Document of The World Bank OF THE PRESIDENT OF THE TO THE EXECUTIVE DIRECTORS ON A. IN AN AMOUNT EQUIVALENT TO USt250.0 MILLION.

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY e1-a V t Z REPORT AND RECOMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED THIRD STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO USt250.0 MILLION TO THE REPUBLIC OF CHILE November 20, 1987 Report No. P-46S 5-CH This document has a restricted distribution and may be used by recipients oniy in the performance of their official duties. Its contents may not otberwise be disclosed without World Bank authoriaon

2 CURRENCY EQUIVALENTS (Currency Unit Chilean Peso (Ch$)) Calendar 1986 Currency Unit Average July 31, 1987 US$1 Ch$ Ch$ UF Ch$3, US$3, FISCAL YEAR January 1 to December 31 ABBREVIATIONS AFPs - Administradores de Fondos de Pensiones (Pension Fund Administrators) CODELCO - Corporacion del Cobre (Chilean State Copper Company) CORFO - Corporac ion de Fomento de la Producc ion (Chilean Development Corporation) ENAP - Empresa Nacional del Petroleo (National Petroleum Company) FONSA - Fondo Nacional para Salud (National Fund for Health) ISAPRES - Instituciones de Salud Provisional (Private Health Insurance Plans) LIBOR - London Interbank Offered Rate PEM - Programa de Empleo Minimo (Minimum Employment Program) PROCHILE - Chile's Export Promotion Agency UF - Unidad de Fomento Reajustable (Financial Unit of Account which reflects the movements in the country's consumer price index)

3 Table of contents FOR OFmFCLAL USE ONLY PaRe No. LOAN AND PROGRAM SUMMARY... i-ii PART I - THE ECONOMY l. Background: Macroeconomic Developments I PART II - PROGRESS OF THE ADJUSTMENT PROGRA. 3 Balance of Payments. 4 Debt Management. 5 Fiscal Policy and Public Finances. 6 Savings and Investment..., 6 Financial Sector. Social Policies. 8 Adjustment Priorities.13 PART III - PROPOSED PROGRAM FOR SAL III Macroeconomic and Export Promotion Policies Public Finances and Investment Financial System Social Sectors Impact of the Structural Adjustment Program... # Benefits and Risks Loan Amount and Tranching Disbursement, Procurement, Administration and Auditing IMF Extended Fund Facility PART IV - BANK GROUP OPERTIONS AD STRATEGY PART V - RECOHMENDATION ANNEXES: I Economic Indicators II Status of Bank Group Operations.. 37 III Supplementary Loan Data Sheet.. 39 IV Proposed Structural Adjustment Program: Issues and Scope..41 V Letter of Development Policy.. 44 MAP This document has a restricted distribution and may be used by recipients only in the perfu..nanace of their offcia duties. Its contents may not otherwise be disciosed without World Bank authorization.

4 CHILE THIRD STRUCTURAL ADJUSTMENT LOAN LOAN AND PROGRAM SUMMARY Borrower: Amount: Te!mt DescriDtion: Republic of Chile US$250.0 million equivalent Repayment in 17 years, including four years of grace, at the standard variable interest rate. Tne proposed loan would support the Government's structural adjustment program. The main areas covered by the Government's medium-term program include: (i) measures to maintain and strengthen incentives for noncopper exports; (ii) steps to increase public savings and the efficiency of public expenditures; (iii) measures to improve the mobilization and allocation of long-term savings; and (iv) measures to improve public efforts in the social sectors. The loan would finance all imports, vith the exception of luxury items and military goods. Proiect Benefit8s The ongoing structural adjustment program has accelerated exports and increased domestic savings while producing a strong recovery of economic growth and employment. The country has also consistently serviced its external debt. Maintaining the program is expected to reir.force this performance and result in higher levels of economic growth, employment and income while enhancing the country's ability to service its external debt through increased exports. The increased growth and improved balance-of-payments performance will also strengthen Chile's creditworthiness and facilitate continuation of external financial flows. Proiect Risks: The principal risks--and they are not minor--center on the Government's ability to generate the required domestic savings and investment, especially from the private sector, on Chile's terms of trade, and on access to foreign capital. If external developments adversely affect Chile's terms of trade or interest rates, or if foreign capital inflows are less than projected, domestic savings may be insufficient to permit satisfactory growth and impede debt service payments. Internal political developments also entail uncertainty that may affect private investment.

