Trade in Financial Services: The Case of Chile. Raúl E. Sáez

Transcription

1 Free Trade Agreements and Financial Services in Latin America and the Caribbean LCR Study Background Paper Trade in Financial Services: The Case of Chile by Raúl E. Sáez Finance, Private Sector and Infrastructure Department Latin America and the Caribbean Region The World Bank December 2006

2 TRADE IN FINANCIAL SERVICES: THE CASE OF CHILE Raúl E. Sáez 1 INTRODUCTION The purpose of this paper is to describe and analyze Chile s experience with the liberalization of trade in financial services, starting from the unilateral measures taken in the 1970s to the commitments taken with the EU and the US in the early years of the 21 st century. The experience acquired by Chile in negotiating with the US and the EU has allowed Chile to better address other pending negotiations, as the country has been able to refine its negotiating stance. There is better understanding on the part of government authorities, supervisory agencies and the private sector of what is at stake in negotiating on trade in financial services. The paper is organized as follows. Section I describes Chile s policy of unilateral liberalization and deregulation of financial services since the mid-1970s, the issue of capital controls in Chile and a brief overview of the economic and regulatory environment when the negotiations with the EU and the US began, including the level of internationalization of Chile s domestic financial system. Section II describes Chile s international commitments in financial services prior to the negotiations with the EU and the US. Section III analyzes the issues involved in a bilateral negotiation in financial services and how Chile prepared to address them. Section IV takes a look at how the negotiations themselves were organized, including the relationship with stakeholders both in the public (Central Bank and regulatory agencies) and private (financial services organizations) sectors. Section V examines in detail the negotiations with the EU and the US, including the major features of the texts negotiated and the commitments taken by Chile. What happened once the negotiations were concluded, the text approved by Chile s Congress and the agreements entered into force is the subject of Section VI. The final section draws some policy lessons from Chile s experience. I. UNILATERAL LIBERALIZATION AND EVOLUTION OF CHILE S FINANCIAL SYSTEM This section, firstly, describes the liberalization of financial services in Chile from the 1970s onwards, the financial crisis of the early 1980s, the policy responses to it and the consolidation of openness during the 1990s leading to full convertibility in Secondly, 1 The author (rsaez@hacienda.gov.cl) is Director of International Affairs at the Ministry of Finance in Chile. This paper forms part of a broader project on trade in financial services undertaken by the World Bank s Latin America and Caribbean Region. The views presented in this paper are those of the author and do not represent those of the Government of Chile neither do they constitute a legal interpretation of the agreements and legal texts cited. Costas Stephanou, Luis Oscar Herrera, Christian Larrain, Sebastian Saez and Pierre Sauvé provided comments and suggestions. Of course, none of them is responsible for its contents. 2

3 the macroeconomic conditions and the situation of the financial system, including its degree of openness to foreign providers, on the eve of the negotiations with the EU and the US are presented. a) Unilateral financial services liberalization in Chile 2 Chile is seen as an early reformer in the Latin American context. In the mid 1970s, the Chilean capital market was considered to be a textbook case of financial repression (Reinstein y Rosende, 2001). Thus, the first measures adopted by the military regime that took power in 1973 aimed at liberalizing and privatizing the financial system. All private banks nationalized by the previous government were privatized, with only the Banco del Estado remaining as a state-owned bank. Specialized banks were phased out ending the existing segmentation and promoting banks that would provide a full range of deposit-taking and lending services. Other measures adopted gradually from 1974 onwards included the freeing of interest rates, the elimination of credit controls and the reduction of reserve requirements on deposits. Regarding cross-border liberalization, direct access to foreign credit was authorized. Banks were allowed to borrow overseas to lend those funds domestically. As part of the removal of the barriers to entry, foreign banks were authorized to open branches or subsidiaries (Marshall, 1991). These reforms led to much innovation in services and products that covered all major segments of the market: consumption, enterprises and mortgages. Notwithstanding, the share of foreign banks in the domestic market remained quite small: in 1981, they held less than 7% of deposits and 6.5% of outstanding loans (Marshall, 1991). Similar measures were taken in the insurance industry: insurance premiums were freed, foreign companies were allowed to enter the Chilean market, either by setting up subsidiaries or buying shares of domestically-owned companies, the purchase of insurance abroad was permitted and all prices were freed. However, no reforms were adopted regarding bank supervision as a growing moral hazard problem was developing, particularly when after the collapse of a bank in 1977 the Central Bank established a guarantee on deposits (Reinstein y Rosende, 2001) The banking regulator (the Superintendency of Banks and Financial Institutions, SBIF) had insufficient knowledge of the quality of the banks loans portfolios as well as of the problem of loans provided to parties related to the owners of the banks. Only when some of these problems related to effective supervision became evident, minimum principles of supervision were established and were introduced as the financial crisis of the early 1980s broke out. One of the most fundamental reforms, one which would have a significant impact on the domestic capital market, was introduced in The pay-as-you-go pension system was replaced by a new system of pension funds based on individual and compulsory (only for dependent workers) retirement savings accounts managed by private companies called AFP. All dependent workers have to contribute 10% of their salary to such a fund until 2 This section is based on Saez and Saez (2006). For a detailed analysis of financial liberalization in Chile see Marshall (1991) and Reinstein and Rosende (2001). 3

