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Chile’s Economy In Perspective – October 2008

Edward Hugh — Sun, 05 Oct 2008 22:21:00 +0000

Chile Country Outlook

Claus Vistesen: Copenhagen

Executive Summary and Outlook on key indicators

There are many lenses and perspectives through which to look at economic development. In this note, the process known as the demographic dividend is conceptualized in a Chilean context. The analysis shows how Chile during the past two decades has benefited from the dividend proxied by the increasingly favorable trend in overall age structure of the society. By some measures Chile’s demographic dividend is ending in these very years, but by adapting a slightly broader definition of the optimal working age and subsequent productivity profile it appears that Chile still finds itself in the proverbial sweet spot. Coupled with the favorable windfall from copper exports and the subsequent transformation of this into an unprecedented net wealth position of Chile’s public accounts, the economy looks on a very solid footing to face whatever travails which might come next.

As for the immediate outlook for Chile it appears that a slowdown is steadily rolling its way in. Tightening credit supply by financial institutions, a hawkish central and deterioration in terms of trade (forecast by the central bank) are all factors to be taken into account. Finally, a slowdown in the economy’s rate of job creation rate suggests that the slowdown may now finally be set to take hold in the immediate future. Consequently, headline GDP is expected to moderate somewhat in H02 2008 and H01 2009.

Chile has benefited immensely from the global boom in commodities and specifically the surging price of copper. The revenues from copper exports have kept Chile’s external trade balance solidly in the black for he past 4 years and the subsequent windfall have provided Chile with bulging coffers in the treasury. Official forecasts suggest that this may now be about to end, but it needs to be stressed that as long as copper prices stay in the region of the current level and absent a complete slump in demand, the trade balance should continue to provide a sound counter balance to the negative income account.

As is the case in most other emerging economies the Chilean central bank is strongly focused on an inflation rate currently running well above its 3% target (9.5% in July). With this in mind, it is reasonable to expect that the central bank will continue to raise to a policy rate of 9.5% before the end of 2008. Coupled with the recent suggestion by official advisors that the central bank abandon open market operations to manipulate the Peso, the hawkish position should benefit the Peso in H02 2008. One risk to this call would be a significant spike in risk aversion that could lead to an emerging economy wide capital flight.

An Orderly Slowdown Ahead

The Chilean economy continued to expand in Q1 albeit at a slightly lower pace than in 2007. GDP growth expanded 3 % on the year and 1.4% q-o-q where the latter figure translates into an annualized growth rate of 5.6%. Not many forecasters, official as well as commercial, expect this figure to hold however. Morgan Stanley recently revised its 2008 GDP estimate downwards from 4.3% to 3.8% whereas the central bank is more sanguine in their bid of 4.0 to 5.0% for 2008. Chile expanded 5% in 2007.

On the demand side the expansion in Q1 was largely driven by gross fixed capital formation. For 2008 the central bank is predicting investments to increase by 13% driven, to a great extent, by energy and mining related capex. Consumption however grew at an overall slower pace than 2007 and is not expected to top a 5% growth rate in 2008. As for government spending, the central predicts that the formal rule established in light of the recent copper bonanza (see below) will persist in 2008 where the public surplus is expected to clock in at 0.5% of GDP.

Despite the apparent solid performance figures signs are emerging to indicate the Chilean economy may be slowing. This possibility is hinted at in the recent central bank monetary report where a decidedly cautious tone is presented. The central bank ascribes a relatively high downside to the effects from incoming inflation pressures as well as negative hydrological conditions which are tantamount to the energy supply in Chile.

One sign that the economy may be entering a softer patch comes from industrial production figures where production fell in both April and May at -2.8% and -0.9% (m-o-m) respectively. If we turn to yearly figures, the recent months have been more volatile than the stable levels observed in 2006 and 2007 but the trend is inexorably one of decline. Over the first six months of 2008 industrial production averaged a 4.2% increase which compares to an average of 5.2% in the corresponding months of 2007.

Domestic demand as proxied by sales of consumer goods also shows signs of decline in growth rates. In the first half of 2008 sales averaged a monthly (y-o-y) growth rate of 4.2% which compares with 7.7% in H01 2007 and 5.0% in H02 2007. An educated guess suggests that domestic demand will grow in the region of 3.5% to 4% in 2008 which must be compared to a corresponding growth rate of 6.3% in 2007. Clearly, this does not signify a crash, but more so a moderate slowdown in line with global fundamentals. Morgan Stanley’s in-house Chile analyst Luis Arcantales also weighs in on the situation of the consumer. Arcantales notes three headwinds in the form of rising inflation, tightening credit standards, and a slower job creation. According to Arcantales the banking sector in Chile has acted swiftly, and in essence proactively, in the face of the global outlook where tighter credit standards seem certain to be a part of the equation. In the second quarter of 2008 44% of banks consequently reported that they have tightened credit standards. If we add the fact that the central bank of Chile is still in the midst of a hiking cycle, which so far as taken the rate to 7.75% from 5% in June 2007, it is clear that demand and supply for consumer credit is likely to fall further.

