ECONOMICS CHILE. Inside Latin America 4Q08: 2009, Surviving the Storm

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1 ECONOMICS Economics Research Ernest W. (Chip) Brown, Head CHILE October 21, 28 Inside Latin America 4Q8: 29, Surviving the Storm Pablo Correa, Juan Pablo Castro POSITIVES Chile has a healthy financial position, which could allow the Finance Ministry and the Central Bank to implement measures to deal with the direct effects of low liquidity and limited access to international credit. A sound fiscal position we highlight the fact that government-held sovereign wealth funds could reach US$3 billion in 29 could allow the government to implement a countercyclical fiscal impulse, supporting private consumption and investment. Inflation, which has been the biggest problem for the Chilean economy in 28, is likely to diminish in 29 owing to lower inflation pressures from the external scenario and wider capacity gaps. NEGATIVES We expect both the export sector and internal demand to be affected by the financial crisis. We highlight three negative effects for the Chilean economy: (1) lower demand for exported goods and services, (2) a rise in financing costs, and (3) a negative impact on both investor and consumer confidence. We expect GDP growth to decelerate in 29, when we see GDP expanding at a rate of 3.3%. Moreover, we see downward risks to our output estimate as a result of the worst international scenario in the last several years. PROSPECTS Economic growth Our base scenario estimates GDP growth at 4.3% by the end of 28. Growth is likely to slow in 29, when we see GDP expanding 3.3%. Moreover, there are downward risks to our output estimate, namely reduced demand for Chilean exports and lower internal demand. Although decelerating strongly compared with 28, we expect internal demand to grow above GDP, at a rate of 4.4%, mostly due to private consumption. Concerning the impact of the global financial crisis on internal demand, our first impression is that it will enhance the monetary tightening process at the Central Bank. The Central Bank left the reference interest rate at 8.25% in its October meeting, and we expect it to remain unchanged until 1Q9, when we see a reversal in the direction of the monetary policy, which we believe means the reference interest rate is likely to finish 29 at 6.5%. In addition to the fact that we see the reference interest rate tighter than neutral for the whole of 28 and 29, the global crisis could imply tightening access to credit for both consumers and companies as financial institutions restrict risk exposure. We expect private consumption to remain relatively healthy, but decelerating compared with 28. Reflecting the transition of the economy s fundamentals toward those of a high-middle income country, private consumption has been one of the most stable variables in the Chilean economy since 24. However, we expect private consumption to decelerate in 29, growing at 4.8% compared with the average of 7.% between 24 and 28E, mostly owing to the negative impact of (1) lower real U.S. investors inquiries should be directed to Santander Investment at (212)

2 disposable income due to high inflation, (2) restrictive financial conditions due to the increase in interest rates and stricter risk management, (3) lower consumer confidence as a result of the deceleration of economic growth and the news coming from the international crisis, and (4) a moderation of the labor creation rate due to the slowdown of activity. Among the factors that could offset the negative issues, falling inflation could allow a recovery in real salaries next year, implying that real payroll could resume growth of more than 5%. In addition, we expect consumption to be supported by the rise in the perception of permanent income. This is likely to be explained by an increase in the top quality segment of employment (the wage-earning component of employment has been growing at 5.7% this year), as it is usually linked to formal job positions. Private consumption could decrease on higher interest rates 1% 9% 8% Private consumption %YoY 1/MPR 7% 6% 5% 4% 3t3 2t4 1t5 4t5 3t6 2t7 1t8 Sources: Central Bank and Santander estimates. In addition, the fiscal sector should play a role in supporting private consumption next year, mostly through transfers and subsidies to consumers. In this regard, the 29 fiscal budget contains a 5.7% real increase, which, in our opinion, is in line with the commitment of the government to controlling inflation, at