4 their retirement age. The pension obtained upon retirement depends on the funds accumulated. There are three options for the retiree: 1) to contract an annuity with an insurance company; 2) to program the monthly withdrawal of the fund while maintaining the balance in the AFP; or 3) to contract an annuity with an insurance company starting at a date later than the retirement date while withdrawing from the fund between retirement and the starting date of the annuity. 3 The AFP also provides disability and survivor insurance contracted with an insurance company and financed with an additional contribution by the worker as a percentage of its salary. Individuals can also make contributions to a voluntary savings account by having an additional percentage of their salary withheld by the employer. The pension funds are managed by private companies (AFPs) whose purpose is to manage individual accounts for retirement, and also provide disability and survivors insurances as well as other financial services established by law (such as voluntary savings schemes). The investment of the funds is regulated with only certain financial instruments eligible and with limits by type of financial instrument or category of instruments. The range of eligible instruments and the limits have been varying over time. Initially the funds could only be invested in fixed-income instruments: bonds issued by the Central Bank and the government, time deposits and bonds issued by private enterprises. Stocks from corporations became eligible in 1989 while investment in collective investment schemes and derivatives where authorized in Investment in foreign-issued securities was allowed at the end of 1990 with an upper limit of 10% of the fund. This limit was gradually increased over the decade reaching 16% for overall investment abroad with a sub-limit of 10% for variable-income securities in 1999 (Cowan and De Gregorio, 2005). Pension funds are regulated by the Superintendency of Pension Fund Managers (SAFP) which is administratively related to the Ministry of Labor. In parallel, the health care industry was also reformed opening the possibility for employees to contract a health plan with a private manager, called social security health provider (ISAPRE), using the compulsory 7% payroll tax for health coverage. These specialized companies provide health coverage and pay subsidies during maternal leave and The other option is to contribute the same 7% to the government-managed National Health Fund (FONASA). A major financial crisis, characterized by the massive failure and intervention of financial institutions, began to develop in the second half of The crisis reached its highest point in January 1983 when the two major private banks, together with another two banks and four financial companies had to be taken over, while two other banks and one financial company were closed down. 4 As a result 50% of outstanding loans ended up controlled by the State (Reinstein y Rosende, 2001). The severity of the financial crisis can be explained by the coincidence of three elements. Firstly, regarding macroeconomic policy, the adoption, in mid-1979, of an exchange rate policy based on the monetary approach to the balance payments led to the fixing of the nominal exchange rate. Secondly, a negative external environment characterized by an increase in international interest rates 3 There is also a minimum pension guaranteed by the State. 4 From 1981 and January 1983, six banks and five financial companies had already been liquidated. 4

5 and a fall in the terms of trade. Finally, banking regulation was not adapted to the new demands arising from a deregulated financial market. Some authors have commented that from the beginning of the liberalization process there was some tension between liberalizing and regulating, as it was not desirable to weaken the market s role in allocating resources by establishing a heavy regulatory framework. 5 In 1986, a new banking act was passed. The new law explicitly establishes which financial services a bank can provide. Among them, take deposits, issue bonds, provide loans including mortgages, perform foreign exchange operations and issue credit cards. The law allows banks to provide other services through completely separate subsidiaries with their own capital and management. Such subsidiaries are divided in two categories: 1) those that are complementary to the banking business and 2) those that provide support to the banking business. The former include securities agencies, stock brokerage, mutual funds management, leasing companies, credit card administration and financial advisory agencies. The latter include companies that provide collection services and electronic transfer networks. New regulations were introduced in the case of lending: loans to a single debtor, including parties related to the bank (a major cause of the collapse of banks in ) are limited to a percentage of the banks net worth. The 1986 banking act made it mandatory for banks to maintain in a technical reserve in cash or in Central Bank bonds, all sight deposits above 2.5 times the bank s paidin capital and reserves. In addition a full guarantee was established for sight deposits. In the case of time deposits a partial guarantee was introduced: it covers 90% of the deposit per person up to maximum amount. The SBIF has to publish at least three times a year information on the situation of institutions, and the latter have to hire at least two private risk rating agencies. One of the major innovations of the 1986 act is the power given to the SBIF to require banks to make provisions regarding risky loans. Finally, the new law sets a debt/capital ratio of 20. If the actual ratio surpasses this limit then it is presumed that the bank is at risk and therefore corrective actions must be taken. However, the 1986 law maintained the separation between banking, insurance and pension fund management. Banks were -and still are- not allowed to participate in the business of managing pension funds or insurance. The new law did not change the operation of foreign banks in Chile. It allows them to operate as subsidiaries, that is Chilean stock corporations, or branches of foreign corporations. 6 Under both legal forms, foreign-owned banks can provide the same financial services, which in turn are the same that can be provided by domestically-owned banks, and under the same separation of activities between those that can be provided directly by the bank and those that have to be provided through separate subsidiaries. For regulatory purposes both subsidiaries and branches of foreign banks also receive the same treatment. That is, they have the same minimum capital requirement and they are considered to be separate entities from their parent. In other words, what Chile s banking act defines as a branch is not in practice a branch. Its capital in Chile is separate from that of its parent so the size of its operations in Chile (basically lending) is based on that capital and not on their 5 See Meller (1996), Reinstein and Rosende (2001) and Ffrench-Davis (2003). 6 Foreign banks can also open offices of representation, but these cannot provide banking services. 5