5 - it - Estimated Disbursements: The proceeds of the loan would be disbursed in two tranches: US$125 million equivalent upon effectiveness, and the remaining US$125 million equivalent after a performance review to be held within 12 months of effectiveness. Appraisal Report: None. IBRD 14306R1

6 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED THIRD STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALEN TO US$250.0 MILLION TO THE REPUBLIC OF CHILE 1. I submit the following report and recommendation on a proposed Third Structural Adjustment Loan (SAL) to the Republic of Chile for the equivalent of US$250.0 million. The loan would have a term of 17 years, including four years of grace, with interest at the standard variable rate. 2. An economic memorandum on Chile (Report No CH) was circulated to the Executive Directors on September 24, 1984; subsequent President's Reports and Country Briefs have updated that analysis, the latest of which was circulated to the Board in September The Bank approved a first SAL in' October 1985, and a second SAL in November 1986, each worth US$250 million. In addition, the Bank provided a partial guarantee of a $300 million B-Loan in 1985, a key to the financial program. The World Bank's support to Chile's structural adjustment program was central to support from the international financial community (paras ). The IMF provided a three-year EFF of SDR 750 million beginning August The commercial banks have rescheduled US$18.1 billion since the beginning of the program and provided US$1.1 billion of new money as well as other forms of debt relief. Creditor governments rounded out the support by rescheduling US$285 million in interest and principal. 3. A Bank mission reviewed the implementation of SAL II in May 1987 and the second tranche was disbursed in June The Government formally requested a third SAL in May 1987 in support of the country's economic adjustment program; this request was appraised during a subsequent mission in July 1987, and the conclusions of the mission are reflected in this report. This operation is designed to support a coherent ongoing program (as distinct from major new reforms) as well as institutionalizing new patterns of savings and investment and strengthening social security and health systems. Country data sheets are attached as Annex I. PART I - THE ECONOMY Backgroundt Macroeconomic Developments 4. In the early 1980s, external events interacted with inappropriate domestic policies to cause one of the severest depressions in Chilean history. The economy was heavily battered after 1979 by the steep oil price increases, falling copper prices, surging real interest rates and the subsequent deep international recession. Between 1980 and 1985, Chile's terms of trade fell 22 percent, among the severest losses for any

7 . 2 - Latin American country. During , Chile's open capital account, fixed exchange rate, and a lagged convergence of domestic and foreign inflation and interest ratea stimulated an unsustainable boom. As the peso appreciated and copper prices began falling, massive inflows of unguaranteed long-term credit fed the boom in consumptiont external debt rose from US$6.7 billion by end-1978 to US$17 billion by end Export and import substitution sectors started to slump by the end of The bubble burst in 1982, when voluntary lending to La.in America ended and international real interest rates reached record heights. Chile was forced to devalue its currency, precipitating a financial critis for major banks and bankruptcy of many enterprises. Real GDP dropped over 14 percent (Figure 1) and unemployment rose to over 25 percent. Average per capita private consumption fell to levels prevailing in The Government's initial response to the crisis was to enact several emergency measures to stave off the complete collapse of the financial and real sectors. These included infusing liquidity into the financial system (and in the process extending public guarantees to the formerly private nonguaranteedebt), large public employment programs, severely austere fiscal policies, and real wage compression in the public and private sectors. Piar 1, ""nt x Chow -sj 6& OSS Z SCUZSUG PRO2U? e9 - _ t St 656 e6 6574?i t Ut "Z ala- 'En w sm e as 197? * 1St ~~1 4 1, 13~~ tot ~ - SrBo ot tot :- 41 j i a g 9