the same time that it could allow the government to fund several programs intended to support economic growth. About 7% of the fiscal budget is social spending. We expect investment spending growth to slow in 29 compared with its strong performance in 28. This year, we estimate capital formation will have grown by 17%, mainly explained by investment in electricity and mining projects. We expect investment to rise by 2.9% next year. First, we see a moderation in spending on machinery, as important mining and electricity projects ended their building phase. In addition, investment is the macroeconomic variable most sensitive to the increase in interest rates, which have prompted the delay of some projects in addition to affecting the real estate sector. We anticipate a modest growth of capital expenditures in private and public projects in 29. The Corporación de Bienes de Capital (which collects investment data from private and public companies) expects investment spending to equal US$14.7 billion in 29, compared with US$13.7 billion and US$9.5 billion in 28 and 27, respectively, which implies a decline from growth of 44% to 7%. October 21, 28 2

3 Investment shows a high negative correlation with interest rates 3% 25% 2% Investment %YoY 1/BCU5 15% 1% 5% % 3t3 2t4 1t5 4t5 3t6 2t7 1t8 Sources: Central Bank and Santander estimates. The export sector could be particularly affected by the international slowdown. At current prices, copper exports represent about 6% of the total, but volume growth has been driven by non-commodity items such as wine, processed food, salmon, wood products, etc. In fact, while mining production has grown by.7% yearly since 25, real exports have increased 5.1%. Therefore, as most of these non-commodities products are sold in high-income countries (38% of Chilean exports go to the U. S. or Europe), if we experience a recession in the industrialized economies, we could see an impact on demand for Chilean exports. Thus, we expect them to rise by 2.3% in 29, compared with 3.4% estimated for all of 28. Growth in exports depends on growth in high-income countries OECD countries GDP %YoY Real exports %YoY Sources: World Bank and Santander estimates. Internal financing We expect the international credit crisis to affect the local financial system indirectly, mainly through a rise in funding cost and an increase in local risk aversion. Thus, because we expect the reference interest rate to remain tighter than neutral in 28 and 29, we expect restrictive financial conditions for the Chilean economy as well. Even though no Chilean financial institution has exposure to so-called toxic assets, we expect the global financial crisis to indirectly affect local financial conditions. The Central Bank s quarterly survey of credit conditions points to an acceleration in the slowdown of loan growth in Chile. The last three surveys have shown consistently lower rates of credit approval (as a percentage of loan applications). Moreover, credit approval conditions have deteriorated across the board, affecting virtually all sectors of the economy with higher rates and/or tighter covenants but also shorter loan terms, smaller credit lines, and higher spreads related to the increase in risk perception. We believe that the persistent high inflation and continued increases in interest rates, in addition to the impact of the international credit crunch on credit approval conditions, are leading to a significant deceleration in credit supply, and we now expect slower volume growth for the system. In addition, there could be an increase in October 21, 28 3

4 the funding cost of banks, because 8.5% of the system s funding was internationally obtained. Thus we expect this source of funding to see an increase in costs or limited availability. Monetary policy and inflation While we expect inflation to stay high in the remainder of 28, finishing the year at 8.8% annual, lower inflation pressures coming from the international scenario of slower growth and wider capacity gaps in Chile are expected to drive inflation down in 29, reaching 4.4% annually by December 29. In line with this trend, we expect the Central Bank to decrease its reference interest rate 175 bps in 29, finishing the year at 6.5%. If we want to find any positive news coming from the international crisis, we should look to inflation. In fact, the international scenario has prompted a huge fall in commodities prices relevant to local inflation (especially oil and food-related commodities). In addition, the