With respect to labour market dynamics employment continued to expand briskly in Q1 2008, but seems to have slown down somewhat in Q2. Out of an estimated 7.186.130 people in the labour force 6.583.130 were in employment which translates into an unemployment rate of 8.4% (603.000). In Q2 the number of people in employment furthermore decreased slightly 0.3%. Compared to Q2 2007 the unemployment rate increased 1.5% and compared to Q1 the corresponding figure was 0.4%.

This coupled with a hawkish central bank and a deteriorating credit environment for consumers suggests that Chile may be heading down a notch a two when it comes to top line economic growth.

Inflation is creeping up

As a part of the general slowdown in economic activity the lingering increase in inflation definitely seems to be the most pre-occupying threat from the point of view of policy makers and sell side research.

JPMorgan suggests that Chile may be set to enter a stagflationary phase as growth nudges below trend at the same time as inflation remains elevated. JPMorgan furthermore anticipates the central bank to move in strongly to counter the inflation trends which will further put pressure on Chile’s economy.

Unlike in other economies inflation pressures do not seem to come as quickly on the back of easing commodity pressures as first expected. In July, inflation rose to an annual rate of 9.5% and even though the central bank opted to raise interest rates 50 basis points on the 14th of August the real interest rate is still negative. This may not in itself be a solid policy gauge since, as we learned above, credit already seems to be tightening considerably due to restraints on the part of a proactive financial services sector. At this point, inflation forecasts for 2008 are hovering between 8-9% and with a formal target of 3% we can expect the central bank to continue with the rating cycle. The central – confident in its investment strategy, forecasts that inflation should fall towards its 3% target in Q2 2009.

We are reluctant to look this far ahead but concur that inflation is set to remain high for the rest of 2008. This, in turn, will in turn keep the central focused on inflation. It is thus perfectly possible that we see a central bank refi rate of around 9.5% before 2008 is out.

One important factor here is also the Peso where the central bank has recently been engaged in open market operations to stem the flow of appreciation against the USD and in fact to maintain what has been a steady depreciation since April.

Given the inflationary tendencies and their persistence advisors close to the central bank have explicitly suggested that such open market operations be abandoned due to the threat from inflation. Given the recent and new found strength of the US dollar it is difficult to say whether the Peso will be flattered too much by the central bank’s hawkish stance (against the USD that is). However, it is reasonable to expect we think that the Peso will appreciate moderately provided that the central bank decides to stop its open market operations. At the end of June the Peso marked a 10 year low against the Dollar, a value we feel should fall slightly in H02 given the continuing hawkish position by the central bank.

Copper, Copper Everywhere

Perhaps the most important aspect of the Chilean economy since the advent of the 21st century has been the extraordinary windfall from copper production and exports. According to most estimates Chile alone accounts for one third of the world’s copper production and in light of the relentless upward March of copper prices Chile has seen its goods trade surplus swell accordingly.

In formal terms, the so-called copper Bonanza began in 2004 and has continued un-abated up until this point. Given the recent decrease, across the board, in basic commodities the goods trade balance seems set to deteriorate but only slightly as far as goes 2008. In Q1 the goods balance stood at 6231 mill USD which is up considerably from the previous quarter. In Q2 and Q3 the goods balance is forecast [1] to take the value of 6555 and 6147 mill USD respectively where the trend is more important than the point forecast itself.

However, the external balance is not only about tangible goods.

Consequently, and while a positive trade balance is still keeping the overall current account in surplus, a negative income balance is beginning to pull the trend down. Add to this that the trade balance in 2008 looks set to be weaker than in 2007 the current account could very well swing into negative in 2009 which would be the first time in five years. In fact, the central bank is predicting the current account to swing into negative already in 2008. This seems a quite bearish forecast but much will depend on the rate of import growth which is the major determining factor in the forecast. As such, the central bank forecasts the goods balance to deteriorate to 17.000 mill USD in 2008 from 23.653 mill USD in 2007. Clearly, this would be at odds with the model deployed above but given its high degree of prediction error in terms of point forecasts, the central bank’s forecast should not be explicitly challenged at this point.