6 parent s capital. The only difference between a subsidiary and a branch is that in the latter case there is no board of directors in Chile. It is significant to note that the reforms adopted in the years following the crisis were aimed at addressing through regulation and supervision the market failures and risks involved in financial intermediation, particularly banking, stressing the role of information in this market and not at reestablishing strict controls over the financial market and even less a return to state-owned financial institutions, credit controls, fixed interest rates or similar measures. In other words, there was no backtracking in financial liberalization. At the same time, plans were made for the re-privatization of the financial institutions taken over. 7 In this post-crisis period the participation of foreign-owned banks started to become significant. At the end of 1984 their share in deposits was already 16% and further increased to 18% in In the case of loans, their share rose from 9% in 1984 to 15% in 1989 (Marshall, 1991). In the 1990s, the banking industry was again fully private with the exception of the Banco del Estado and showed significant growth. Loans as a percentage of GDP grew from 59% in 1990 to 68% in 1998, the number of branches increased from 1121 to 1527 and the number of employees from to The spread between loans and deposits fell from 9% in the early 90s to 4% in Through their subsidiaries banks increased their activities into leasing, mutual fund management, financial advisory services, stock brokerage, among others. In 1997, a new reform of the General Banking was adopted. This represented the most significant changes to the regulation of banks since However, the new act was different in spirit from the Banking Act of 1986 to the extent that the latter was much influenced by the experience of the period prior to the crisis of The changes adopted in 1997 were aimed at creating a banking system integrated to the rest of the world, especially as a provider of financial services abroad, through a mix of deregulation and modernization of the regulatory approach. Firstly, the criteria for capital requirements of the 1988 Basel Capital Accord (Basel I) were adopted. Accordingly, the minimum capital as a percentage of risk-weighted assets was set at 8%. Secondly, the powers of the SBIF, responsible for banking supervision, were revised so as to make them closer to the recommendations of the Basel Committee and, at the same time, to promote a self-regulatory approach. The SBIF was authorized to rate banks according to their management practices and solvency. Thirdly, the scope of activities that banks can perform, either through subsidiaries for the support of their main business, was expanded. Banks were authorized, through these subsidiaries, to provide services such as securitization, factoring, insurance brokerage excluding insurance related to the pension system, and underwriting. Fourthly, the 7 See Reinstein and Rosende (2001) for more details of the changes introduced to the regulatory framework of banks. 8 These statistics are taken from Reinstein and Rosende (2001). 6

7 internationalization of banks was stimulated. Banks were allowed to provide cross-border services from Chile to domestic and foreign enterprises operating abroad and they were authorized to open subsidiaries abroad but providing the same financial services that they can provide in Chile. Finally, objective criteria were established for granting (or rejecting) a banking license and the regulator would have to justify a rejection in writing. This meant the lifting of the existing de facto limit on the number of banking licenses and the elimination of an economic needs test in bank licensing. The new law also removed the requirement that all investments in the banking sector had to go through the investment regime of DL These latter liberalizing measures were to prove very helpful when facing bilateral negotiations in financial services a few years later. b) The issue of foreign exchange controls in Chile As Chile began to negotiate more comprehensive trade agreements that contain disciplines regarding investment, following the NAFTA model, the issue of controls of both inflows and outflows of capital was to come to the negotiating table. Although not directly related to financial services, it is important to discuss this issue because emerging economies have used them in the past and may face different conditions for their application once such comprehensive agreements are completed. In order to understand Chile s position regarding capital account controls it is necessary to briefly explain the legal basis and practice of capital controls in the 1990s in Chile, in particular the well-known unremunerated reserve requirement (URR) on foreign loans. The Central Bank Act, which has a constitutional-legal standing, 10 states that the Bank has as its purpose to look after the stability of the currency and the normal functioning of the internal and external payments services (our emphasis). 11 For this purpose the Bank can regulate the amount of currency and credit in circulation, the performance of credit transactions and foreign exchange, as well as the issuance of regulatory provisions regarding monetary, credit financing and foreign exchange matters (our emphasis). 12 Regarding the latter, the Central Bank Act specifies the measures that it can adopt. 13 These include: 1) the obligation of repatriation into Chile, in foreign currency, 9 Decree-Law 600 of 1974 or the Foreign Investment Statute is a voluntary regime for investing in Chile under which foreign investors sign a contract with the State of Chile for the transfer of capital or other forms of investment into Chile in exchange for certain guarantees such as the right to repatriate capital one year after its entry, to remit profits at any time with free access to freely convertible currencies and the invariability of the tax regime prevailing when the investment is made. Some of these guarantees were important at a time when there was uncertainty regarding Chilean economic policies and exchange controls were extensively used. Foreign investors can also enter capital into Chile through the general foreign exchange norms contained in Chapter XIV of the Central Bank Compendium of Foreign Exchange Norms, but none of the guarantees contained in DL600 apply to such investments. 10 This means that any reform to the Central Bank Act requires a special quorum which is greater than regular legislation for its approval. 11 See Article 3 of the Central Bank Act of Chile. 12 See Article 3 of the Central Bank Act of Chile. 13 See Article 49 (and also 42) of the Central Bank Act of Chile for a complete listing of the measures that the Central Bank can adopt regarding foreign exchange transactions.. 7