slowdown of internal demand could imply wider capacity gaps, meaning lower inflation pressures in the mid-term. Since early September, WTI oil price and grains have decreased nearly 35% Copper WTI Grains Oct-7 Nov-7 Dec-7 Jan-8 Feb-8 Mar-8 Apr-8 May-8 Jun-8 Jul-8 Aug-8 Sep-8 Sources: Bloomberg and Santander. However, we prefer to remain cautious about inflation in the short term. First, the steep decline in commodities prices has been offset by the depreciation of the Chilean peso, which has weakened 17% in the same period. In addition, wider capacity gaps may imply lower inflation pressures, but with a lagged impact on the variation of the CPI. In our opinion the main driver of inflation in the short term is the impact of second-round effects, or the transmission of inflation shocks to other prices in the economy. Indeed, second-round effects are gaining importance in explaining the current high level of inflation in Chile, and are reflected in significant increases among items not directly related to food and energy, such as services. Moreover, this kind of inflation has a higher persistence, as it is related to margins and indexation clauses in several services, such as regulated tariffs and education services. Thus, we expect CPI inflation to finish at 8.8% this year. Nevertheless, the propagation of inflation can be controlled by the increase in the interest rate, as it directly affects the possibility of passing through to prices high costs or increasing margins, due to the slowdown of demand, so we see the annual CPI inflation at 4.4% next year. October 21, 28 4

5 Inflation has been explained by supply shocks and second-round effects 1% 8% CPI YoY Super core CPI YoY 6% 4% 2% % Sep 4 Sep 5 Sep 6 Sep 7 Sep 8 Sources: National Institute of Statistics and Santander estimates. Among the risks to our base scenario that could either raise or lower the prospects for inflation, we highlight the following: Weak economic activity. Our base scenario assumes that the economic slowdown will help curb inflation next year. Nevertheless, as the impact of the international crisis is unclear, we do not rule out different scenarios that could imply wider-than-expected capacity gaps. Oil and food prices. The volatility in commodities prices is a phenomenon that could persist in the next few months. However, our base scenario considers an average oil price of US$9 per barrel in 29. Therefore, if current prices around US$7-8 per barrel persist, there could be a downward risk to our estimates. We expect food prices to increase by 2-3% annually in 29 after increasing by 12% in 28, owing to the decline in international food prices and the return to normal weather conditions. Labor market. Nominal wages have increased in a trend that is in line with typical indexation clauses. Thus, in addition to a labor force that is increasing at sound rates, averaging 4% in 28, we believe there are no additional inflation pressures coming from the labor market this year. However, indexation clauses could become a source of inflation in 29, because indexation clauses are linked to past CPI inflation. Therefore, because we expect the annual change in the CPI to decrease in 29, real wages could expand significantly, implying inflation pressures coming from the labor market. Nevertheless, this effect could be partly offset by an increase in the unemployment rate next year. Related to this inflation scenario, and fueled by the international crisis, inflation expectations in the medium term have decreased significantly in the last month. Thus, in addition to the uncertainty of the impact in the local economy of the international scenario, we expect the Central Bank to adopt a wait-and-see stance in the next months, until the impact and extent of the financial crisis over the economy becomes clearer. Looking into 29, we believe the Central Bank could start loosening monetary policy in 1Q9, finishing next year at 6.5%, as inflation should start to decrease, and the economic slowdown could imply the anchoring of inflation expectations to the target of 3% in the policy horizon of 24 months. We expect CPI inflation to reach 3.3% in 21. Fiscal policy The 29 fiscal budget has a real spending increase of 5.7%, the lowest expansion in recent years. We see this budget as positive, as we believe it helps control inflation at the same time it provides adequate funding for programs intended to support the economy. While the budget law provided for a real increase of 8.9% in 28, the 29 law assumes a much lower real increase. In our view, the fiscal budget is in line with the commitment of the government to controlling inflation, in addition to provide funding to programs focused on supporting the economy. 