Much more important than the immediate outlook of the external books is, however, the way Chile has chosen to manage the recent years’ copper bonanza. One crucial aspect to note is then the extent to which Chile has maintained fiscal discipline in the face of the surging commodity boom. In numbers, Chile has consequently aimed at an annual fiscal surplus of 0.5%/GDP to act as a counterweight to the incoming copper revenues. In more traditional economic terms one could also see this as a proactive attempt to avoid that Chile fall under the yoke of a Dutch disease type correction.

So far, Chile has honed up to its intentions.

Between 1996 and 2006, Chile’s public balance averaged 1.5% of GDP a position much better than that held by its peers in East Asia and Latin America. From 2005 to 2007 the structural surplus as a percentage of GDP was 1% and is expected to 0.5% in 2008. However, the pure fiscal surplus, in 2008, as a percentage share of GDP stood at 8.1% which is quite extraordinary on any measure. In 2008 the corresponding figure is set to decline to 4.8% which still represents a solid cushion.

Apart from handing Chile the highest sovereign debt rating in Latin America it also prompted Luis Arcantales recently to dub Chile the real thing referring to the fact that Chile, unlike its Latin American peers, has chosen to build up a structural fiscal war chest rather than one of foreign FX reserves. Ultimately however and a in a context of global liquidity the bottom line remains much the same. Consequently, Chile’s treasury recently laid out a plan on how to construct an optimal global portfolio from which the copper windfall could be transferred into financial assets. Through the so-called Economic & Social Stabilization Fund (FEES), Chile plans to put a substantial amount of its savings into equities and corporate bonds. Thus, and quite in line with other sovereign investment vehicles (SWFs), so will Chile’s savings also be going for yield, even in a situation where the government is a net creditor with outstanding debt at about -11% of GDP.

Notes

[1] This is how our model performs in a post mortem perspective.

In general, the fit in terms of point forecasts is not that good, but the fitted trend is very close to the actual movements with a correlation coefficient of 0.92. From a standard model selection criteria point of view the model performs marginally better at predicting the trade balance than a random walk model although it is considerably better to predict the time series in changes. The model is consequently formally built upon variables in changes to correct for stationarity problems.

List of References

Arcantales, Luis: Morgan Stanley GEF - Can’t Beat the Real Thing! 18.03.2008
Arcantales, Luis: Morgan Stanley GEF – Dark Clouds for the Consumer 20.08.2008

Thailand Outlook August 2008

Claus Vistesen — Thu, 07 Aug 2008 20:23:00 +0000

by Claus Vistesen: Copenhagen

Executive Summary

Thailand's economy grew at 4.8 percent in 2007. Despite a number of factors affecting public sentiment - the political uncertainties, the imposition of capital controls in December 2006 (subsequently removed in March 2008), and the proposed amendments to the Foreign Business Act - net exports continued to provide the main support for growth while domestic demand has continued to remain weak. The Thai economy is expected to slow slightly in the second half of 2008, and then pick up speed again in 2009 as long as global energy prices continue to fall back somewhat from their June 2008 highs.

Headline inflation had been on a downward path after peaking in mid-2006, but started to pick up in Q4 2007 on the back of escalating energy prices, and reached an annual rate of 9.2 percent in July. Core inflation has been lower, but has followed a similar trajectory, reaching 3.7 percent in July and thus falling just outside the Bank of Thailand's 0-3½ percent target band. The Bank of Thailand has, belatedly, begun a process of monetary tightening, but we do not anticipate they will move into truly “hawkish” mode.

Following an appreciation of about 14 percent against the U.S. dollar in 2006, the baht appreciated by a more moderate 6.4 percent in 2007, in line with other regional currencies. The current account registered a surplus of over 6 percent of GDP, and reserves increased to US$87½ billion by end-2007 (equivalent to 6½ months of imports of goods and services). This appreciation has continued into 2008, and given the importance of exports to the Thai economy it is likely that restraining any further significant rise will be an important objective shaping policy formation both at the central bank and at the Ministry of Finance.

Country Outlook

As is to be expected, both the cyclical and the structural performance of Thailand’s economy tend to be somewhat adversly affected by the various comings and goings associated with the country’s ongoing internal political conflicts. Historically the political instability which these create has tended to manifested itself in the form of what are admitedly normally rather benign military coups. Although a strong argument could be made that these specifically Thai political theatricals have already been incorporated into market pricing and practice it is still a factor which investors need to bear in mind, as capital flows may, on occasion, be temporarily affected.