8 It became increasingly apparent that the harsh external environment--low copper prices, commercial bank retrenchment, and high real interest rates--would not pass quickly. The Government began to supplement emergency measures with a new, mere coherent long-term program. In early 1984, the Government produced a three-year public investment program. In 1985, the Government put in place the Bank-supported adjustment program. Economic policy since then has been to maintain international competitiveness and forego increases in consumption to raise savings for investwent and debt service. Even though unfavorable terms of trade and high real international interest rates persisted, the economy began to recover in 1984 and, after the initiation of a consistent adjustment program in 1985, the pace of expansion has quickened to nearly 6 percent in 1986 and Investment picked up and capital expenditures grew by more than 10 percent in Per capita consumption grew modestly in 1986 and unemployment has fallen to about 10 percent. S. Growth rates in the first quarter of 1987 topped an annualized rate of 7 percent and the Government felt it necessary to adopt a slightly restrictive monetary stance to evert excessive demand pressures. Monthly inflation, spurred by temporary upsurges in the international price of oil, had increased to 2 percent in January; the adjustment in monetary policy increased real interest rates by percent and was sufficient to oull growth down to 5 percent in the second quarter and reduce internal inflationary pressures; growth continues at about the same rate and the increase in GDP will probably fall between percent for the year. PART II - PROGRESS OF THE ADJUSTMENT PROGRAM 9. The Bank and the Government have consistently shared the view that Chile's structural problems require a sustained program over several years. Overdependence on copper had resulted in repeated cycles of boom and bust, broadly correlated with movements in the terms of trade. 3istorically low savings and investment rates impeded the development of noncopper economic activities. Internal policies often aggravated these problems or were themselves the impetus to instability. Excessive reliance on foreign savings had increased debt to over 100 percent of GDP and, by 1986, interest payments absorbed 10 percent of GDP. The complication of the enormous debt burden added to other structural problems of copper dependence and low savings/ir.vestment necessarily lengthens the time required for the adjustment period: since the potential to expand near-term savings through belttightening contraction in consumption is clearly exhausted in Chile, increases in savings to service debt and to finance investment can only occur with successive years of increased output. The program therefore defined broad actions in several areas concurrently: balance of payments, debt management, fiscal policy, savings and investment, financial rehab.litation, and the social sectors.

9 -4- Balance of Paymts 10. The adjustment program that began in '985 put heavy emphasis on accelerating exports and efficient import-substitution. During 1985, the uniform import t..riff rate, which had been raised in 1984, was reduced from 35 percent to 20 percent. The currency--already on a crawling peg adjusted with domestic Inflation--was depreciated progressively to accumulate a 25 percent real devaluation relative to July The depreciation of the US dollar against other currencies led to a further real depreciation of the peso of 7 percent'in 1986 and 1-1/2 percent in the first two months of the Government also strengthened export incenttives in 1985, and in January 1986, established a Copper Stabilization Fund to avoid future vervaluation of the currency dule to volatile copper prices. The Fund ensures that part of the revenues of the public copper company (CODELCO) from higher-than-budgeted copper prices are sterilized in a reserve fund through budget adjustments. The Government also changed investment laws to promote exports from small-size producers and to facilitate joint ventures in the energy sector between private firms and the state petroleum firm (ENAP). 12. This program had positive results. During , noncopper exports grew at a real rate of 13 percent annually; imports declined 1.2 percent. Import substitution occurred at a strong pace. Industry grew by 4.6 percent annualiy and agriculture grew by 7.2 percent. This growth has continued into 1987; agricultural and industrial exports were 18 and 29 percent higher in dollar terms in the first semester of In spite of a 10 percent deterioration of its terms of trade, Chile's trade surplus almost q1tadrupled between 1984 and 1986, rising to US$1.1 billion (Table 1). Lower-than-expected international interest rates and the repricing obtained through external debt negotiations complemented Chile's trade effort. The current account deficit was reduced from US$2 billion in 1984 to US$1.1 billion in 1986 as programmed. Chile's reserves registered a small increase in Evolution of the current account in the first semester of 1987 indicates the deficit for the -ear will be about US$1 billion. Table 1: CHILE - BALANCE OF PAY1ENTS, (In US$ Millions) Exports of Goods and NFS 5,009 4,642 4,629 4,494 4,469 5,030 Imports of Goods and NFS 8,386 5,134 4,095 4,635 3,958 4,319 Merchandise Balance -2, ,100 Net Factor Income -1,463-1,921-1,748-2,018-1,901-1,888 Current Account -4,732-2,304-1,117-2,060-1,329-1,092 Capital Account 4,631 2,380 1,049 1,961 1,332 1,140 Reserve Change 67-1, (- = increase) Source: Central Bank; see Annex I for details.