7% of the fiscal budget is related to social spending. Under the.5% of GDP structural fiscal surplus rule, the government uses a potential GDP growth of 4.9% and a long-term copper price of US$1.99 per pound. We expect social spending to increase by around 7.8%. Thus, we see the public sector budget adding demand to private consumption. There is US$5 million intended to fund new benefits under the pension system reform and an increase of US$45 million in education funding. October 21, 28 5

6 Trade balance and current account We are forecasting an US$11. billion trade surplus in 29, below the figure of US$15.6 billion in 28 due to the deterioration of the terms of trade. The current account should show a small deficit in both 28 and 29, after four years of being in surplus. Although we expect sound trade surpluses in 28 and 29, we estimate the Chilean economy could face a deterioration of the terms of trade ahead, mainly due to the expected trend of the oil and copper prices. In addition, we expect weak growth of export volumes, mostly due to a lower demand for Chilean goods. We assume a copper price of around US$2.75 per pound, which could imply a 2% decrease compared to 28 levels. We expect imports to decelerate in 29 as a result of the slowdown of internal demand (which could imply a lower demand for durable goods and machinery and equipment) and a lower average oil price. Thus, we expect exports to reach US$69.1 billion in 29 (decreasing 5.5% y/y), while we see imports at US$58.1 billion (increasing 1% y/y). The deterioration of the trade balance implies a current account deficit in 28 and 29, reaching.6% and 2.3% of GDP, respectively. Trade balance could narrow in 29 due to the decrease in exports Exports Imports Trade Balance Sources: Central Bank and Santander estimates. External financing The consolidated public sector has no net financial needs, and has a consolidated creditor position of 14.4% of GDP as of 28. In this scenario, we think it is very unlikely that we will see any external issuance of central government debt during 29. Nevertheless, we expect the international financial crisis to limit external issuance by Chilean companies. The government has a surplus in U.S. dollars and a deficit in Chilean pesos, as revenues in U.S. dollars are higher than expenditures in foreign currency. Thus, we think it is very unlikely that the public sector will issue external debt in the short term, because aside from the net creditor position of the consolidated public sector, we believe the Finance Ministry could add some liquidity in dollars to the local market by allocating some of these resources internally. In addition, looking to the medium and long term it is also unlikely that we will see any external debt issuance due to strong accumulation of so called fiscal assets of the government. Fiscal assets reached US$26. billion in June 28, including the Social and Economic Stabilization Fund (US$18.8 billion) and the Pension Fund (US$2.5 billion). Management policy has encouraged investment overseas, which was originally intended as a way to deal with Chilean peso appreciation resulting from increasing copper-related revenues in U.S. dollars. With regard to corporate issuance, we expect credit conditions for issuance overseas to worsen as a direct result of the financial crisis. Therefore, we could see Chilean companies financing their dollars needs locally instead of issuing bonds internationally. Currency Despite recent strong Chilean peso depreciation (that we believe is not related to fundamentals), we believe the Chilean peso could weaken in the medium term because of deterioration of the terms of trade, strengthening of the U.S. dollar internationally, and the expected decrease in the Chilean reference interest rate. Like other emerging currencies, the Chilean peso has depreciated strongly in recent weeks (17% in the last month) as a result of the lack of liquidity of U.S. dollars and the fact that the U.S. currency is still seen as a safe haven. October 21, 28 6