8 of the proceeds from transactions such as exports of goods and services and in general payments accrued abroad by individual and entities resident in Chile ; 14 2) determine that credits, deposits or investments in foreign currency originating or sent abroad be subject to a reserve requirement, with a limit of 40% (our emphasis); 3) establish that payment or remittance obligations related to imports of goods and services, royalties, other payment made in foreign currency abroad or to persons not having residence in Chile and the remittance of foreign currency for purposes of investments, capital contributions, loans or deposits abroad shall require prior authorization from the Bank; 4) order that the entities operating in the Formal Exchange Market 15 can only perform those foreign exchange transactions expressly authorized by the Bank; and 5) set limits to holdings in foreign currency or investments denominated in foreign currency that banking entities or persons may maintain within the country or abroad. As can be seen the legal power of the Central Bank to adopt measures restricting payments and transfers is quite broad and covers both the current and the capital account. The law, promulgated in 1989, reflects the dramatic experience of the crisis. Extensive exchange controls were re-introduced during the economic and financial crisis. Such controls were gradually removed during the 1990s on the side of outflows until their complete elimination in April Examples of the measures taken are the reduction in 1993 of the minimum period before a foreign investor can repatriate capital, 16 the increase in the share of pension funds, insurance companies reserves and mutual funds that can be invested abroad, the elimination of restrictions on investment abroad by Chilean residents and the authorization for Chilean residents to place bonds outside Chile. 17 However, starting in June 1991 the URR or encaje on short-term capital inflows was introduced. It required that a percentage of a foreign capital inflow be deposited in a non-interest bearing account in the Central Bank. The rate was initially set at 20% for a period going from 90 days to one year and was modified later in terms of its rate and coverage of financial transactions. It was raised to 30% in January 1992, then reduced to 10% for foreign loans, capital contributions and investment. Several reasons were given for the use of the encaje (Cowan and De Gregorio, 2005): i) to prevent an appreciation of the peso by reducing capital inflows; ii) to allow for some degree of independence of monetary policy in the context of a managed crawling-peg foreign exchange policy; and iii) to reduce the vulnerability of the economy to hot money flows by making short-term inflows relatively more costly. After the introduction of a freely floating exchange rate in September 1999, a series of measures were adopted that led to the full opening of the capital account. The unremunerated reserve requirement (URR) in place during most of the 1990s was reduced to 0% in September 1998, and was completely eliminated in April 2001, together with all 14 Article 49 paragraph 2 of the Central Bank Act of Chile. 15 Mostly made up of banking institutions. 16 In the case of investments through DL600 the minimum period was reduced from two to one year and in the case of those through Chapter XIV of Central Banks regulations on foreign exchange from three to one year. 17 See Cowan and De Gregorio (2005) for description and history of the evolution of capital controls and exchange regulations from 1990 to