In our most recent long term analysis of the Thai economy (see Thailand’s Economy – At a Crossroads) we showed how GDP growth in 2006 was almost exclusively driven by net exports as household consumption and fixed capital formation came grinding to a halt. A key internal development to take into account here has been the military coup and ensuing economic uncertainty which lingered throughout 2006 and which naturally put a significant lid on domestic activity.

In 2007 the positive contribution from net exports remained the core component in GDP growth but there has also been a clear change in the underlying tempo. Domestic demand was on the upswing in the second half of last year with private consumption expenditure up by a moderate 1.8 percent y-o-y in each quarter, following a very lacklustre performance indeed in each of the previous two quarters. This tendency was sustained into Q1 2008, with private consumption up by a much more solid 2 pedrcent y-o-y.

Agricultural output has, as might be expected given the surge in global prices, grown considerably, and was up by 3.5 per cent year-on-year in the first quarter, accelerating slightly from 3.1 per cent in the previous quarter. Both livestock and crop production increased significantly, and particularly the production of rice and energy crops such as cassava, palm oil and soybean. High agricultural price evidently encouraged farmers to expand their production. Growth in manufacturing output remained healthy, and was up 9.7 percent year-on-year, as compared to an average growth rate of 5.7 per cent in 2007. This surge in manufacturing was driven by both export-oriented and domestic-oriented industries. Export-oriented industries which put in a strong showing included electronic products, computers and equipment, televisions and air conditioners, while domestic-oriented industries such as the production of alternative energy (E20) compatible cars and petroleum products also expanded well.

Private investment was up a healthy 6.5 percent year-on-year in Q1, largely accelerating on the back of increased machinery and equipment investment from the previous quarter’s growth rate of 3.9 percent. Previous baht appreciation helped cap import costs, while at the same time attracting the capital to replace and expand plant and equipment. Business confidence also improved in Q1, and the Business Sentiment Index rose from 45.0 in the previous quarter to 45.9. Investment in construction also began to recover, following a sharp contraction in Q4 2007.

Finally, and after a predictable slump in 2006 on the back of the political tensions and the aftermath of the Tsunami tourism, has continued to accelerate in 2008 and preliminary data for Q2 show an improving trend, partly due to a low base in the same period last year, and the number of tourists during the first 2 months of the quarter expanded on average by 16.6 per cent year-on-year.
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On the external front, net exports in Q1 contributed 0.6 per cent to GDP, down from the 2.5 per cent registered in the previous quarter. This was mainly due to a rise in imports following an expansion in domestic demand, and of course the increased cost of oil. Imports were up by 10.3 per cent year-on-year in Q1 accelerating across the board in every category from 6.2 per cent growth in the previous quarter. Meanwhile, exports of goods and services continued to expand well with a growth rate of 8.7 per cent year-on-year. Noticeably, income from foreign tourists rose sharply while exports of goods softened slightly compared to the previous quarter. This was due to a softer growth of exports in fisheries and electronic circuits, despite healthy export growth in agricultural products, jewelry, vehicles and parts, and electrical appliances.

For 2008, the central bank is forecasting GDP to be in the range of 4.8% to 5.8%, while Thailand's Finance Minister Surapong Suebwonglee is predicting 6%. Since 2007 saw growth at only 4.7% this latter view must be considered a decidedly bullish forecast, and it is more than likely that general global conditions will dictate a rather slower pace of growth in the second half of the year following a strongish showing in the first half.

As regards its external balance Thailand still seems to be laboring under a once bitten twice shy mantle. Thus, with the exception of a rough, but short, bout of capital flight in 2005 Thailand has maintained a small but clear surplus on its external books. Given Thailand’s economic development profile this may seem rather odd but the effects of the Asian currency crisis still clearly in the forefront of Thai policy makers thinking.

This surplus has been achieved through continuous attempts by the Thail authorities, not to halt capital outflows, but rather to slow down inflows and the ensuing appreciation of the Bhat. Consequently, in December 2006 the BOT put in place capital controls and demanded unremunerated reserve requirements (URR) on short term capital inflows in order to deter speculation over possible appreciation of the Bhat. Capital controls were finally lifted in November 2007 and the reserve requirements disappeared at the end of February 2008.
However, and even though Thailand has been rather cautiously dipping its toe into the water with respect to a full blown exposure to the global search for yield, the post 1998 currency crisis economy has still seen a steady flow of foreign investors moving into Thailand (see here Thailand’s Economy – At a Crossroads).