7 Recent CLP depreciation is mainly explained by the intensification of the financial crisis 68 5 CLP (l-axis) Ted spread (US Libor - T-Bill) 1 month (r-axis) Aug 1-Aug 19-Aug 28-Aug 6-Sep 15-Sep 24-Sep 3-Oct 12-Oct Sources: Bloomberg and Santander estimates. First, we expect the U.S. dollar to gain value compared with the euro, given the marginally better outlook for the U.S. economy compared with the eurozone. This process could imply an appreciation of the U.S. dollar internationally. In addition, the current account deficit implies depreciation pressure on the peso. Finally, the widening of the interest rate differential between Chile and the U.S. could decrease in 29; while it currently reaches 675 bps, we expect the Chile s Central Bank to decrease the reference interest rate by 175 bps in 29. In the meantime, in our view, although additional rate cuts by the Fed cannot be discarded, the fact that the current Fed funds rate is at a low level limits stronger rate cuts. The Chilean peso has shown a trend in line with other currencies 14 CLP 1/Euro Real Oct 19-Nov 21-Dec 22-Jan 23-Feb 26-Mar 27-Apr 29-May 3-Jun 1-Aug 2-Sep 4-Oct Sources: Bloomberg and Santander estimates. Employment and labor market trends In 28, the labor market has posted sound figures, representing the main pillar of private consumption. Nevertheless, we expect labor demand to moderate next year as a result of a lower job creation rate due to the activity scenario. Although unemployment has increased in recent months, reaching 8.2% in August, it is mainly explained by a higher rate of growth in the labor force rather than a decrease in the creation of jobs. We expect the unemployment rate to average 7.8% this year, largely due to an increase in the growth of the labor force, pushed by a rise in women s participation rate and a deceleration of employment creation, which has been growing at yearly rates over 3% this year. The women s participation rate has reached 41%, a sharp increase compared with the 26 figure of 38% and 34% 1 years ago. However, comparing this figure with other developing countries with similar levels of real purchasing power, the participation rate among Chilean women seems very low. October 21, 28 7

8 In 29 we expect labor demand to moderate. In our view, the economic deceleration implies lower employment creation compared with this year. In this sense, two of the main economic sectors that are responsible for job creation (construction and financial services) could decelerate next year owing the slowdown of internal demand. Therefore, we expect the unemployment rate to increase to 8.5% in 29. The labor market has posted sound numbers in 28, but we expect it to moderate in Unemployment rate Employment creation YoY Labor force YoY Jan-5 May-5 Sep-5 Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8-2 Sources: National institute of statistics and Santander. Politics Although there will be a presidential election in 29, we believe the economic agenda could maintain its importance, as inflation and economic concerns remain a very important focus of popular attention. 28 and 29 are election years (municipal elections are this year, while in 29 there is a presidential election), and economic news has gained importance in the political agenda. Inflation directly affects the population and, thus, support for the current government. The Bachelet administration has implemented several policies to help curb inflation, including diminishing fuelspecific taxes and presenting a 29 fiscal budget with a real increase of 5.7%, which we believe is in line with the objective of controlling the increase in prices. In addition, the international crisis has hit consumer confidence, mostly related to increasing concerns to the labor market. Thus, we expect the government to implement measures to mitigate the impact of the financial crisis on the economy, such as coordinating an agenda between the Finance Ministry and the Central Bank focused on the effects on the financial system, and maintaining employment programs. October 21, 28 8

9 Chile Economic Projections, 25-21F % GDP E 29F 21F National Accounts Real GDP ( % y/y) Total Demand ( % y/y) Consumption ( % y/y) Investment ( % y/y) Gross fixed capital formation ( % y/y) Government Spending ( % y/y) Exports ( % y/y Local Currency) Imports ( % y/y Local Currency) GDP (US$ bn) GDP Per Capita (US$) 7,314 8,875 9,923 1,747 11,115 11,138 Population (Mn) Monetary and Exchange Rate Indicators CPI Inflation (Dec Cumulative %) WPI Inflation (Dec Cumulative %) US$ Exchange Rate (Year-End) US$ Exchange Rate (Avg) Central Bank rate (interbank 24h target) (Year-End) Central Bank rate (interbank 24h target) (Avg) Money Base (US$ bn) M1A ( % y/y) Fiscal Policy Indicators Fiscal Balance (% of GDP) Primary