9 remaining restrictions on foreign exchange operations such as obligations to selling or buying foreign currency in the formal foreign exchange market and the prior authorization for both capital inflows and capital outflows. However, the power of the Central Bank Board to impose capital and foreign exchange controls in the future, such as the URR or similar measure has not been removed from its Act. c) Macroeconomic conditions and the financial system and its regulation on the eve of the negotiations with the EU and the US When the time came to negotiate financial services bilaterally with the EU and the US, Chile had a privatized and liberalized financial market, open to foreign competition and with strong institutions in charge of supervising the financial system. The latter was well-capitalized and with a significant presence of foreign-owned institutions and institutional investors that provided depth to the market. Also the macroeconomic context was one of stability and prudent fiscal management. We take up each of these aspects as they are important in determining the consequences of liberalizing financial services in a negotiation. In 2000 and 2001, the Chilean economy grew by 4.5 and 3.4%, respectively. Although initially the economy recovered fast from the impact of the Asian crisis of the late 1998, in 2002 it was hit by deteriorating external conditions and GDP growth fell to 2.2% that year (see Table 1). Inflation was low and declining towards the lower bound of the Central Bank s target range of 2-4%, reaching end-of-year annual rates of 4.5% in 2000, 2.6% in 2001 and 2.8% in The public sector s net debt had reached by 2000 levels of around 11% of GDP. In 2001, the government introduced a fiscal policy rule. The government was to run a structural surplus of 1%. That is, if GDP were at its fullemployment level and the price of copper (an important contributor to government revenue) at its estimated long-term level, then the government would be running a surplus equivalent to 1% of GDP. This implies that the government s actual balance would depend on where the economy would be in the cycle. With GDP below its full-employment level and the price of copper below its expected long-term level, the government would run a deficit, and vice versa. With the economy still in the low phase of cycle and historically low levels of the price of copper, the government ran deficits in the period. In the three years, 2000, 2001 and 2002, Chile ran small current account deficits, amounting to 1.2%, 1.6% and 0.9% of GDP, respectively. Thus, when Chile sat at the negotiating table with the EU and the US, macroeconomic policy was being conducted under rules and in general the environment was one of stability. In addition, the exchange rate was freely floating and the capital account fully convertible. In 2000, Chile s financial sector showed strong solvency indicators, as can be seen in Table 3, and a very low share of non-performing loans in the banking sector. Commercial banks assets exceeded 90% of GDP, insurance company assets and net assets of mutual funds were growing and pension funds represented just under 60% of GDP. The State s participation through its single bank in bank assets and securities trading was 13% and 2%, respectively. An important feature of Chile s domestic financial market is the high 9

10 participation of foreign-owned financial institutions. In the early years of this decade, it was just under 50% in terms of banking assets and above 50% in securities trading, insurance premiums and pension funds management. The major origin of foreign investment in financial institutions are the EU (mostly Spain), the US and Canada. Thus, for domestic financial institutions, potential competition from foreign-owned ones was nothing new. Table 1. Basic macroeconomic indicators of the Chilean economy Macroeconomic Variables GDP per capita (PPP, current US$) 9,115 9,566 9,799 10,312 10,874 Nominal GDP (US$ billion) Real GDP Growth (% p.a.) Inflation Rate (end of period) Current Account Balance (% of GDP) Public Sector Net Debt (% of GDP) Central Government Balance (% of GDP) Source: World Bank and IMF. Table 2. Internationalization and privatization of Chile s financial system State Ownership State Ownership of Commercial Banks (% of total assets) State Ownership of Securities Firms (% of total securities trading) State Ownership of Insurance Companies (% of total premiums) State Ownership of Pension Funds, if applicable (% of total assets) Foreign Ownership Foreign Ownership of Banks (% of total assets) Foreign Ownership of Securities Firms (% of total securities trading) Foreign Ownership of Insurance Companies (% of total premiums) Foreign Ownership of Pension Funds (% of total assets) Source: SBIF, SVS, SAFP, and Stephanou (2005). 10

11 Table 3. Basic characteristics of Chile s financial system Size/Depth Contribution of Financial Services to GDP (%)* Total Commercial Bank Assets (% of GDP)* Stock Market Capitalization (% of GDP) Stock Market Turnover (% of GDP) Domestic Outstanding Government Debt (% of GDP) Domestic Outstanding Private Sector Debt (% of GDP) Domestic Credit to the Private Sector (% of GDP) Total Insurance Company Assets (% of GDP) Total Net Assets of Mutual Funds (% of GDP) Total Pension Fund Assets (% of GDP) Concentration Concentration Ratio - Top 3 Commercial Banks (% of total assets) Concentration Ratio - Top 3 Securities Firms (% of total securities trading) Concentration Ratio - Top 3 Insurance Companies (% of total premiums) Concentration Ratio - Top 3 Pension Funds, if applicable (% of total assets) Bank performance Return on Assets Return on Equity Cost-Income Ratio (Operating Expenses/Gross Income) 57,9 56,1 55,2 53,6 57,1 Operating Expenses/Total Assets** 3,0 2,9 2,9 2,7 2,5 Bank Solvency and Asset Quality Bank Capital to Assets Bank Capital Adequacy Ratio Bank Non-Performing Loans/Total Loans Bank Provisions/Non-Performing Loans * Includes financial services and business services according to Chile s national accounts. Source: Central Bank of Chile, World Bank, IMF, Standard and Poor s, BIS, ASSAL, Investment Company Institute, AIOSFP, SBIF, SVS, and SAFP.