This leads us neatly to the break-up of the current external position. In light of a consistent positive financial account and thus inflow of portfolio investments Thailand’s income balance is, as might be expected, negative. This is perfectly in line with economic fundamentals as it merely means that foreigners hold more claims on Thailand than Thailand holds on foreigners.

In fact, as the GDP break down above shows, this persistent surplus on the external balance is what propelled Thai GDP growth throughout 2006 and to some extent into 2007, although domestic demand is now picking up, even though the rate of acceleration is slow.

Moving on to price developments, Thailand enjoyed something of a perfect storm in 2007 as headline inflation remained pretty subdued at 2.3% (y-o-y) with core inflation running at around 1%. This was well in line with the central bank’s, rather wide, core inflation target which lies in the 0-3.5% band.

However, a target this wide which is based on core prices does not seem an especially strong or adequate instrument in the current climate. Thus, while headline prices remained relatively low in the first three quarters of 2007, Q4-2007 and Q1-2008 have seen Thailand subjected to the full volley of the global energy and food price inflation shock.

Recent forecasts from the central bank are signalling significant upside risk to future inflation developments. The combination of rising headline inflation feeding into producer prices at one at the same time as domestic demand seems to be staging a recovery points towards further inflation in the pipeline. The quarterly PPI index rose at a significantly higher pace in Q4 2007 (7% y-o-y) and Q1 2008 (10.3% y-o-y) relative to previous quarters. Consequently, in their most recent inflation report the bank does seem to have taken on board the need to take headline inflation into account too . The main argument here is that the latter now seems to be breaking its hitherto strong trend-relationship with core prices.

In light of the increased pressure from headline prices, the central bank (chaired by Mrs.Tarisa Watanagase) opted, at the July meeting, to up interest rates by 25 basis points to 3.50%. This raise broke the 3.25% holding position the bank has maintained since Q3 2007. According to the central banks own 2008 core inflation forecasts (2.2% y-o-y) the 3.5% interest rate translates into a positive real rate of 1.3%. However, if corrected for the current headline inflation the real rate resides firmly in negative territory at -5.7%. In general, and according to the central bank’s own calculations, we can cleary affirm that Thailand’s real interest rate remains one of the lowest among any of its Asian peers.

One key variable to gauge in this context would then also be the Bhat. In light of global fundamentals one would expect a hawkish central bank to coincide with an appreciation of the currency. Given the fact that the BOT has held rates steady for the past 1 ½ year, we are still to see whether this applies in Thailand’s case. So far the appreciation against the USD has seen the Bhat rise in value to the tune of 23.5% (at its peak) since January 2006. The recent months however have seen the USD claw back some of this so that the USD/BHAT now resides in the 33-34 range.

In light of the gradual lifting of reserve requirements and capital controls the outlook on the Bhat has been decisively bullish, with sell side analysts forecasting an appreciation in the region of 15% against other major currencies. In many ways, the Bhat already has been riding an appreciation around these levels and it is unclear that it will move towards 20-25 against the USD anytime soon.

Outlook on Key indicators

GDP growth is expected to remain strong in Q2, and then slow slightly in the second half of the year. However, if we take current prices and deflate with the immediate level of inflation it is not at all unlikely that inflation may eat up a substantial amount (especially if we deflate with headline inflation) of any potential increase in living standards and purcasing power, and private consumption is likely to remain weak, and recent poor showings in consumer confidence would seem to point in this direction. Generally, the slowdown in global momentum should also be put a de-facto ceiling on the current expansion in Thailand’s economy. At the same time, should global oil prices fall back more in the second half of the year, it is our opinion that Thai growth may well accelerate again in 2009, and we are currently forecasting headline GDP growth in the 5.5 – 6 percent range for FY 2009.

In the statement following the recent 25 basis point hike the monetary policy committee (MPC) noted that it would stand ready to counter any effects from further increases in inflation. Given this investors should begin to incorporate the idea of an increasingly hawkish BOT into their thinking. However, it remains unclear whether in fact we are not at a tipping point as far as golbal inflation goes. Should this be confirmed, and should headline inflation finally begin to offer a breathing space, then the BOT may be reluctant to raise rates to any significant extent, especially if this would mean driving up the Bhat further at a time when export growth remains the principle strong point in the economy .

The future course of the Bhat is thus difficult to call at this point in time. Clearly, if the economy continues to expand from its low “post military coup” level, and if the BOT opts for a hawkish course then the scene is set for a significant further appreciation of the Bhat. However, the general outlook for Asian economies is also one of re-coupling to the rest of the world and given that Bhat already is at a fairly high level (e.g. against the USD) we will need to see the BOT’s reaction and investors’ response before making any decisive call on the trend.