Chile Can’t Beat the Real Thing! March 18, 2008 By Luis Arcentales | New York , Morgan Stanley

With Latam watchers torn about the extent of the pain that the ongoing US slump will bring to the region, it is important to ask which countries are more vulnerable to a turn in external conditions, which have played a central role in the robust growth of the past five years (see “Latin America: Growing Disconnect, Growing Risk”, This Week in Latin America, March 3, 2008). The ‘insurance’ purchased in the form of rapid international reserve accumulation could indeed make the region more resilient to a worsening external environment, as could an export base with limited exposure to commodities. By these two metrics, Chile does not seem to be in the most comfortable position, with commodities accounting for over 70% of total exports (30% of GDP) and international reserves of US$16.9 billion which, at 10% of GDP, are the smallest as a share of GDP of any major Latin American economy aside from Mexico’s (starting May 2003, Banco de Mexico put in place a rules-based mechanism of daily US dollar auctions to reduce international reserve accumulation). Unlike any other country in the region, however, Chile has taken advantage of the past few years of abundance to build a war chest that not only allows it plenty of room to conduct counter-cyclical fiscal policy, but which seems sensible from a financial standpoint as well. Record-high levels of international reserves in Brazil, Colombia or Argentina say little about the strength of their fiscal position and how much ammunition these countries have saved for a rainy day. On this front, Chile is the real thing. Saving for a Rainy Day in the Right Way Soaring copper prices in a context of the structural budget surplus framework in place since 2001 has allowed Chile to produce massive fiscal surpluses. Last year, Chile’s public sector posted a surplus of 8.7% of GDP – the largest in two decades since data are available. Chile’s fiscal prudence, in turn, has allowed for significant reduction in public indebtedness and rapid accumulation of assets, which at the end of 2007 stood at US$20.9 billion, split between the Economic & Social Stabilization Fund (FEES, US$14.0 billion), the Pension Reserve Fund (US$1.5 billion) and Treasury deposits (US$5.4 billion). Indeed, Chile’s government is now a net creditor to the tune of 11% points of GDP (see “Chile: Conserving Abundance”, EM Economist, February 15, 2008). Just as Chile has avoided the temptation of super-charging its economy by opening the fiscal spigot in recent years, Chile’s ample savings in its stabilization fund shield its budget from a sudden drop in commodity prices or a cyclical downshift. Not only has Chile’s adherence to fiscal prudence generated ample savings, but we would argue that Chile’s strategy is also financially sound from two separate perspectives. First and foremost, it makes sense for Chile to transform its copper wealth – which based on Codelco’s copper reserves of 77 million tons, we estimate to be around US$1.3 trillion at current copper prices – into financial assets which, over the long term, tend to offer superior returns. Second, the government is planning to diversify the holdings of the FEES – where most government assets currently reside and which is fully allocated to fixed-income instruments – which should provide superior risk-adjusted outcomes going forward. Chile faces a choice between leaving its copper underground while waiting for it to appreciate or extracting it and turning it into financial wealth, in a similar way as our colleagues Stephen Jen and Luca Bindelli have argued about the GCC countries and oil (see GCC: Transforming Oil into Financial Wealth, November 15, 2007). After all, excluding fiscal revenues derived from state-owned Codelco – which produces about a third of Chile’s copper output and holds half the country’s reserves – central government accounts would still have ended in surplus territory in each of the past three years, thanks to record receipts from private mining companies and strong activity-linked VAT and income tax collections. Thus, the issue at hand is on whether financial assets offer superior returns to those of copper. Chile is doing the right thing by turning its copper abundance into financial wealth as financial assets offer superior risk-adjusted returns than copper in the long term, in our view. Over the past century, the value of equities has risen nearly 400 times, trumping returns from bonds, money market and oil (see Norges Bank Deputy Governor Knut Kjaer’s presentation, From Oil to Equities, November 2006). If we look back at data since 1980 – which include the popping of the TMT bubble and the five-fold increase in copper since 2002 – we find that equities offered superior total returns than copper. And returns are only one side of the coin: once we add the volatility of returns into the equation, we find that copper is by far the least compelling asset class. And authorities have laid out a superior diversification strategy with it set to be in place by year-end. The