12 In the context of a package of reforms of the domestic capital market introduced in April 2001, a number of them liberalized international trade in financial services. These included: 1) the tax paid by foreign institutional investors in Chilean fixed-income debt issued in Chile was reduced from 35% to 4%; 2) the creation of a system of voluntary retirement savings plans managed by all financial institutions (banks, insurance companies, collective investment funds and pension fund managers); 18 3) the investment limits for insurance companies were raised and made more flexible, including the instruments in which they can invest, but at the same time self-regulation was promoted by providing more responsibility to the boards of insurance companies, introducing standards of solvency and integrity for owners and raising market information and transparency standards; 4) the creation of multiple investment fund managers; 19 5) the number of pension funds offered by the pension fund managers in the mandatory system was expanded to five based on differences in their composition between fixed and variable-income financial instruments; 6) the creation of agricultural commodities stock exchanges; 7) the elimination of the 4% tax paid on interest of foreign-contracted loans when such funds are used to provide to third countries on a cross-border basis; and 8) the government sent legislation to Congress to raise the foreign investment limit by pension funds gradually to 30%. II. CHILE S TRADE COMMITMENTS IN FINANCIAL SERVICES PRIOR TO THE NEGOTIATIONS WITH THE EU AND THE US After almost two decades of unilateral trade liberalization, Chile began to actively negotiate free trade agreements in This new policy was aimed at complementing the unilateral reduction of tariffs with improved and more secure access to export markets, to remove non-tariff barriers faced by Chilean exports and, in the case of Latin America, to restore Chile s political relationship with the region after the return of democracy. Table 4 shows how actively Chile has been in negotiating trade agreements. The first ones were negotiated with countries in Latin America within the framework of Latin American Association for Integration (ALADI). This implied that these agreements, called Economic Complementation Agreements, covered only trade in goods as that is the context in which ALADI was created in Thus, in this first wave of trade agreements Chile did not negotiate disciplines in trade in services, including financial services, and in investment. The reasons for that, in addition to ALADI s scope, were that negotiating services was not seen as a priority by Chile and its Latin American partners and the Uruguay Round negotiations, which for the first time included services at the multilateral level, had not yet reached a successful conclusion. The negotiations of a free trade agreement with Canada represented a turning point in Chile s model for negotiating bilaterally. In 1994, Chile was invited to join NAFTA. In 18 The creation was very timely as it was possible for Chile to take commitments in the management of these funds as an alternative to the mandatory pension system. 19 Previously, mutual funds, investment funds and housing funds had to be managed by separate entities. 20 ALADI replaced an older effort of integration called the Latin American Free Trade Association (ALALC) which failed in reducing trade barriers between its members.

13 spite of maintaining the commitment to negotiate with Chile, the Clinton Administration faced the difficult task of passing the NAFTA through the US Congress and a negotiation with Chile or its accession to NAFTA were indefinitely postponed. However, Canada offered Chile the possibility of negotiating an agreement modeled after NAFTA as an interim agreement until political conditions in the US would become favorable again and Chile could join NAFTA. This negotiation gave Chile the opportunity to strengthen its negotiating teams and gain expertise in new areas such as investment, services, intellectual property rights and government procurement. Chile became a convert of the NAFTA-style trade agreements. The negotiations started in 1995 and concluded in However, Chile and Canada did not negotiate a chapter on financial services. The two countries took the commitment to negotiate such a chapter, based on NAFTA Chapter XIV, no later than April Then Chile and Mexico agreed to replace their ALADI-style only-goods agreement with an agreement based on the NAFTA model. This new agreement was signed in April 1998 and entered into force the following year. However, the financial services chapter was also left for future negotiation. Such negotiations were to start no later than June Financial services were not negotiated with Canada and Mexico because these agreements were seen as steps towards NAFTA accession. It was the first time that Chile negotiated complex issues such as investment and, even though financial services were of interest to Canada, Chile s negotiating team felt that in an accession to NAFTA they would need financial services as a negotiating chip with the US. The Canada-Chile FTA was the template for the Chile-Mexico FTA so financial services were also left for future negotiations. The deadlines for negotiating with Canada and Mexico were never met. Thus, prior to the negotiations with the EU and the US, Chile s only significant commitments in financial services were made in the context of the Uruguay Round. a) Chile s financial services commitments in the Uruguay Round Chile followed a very conservative and cautious approach in negotiating its financial services schedule in the Uruguay Round and did not consolidate the status quo. 22 Chile left unbound cross-border trade and consumption abroad (modes 1 and 2) for all financial services except for reinsurance and retrocession and brokerage of reinsurance. Its commitments in mode 4, movement of natural persons, were limited to its general commitments in services regarding intra-company transferees. Chile maintained an economic needs test for commercial presence in all scheduled financial services. 23 Almost all of Chile s commitments were taken in commercial presence (mode 3). In insurance services, both life and general insurance are included, as well as insurance 21 In both agreements, the government procurement chapter was also left for future negotiations. In neither case was the deadline respected. Only in 2006 did Chile and Canada begin to negotiate a financial services chapter. Negotiations with Mexico are expected to start in the first semester of Chile s financial services commitments in the Uruguay Round are described in more detail in Annex I. They can be found in GATS/SC/18/Suppl.3 of 28 February At the time, the banking act had not been reformed and foreign banks could only access the Chilean market through the DL600 foreign investment mechanism. 13