Balance (% of GDP) Government Financing Needs a (Local Currency Billions) Gross Total Government Debt (US$ bn) NA Local Currency (US$ bn) NA Foreign Currency (US$ bn) NA Balance of Payments Trade Balance (US$ bn) Merchandise Exports (US$ bn) Merchandise Imports (US$ bn) Services and Income Receipts (US$ bn) Services and Income Payments (US$ bn) Transfers (US$ bn) Current Account (US$ bn) Current Account (% of GDP) Foreign Direct Investment (US$ bn) Debt Profile Total External Assets Fiscal Assets Central Bank International Reserves (US$ bn) Total Internal Govt. and Central Bank Debt (US$ bn) NA Total Internal Govt. and Central Bank Debt (% of GDP) NA Total External Debt (US$ bn) Short Term (less than 12 months) (US$ bn) Long Term (over 12 months) (US$ bn) Total External Debt (% of GDP) Total External Debt (% of Exports of goods & services) Debt Service Ratio a Labor Markets Unit Wages (real % y/y) Unemployment Avg. (% of EAP) Total Payroll (real % y/y) (a) (Amort + Fiscal Deficit). (b) (Amort+Interest Ext Debt)/Exports Goods & Services. Sources: Central Bank and Santander Investment. October 21, 28 9

10 CONTACTS Economics Research Ernest (Chip) Brown Head of Economics Research Sergio Galván Economist Argentina Alexandre Schwartsman Economist Brazil Pablo Correa Economist Chile Carolina Ramirez Economist Colombia Héctor Chávez Economist Mexico Milton Guzman Economist Venezuela Fixed Income Research Juan Pablo Cabrera Senior Economist Local Markets Jorge de Gortari Head of G3 Strategy Denis Parisien Head of Corporate Research Alejandro Estevez -Breton Local Markets Strategy Naveen Kunam Quantitative Analysis Pedro Nieto Corporate Research Equity Research Cristián Moreno Head, Equity Research Walter Chiarvesio Head, Argentina Marcelo Audi Head, Brazil Francisco Errandonea Head, Chile Gonzalo Fernandez Head, Mexico Alonso Aramburú Head, Andean Region Electronic Media Bloomberg Reuters Santander Investment Securities Inc. STDR <GO> Pages SISEMA through SISEMZ This report has been prepared by Santander Investment Securities Inc. ( SIS ) (a subsidiary of Santander Investment I S.A which is wholly owned by Banco Santander, S.A. ( Santander ), on behalf of itself and its affiliates (collectively, Grupo Santander) and is provided for information purposes only. This document must not be considered as an offer to sell or a solicitation of an offer to buy any relevant securities (i.e., securities mentioned herein or of the same issuer and/or options, warrants, or rights with respect to or interests in any such securities). Any decision by the recipient to buy or to sell should be based on publicly available information on the related security and, where appropriate, should take into account the content of the related prospectus filed with and available from the entity governing the related market and the company issuing the security. This report is issued in Spain by Santander Central Hispano Bolsa, Sociedad de Valores, S.A. (SCH Bolsa), and in the United Kingdom by Banco Santander, S.A., London Branch (Santander London), which is regulated by the Financial Services Authority in the conduct of investment business in the UK. This report is not being issued to private customers. SIS, Santander London, and SCH Bolsa are members of Grupo Santander. ANALYST CERTIFICATION: The following analysts hereby certify that their views about the entities and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Ernest W. (Chip) Brown, Juan Pablo Castro, Pablo Correa. The information contained herein has been compiled from sources believed to be reliable, but, although all reasonable care has been taken to ensure that the information contained herein is not untrue or misleading, we make no representation that it is accurate or complete and it should not be relied upon as such. All opinions and estimates included herein constitute our judgment as at the date of this report and are subject to change without notice. Any U.S. recipient of this report (other than a registered broker-dealer or a bank acting in a broker-dealer capacity) that would like to effect any transaction in any security discussed herein should contact and place orders in the United States with SIS, which, without in any way limiting the foregoing, accepts responsibility (solely for purposes of and within the meaning of Rule 15a-6 under the U.S. Securities Exchange Act of 1934) for this report and its dissemination in the United States. 28 by Santander Investment Securities Inc. All Rights Reserved. October 21, 28 1