Estado and Metro), followed by guarantees on education loans. The government occasionally provides limited capital injections to its mining company, Codelco, as well as to ENAP (in its Spanish acronym), a government-owned energy company. Public-sector enterprises pose a limited contingent liability for the sovereign.


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