14 brokerage. However, Chile s list does not include any of the services auxiliary to insurance such as consultancy, actuarial, risk and claim settlement services. Foreign-owned providers have to establish commercial presence in Chile according to the domestic insurance legislation; that is, as stock-corporations and providing through separate companies life and non-life insurance. Chile excluded from its insurance commitments all insurance related to the mandatory social security system, including health insurance provided by the socialsecurity health providers (ISAPRES) and the National Health Fund (FONASA). In banking services, Chile consolidated establishment through the three juridical forms allowed for banks: subsidiary, branch (but with capital separate from the home office) and representative office. Chile s banking services list follows the list activities that banks can provide according to what Chile s Banking Act allows. However, not all services permitted were listed, both among those that are considered as the core business of banks (taking deposits and granting loans) and those that are considered to be complementary to the bank s core business (financial leasing and advisory and other auxiliary financial services). The securities services listed include the trading of publicly-offered securities and stock of corporations, risk rating, custodial services by securities brokers, financial advisory services, portfolio management by securities brokers and warrants. 14

15 Table 4. Chile: Trade Agreements AGREEMENT STATUS MODEL MAIN AREAS COVERED Economic Complementation Agreement with Mexico Economic Complementation Agreement with Venezuela Economic Complementation Agreement with Bolivia Economic Complementation Agreement with Colombia Economic Complementation Agreement with Ecuador Economic Complementation Agreement with MERCOSUR Free Trade Agreement with Canada Economic Complementation Agreement with Peru Trade Preferences Agreement with Cuba Free Trade Agreement with Mexico Free Trade Agreement with Central America Association Agreement with the European Union Free Trade Agreement with the United States Free Trade Agreement with the Republic of Korea Replaced by FTA in 1999 In force since July 1993 In force since July 1993 In force since January 1994 In force since January 1995 In force since October 1996 In force since July 1997 In force since July 1998 Negotiations concluded in August Not yet in force. In force since August 1999 Signed in October Partially in force. b In force since February 2003 In force since January 2004 In force since April 2004 ALADI a ALADI ALADI ALADI ALADI ALADI NAFTA ALADI ALADI NAFTA NAFTA GATT/ GATS NAFTA NAFTA Trade in goods Trade in goods Trade in goods Trade in goods Trade in goods Trade in goods Trade in goods, trade in services, investment, telecommunications. Government procurement and financial services under negotiation Trade in goods Trade in goods Trade in goods, trade in services, investment, air transportation services, telecommunications, intellectual property. Financial services and government procurement under negotiation. Trade in goods, trade in services, air transportation services, telecommunications, government procurement. Investment and financial services not covered. Trade in goods, trade in services, trade in financial services, establishment of investors, government procurement, intellectual property. Trade in goods, trade in services, trade in financial services, investment, government procurement, telecommunications, e- commerce, intellectual property. Trade in goods, trade in services, investment, government procurement, intellectual property. Financial services will be included 15

16 Free Trade Agreement with EFTA c Free Trade Agreement with China Trans-Pacific Economic Association Agreement (Brunei, Chile, New Zealand and Singapore) Free Trade Agreement with Panama Tariff Preferences Agreement with India In force since December In force since October In force since November Signed in 2006 Signed in March Under legislative ratification. Based on EU-Chile Agreement NAFTA NAFTA no later than four years after the entry into force. Trade in goods, trade in services, establishment of investors, government procurement, intellectual property. Financial services will be negotiated two years after entry into force. Trade in goods. Trade in goods, trade in services, government procurement, intellectual property. Investment and financial services will be negotiated two years alter entry into force. Trade in goods, trade in services. Financial services may be incorporated two years after entry into force. Trade in goods a ALADI is the Latin American Integration Association. b The FTA enters into force bilaterally with each country of Central America when the negotiation of a bilateral protocol of tariff preferences for goods is concluded. The FTA is in force with Costa Rica and El Salvador. c European Free Trade Association (Iceland, Liechtenstein, Norway and Switzerland). Source: DIRECON Important areas of services such as pension fund management were left out. Clearly, then Chile in 1997 did not consolidate its level of external liberalization in the GATS. This conservative approach was not related to the possibility of future bilateral negotiations or to unhappiness with the resulting liberalization in agriculture and other areas of interest to Chile in the WTO. It had more to do with the fact that legislative and regulatory changes, especially in banking, were pending. The banking act was been reformed just as the financial services negotiations were being concluded in the GATS. Thus, the uncertainty related to the outcome of the legislative process did not allow for larger commitments in banking services. In the GATS, Chile addressed the issue of the Central Bank s powers to restrict transfers by introducing a market access limitation for all modes of supply. The text can be found in Annex II of this paper. As can be seen there, the text reproduces the relevant text of the Central Bank Act and specifically mentions the URR. Basically, all measures that the Central bank can impose regarding capital inflows and outflows as well as exchange controls for purposes of financial stability and better management of monetary and exchange rate policy are reserved. This text would become a model for some of the bilateral negotiations that came later. The existing limitations for the repatriation of capital associated to commercial presence are also present in Chile s GATS commitments. 16