Finance Committee within Chile’s Finance Ministry has recommended the allocation of 15% of the FEES assets into equities and 20% into corporate bonds, which we consider to be a major step in the right direction. At the end of 2007, the FEES had 68% of its assets in sovereign debt, 4% in agencies and the remainder in bank deposits, all administered by the central bank (40% in US dollars, 40% in euros and 10% in yen). Using monthly data since 1980, we find that the portfolio recommended by the Finance Committee would offer superior risk-adjusted returns than any single asset class and even better than the current asset allocation of the FEES. Importantly, the increase in the risk profile of the FEES seems like a sensible strategy, in our view, in a context in which its assets are unlikely to be needed to shore up the government’s budget anytime soon. Copper markets are set to remain in deficit this year and next, keeping prices well supported around US$3.50 per pound, according to our Metals & Mining team (see Global Commodity Update: Supply in Crisis, February 15, 2008). Even against a backdrop of near-record-high copper, Chile’s 2008 budget incorporates a reference copper price of just US$1.37 per pound, leaving an ample cushion for copper to retrench – even as higher costs such as energy and water continue to put pressure on miners’ margins and thus point to higher equilibrium long-term prices – and still generate a fiscal surplus. A conservative, gradual diversification approach seems sensible, in our view, to further consolidate popular support for Chile’s prudent fiscal management approach. With government popularity near historical lows, consumer confidence at the lowest level since 2003 and prospects for only moderate growth this year, pressures to spend appear to be mounting. Against this backdrop, the authorities seem to grasp that the FEES’ 2009 performance will be an important political and popular test; thus, a small, conservative allocation to riskier assets in the first year seems like a well-suited strategy. Should Chile Be Saving at All? While Chile’s fiscal prudence should pay off as it allows fiscal policy to better smooth out the impact of business cycle fluctuations, it is reasonable to ask if a developing country should be accumulating assets at a rapid rate – in Chile’s case at US$21 billion (13% of GDP) at the end of 2007 and rising. Without going into the merits that saving today brings to avoiding a pro-cyclical fiscal stance in an environment of record-high copper quotes, we offer some thoughts on two important areas, namely education and infrastructure needs. First, while surveys suggest that Chile is among the most competitive economies in the world, its education system is comparably poor. The 2008 budget already allocates historically high spending levels to education, and the authorities have begun to tackle some of the system’s deficiencies. However, research by the OECD suggests that Chile’s educational shortfalls are not necessarily caused by lack of funds but, instead, by the inefficiency of the spending. Indeed, the OECD points out that given its level of spending, Chile’s educational outcomes could improve by 16% if it were to deliver educational services as the best achievers among OECD countries do. Second, Chile does not appear to have significant shortfalls on the infrastructure front. In a recent report, researchers at the World Economic Forum noted that Chile has the highest-quality infrastructure network in the region, with port quality almost matching that of Germany. There seems to be some room for improvement on roads and energy; in the latter area, significant investment is pouring in, which is expected to go a long way towards alleviating today’s tight situation by the end of next year. Moreover, Chile’s stable macroeconomic backdrop and legal framework make it the most attractive destination for private investment in infrastructure, according to the WEF. Bottom Line Unlike any other country in the region, Chile has taken advantage of the past few years of abundance to save for a rainy day. Indeed, Chile is in an enviable position to efficiently conduct counter-cyclical fiscal policy, both relative to its Latin American neighbors and relative to its own history, with a war chest amounting to 13 percentage points of GDP at the end of 2007. Importantly, for Chile, transforming its copper wealth into financial assets is a sensible financial strategy, given the better risk-adjusted long-term return profile provided by stocks and bonds. And with the assets saved for a rainy day unlikely to be needed to shore up the government’s budget anytime soon, authorities are planning to diversify their holdings into stocks and corporate bonds by year-end. Rapidly rising levels of international reserves from Brazil to Colombia and Argentina may make these countries more resilient to the coming global downturn; however, record reserves say little about the strength of their fiscal position and how much ammunition these countries have saved for a rainy day. On this front, Chile remains the real thing.