17 b) Financial services and capital controls in the agreements with Canada and Mexico As explained above, the FTAs with Canada and Mexico did not include a financial services chapter. However, financial services were not fully excluded. Both FTAs contain, in their respective investment chapters, a provision extending protection to investors in financial institutions regarding transfers, and expropriation and compensation. That is, protection for investment in financial institutions was provided after establishment. In neither case the deadline for negotiating a financial services chapter was met. Thus, when Chilean and US negotiators sat for the first time in January 2001 to discuss a financial services chapter, there were no precedents on which the US could base its requests in the financial services negotiations. 24 However, both agreements contain obligations regarding transfers related to investment. When both were negotiated, Chile still had in place capital controls, in particular the URR. Thus, that issue had to be addressed. The negotiations with Canada were being conducted at the same as Chile was presenting its specific commitments in financial services in the Uruguay Round. The model for Canada in its negotiations with Chile was the NAFTA and therefore Canada expected a strong obligation from Chile regarding transfers, of the same level as in that tripartite agreement. Again, the goal of Chilean negotiators was to protect the Central Bank s ability to maintain or adopt in the future an URR for short-term capital flows as well as the minimum stay for capital introduced into Chile through the special investment vehicles, among other capital control measures. The solution reached at the time was that of an annex that introduced an exception to the transfers article or obligation of the investment chapter. In Annex G-09.1 of the Chile-Canada FTA, which is reproduced in Annex II of this paper, Chile reserves the right to apply a reserve requirement but with two limitations: a maximum rate of 30% and for not more than two years. The annex also reserves the right to require that certain transactions be carried out in the Formal Exchange Market, but in the case of authorization to access that market such authorization shall be granted without delay in the case of current international transactions, proceeds from the sale or liquidation of an investment and payments pursuant to a loan provided that they are made in accordance with the maturity dates originally agreed in the loan agreement. There is also a non-discriminatory clause for transactions of the same nature between Canadian investors and other investors. The exact same annex was soon afterwards introduced in the new Chile-Mexico FTA. III. PREPARING THE NEGOTIATIONS: THE ISSUES INVOLVED 24 The US did use Chile s previous market access commitments in services and in investment (including certain parts of the text of the investment chapter as a basis for its negotiations with Chile. On the other hand, at the time the negotiation with the EU was still in its initial stages and financial services had not yet been discussed in detail. 17

18 The technical preparations when the actual negotiations started required a detailed look at the issues that would be involved and/or raised by the negotiating partner (structure of commitments, market access, capital account regulation, etc.) and how financial services fitted into the broader context of the negotiations. This section will review the issues that are involved in a bilateral negotiation of financial services and the negotiating positions that Chile took. The decision to negotiate financial services bilaterally with the US and the EU required the definition of a number of key negotiating issues and a review of the adequacy and preparedness of Chile s financial legislation, supervisors and level of market openness for the commitments that were foreseen. It must be kept in mind that Chile had no prior experience in negotiating financial services bilaterally. Initially, the decision making involved only the public sector: the Ministry of Finance, the Central bank and the financial regulators. Then, once the negotiations started and the other parties position became clearer, the private sector was involved through periodic consultations. The first key negotiating issue that was addressed was how would financial services fit in the more general context of a bilateral negotiation: would they be used as a bargaining chip? Clearly, it was difficult to conceive that it was possible to have a free trade agreement with the US or with the EU without financial services. For both partners this was an important sector in which they expected Chile to take commitments. Thus, it was decided that Chile would accept to negotiate financial services and that this fact would be used as a sign of good will from Chile and that, in turn, Chile expected that both the EU and the US were also going to address areas of offensive interest to Chile, such as agriculture, forestry, fishing and aquaculture, food and beverages (mostly wine), some textiles and professional services. However, it was also decided that the level of commitments in financial services would only depend on the level of comfort that Chile felt in taking commitments in financial services and the extent of the requests from the negotiating partners. In other words, Chile would not, for example, exchange market access in agriculture for concessions in financial services. The negotiation of financial services would be carried on independently of what was happening in other areas. This was possible because it was understood that the Ministry of Finance had sole and full responsibility in the conduct of negotiations in financial services. The second key issue was that of precedents. By coincidence, the negotiations with the US and the EU were being conducted at the same time. In addition to that, Chile was still negotiating a free trade agreement with Korea. The problem was how to manage the three negotiations without setting precedents in one that could weaken Chile s negotiating position in another. In the case of Korea it was possible to reach agreement to conclude the negotiations with only a future commitment to negotiate financial services because Korea had raised the issue towards the end of the negotiations. Given that the US did not have Congressional authority to negotiate trade agreements when the negotiations with Chile began, those with the EU advanced much faster. By early 2002 it was clear that Chile was going to have to wrap up the financial services negotiations with the EU by April. The fact that EU was not prepared to follow a NAFTA style approach in investment and services helped in conceptually distinguishing the two negotiations but undoubtedly what was going to be agreed with the EU in April 2002 was going to be seen by the US as Chile s limits in 18