10 Debt Management 14. Prudent management of Chile's external debt shaped performance in the capital account. The first SAL, IMF EFF, and the partial IBRD guarantee of a US$300 million B-Loan opened the way for a favorable agreement with the commercial banks on the financial package; the Bank guaranteed US$150 million of out-year maturities. Chile and its commercial creditors agreed to restructure US$5.7 billion of maturities due in ; the banks provided US$1.1 billion of new money for In July 1985, eight creditor governments agreed to reschedule US$145 million, representing 65 percent of principal payments due during July 1, December 31, The Government reached an agreement on its financial program with the Bank Advisory Committee in February 1987, formally made effective on June 17, Maturities in worth US$12.4 billion were rescheduled, leaving an anticipated financial gap of US$650 million for The agreement consolidated interest payments into one annual payment, which will defer the July payments of about US$450 million to the following January, beginning with July Also, current spreads on past new money facilities (1983, 1984, 1985 and the cofinancing agreement) were reduced to percent over LIBOR, while those on restructured maturities ( ) were reduced to one percent, producing savings of US$65 million in In April 1987, creditor governments rescheduled 85 percent of maturities falling due between July 1987 and end-year 1988, providing relief of US$140 million. 16. This debt management strategy was complemented by one of the region's first and most innovative schemes to encourage the conversion of discounted foreign debt to equity and domestic liabilities; by mid-1987 the program had facilitated conversions of US$1.9 billion of foreign debt. These events contributed to the improvements in creditworthiness indicators evident in Figure 2. Figure 2 CHILt - Mt? rw T* CDP a DENT SEUICz TO ORt "LT IIO"I*CD s "

11 - 6- Fiscal Policy and Public Finances 17. A conservative fiscal policy has markedly improved public finances, making an important contribution to the balance of payments and recovery. The Government increased collections by 1.2 percent of GDP between 1984 and 1986 through improvements in administration of the valueadded tax. It has made a sustained effort to restrain expenditures by holding increases in salaries and pensions at or below the rate of inflation; the fall in open unemployment permitted lower transfer payments for unemployment; the Government also cut other subsidies, mainly affecting t'.he middle class. Operational surpluses of the public enterprises also contributed to the increase in public savings; they were three percentage points higher as a share of GDP in 1986 than in Finally, lower foreign and domestic interest rates helped keep expenditures down. Public savings increased from 0.5 percent in 1984 to 4.4 percent in With capital expenditures increasing slightly (para. 23), these efforts led to improvements in the consol'dated public finances. The overall deficit of the consolidated nonfinancial public sector shrunk from 4.4 percent of GDP to 2.2 percent in Savings a.d Investment 19. Gross domestic savings have increased by one-third in the adjustment period--from 12.6 percent of GDP in 1984 to 18.4 percent in National savings rose to 7.7 percent of GDP in 1986, up from 2.6 percent in 1984 (Figure 3). Public savings led this effort. Private savings continued to hover around 3 percent, dipping to 1.3 percent in 1985 but rebounding to 3.3 percent in To improve private corporate savings, a major tax reform initiated in 1984 reduced corporate income tax from 40 to 10 percent and suspended taxes on retained earnings; this provided fiscal incentives for the retention and reinvestment of corporate profits. In August 1987, the Government introduced legislation to reduce the surcharge on profit remittances of foreign investors to 32 percent to neutralize the effects of changes in US corporate taxes; the new law establishes a variable progressive tax on remitted profits in excess of 25 percent return on equity. Figure 3 25 ClILE - INVESTMENT & SAVINCS as Percent of CDP *~~~~~~~~~~~ I nve st,n t 1 Notional Savings 1o FoiSin 19?

12 To increase traditionally low household savings, the tax reform, continuing trends begun in 1975, reduced maximum marginal rates to 50 percent. It also provided incentives for individuals to increase their contributions to the private pension fund system and invest in quoted equities and tradable debt instruments; these incent 4 ves permit up to 20 percent of these savings/investments held for more than one year to be deducted from taxable income, subject to certain maximum deductions. 21. With the social security reform of 1981 (see para. 33), pension funds may well play an important role in raising the future national savings rate. In 1986, the capital of the private pension funds amounted to 13 percent of GDP; annual contributions and earnings represented about 60 percent of private national savings; and the funds accounted for 50 percent of the total deposits in the financial system. By late 1986, the pension funds had bought 50 percent of the value of the shares sold of the privatized state enterprises. 22. With taxation primarily on consumption, some fiscal incentives for savings and investment, and positive real interest rates that are internationally competitive, policies strongly favor savings. Aside from maintaining a stable macroeconomic environment over a sustained period, the principal remaining policy problem, addressed in part with this operation, is to channel private savings mobilized in the pension funds and other institutional investors into productive private investment. 23. Total investment as a share of GDP continued to hover around 14 percent in after strong recovery from the depression nadir of 9.8 percent in Public sector investment rose to 7.6 percent of GDP in 1986, up from 6.4 percent in A Bank evaluation in December 1986 found public investment to be generally consistent with the adjustment program. Most projects have either IBRD or IDB financing. Mining absorbs about one-quarter of public investment. CODELCO's investment program of $300 million was directed to upgrading processing facilities to maintain production levels in the face of declining ore grades. Energy, power, and water account for another quarter. ENAP continued its ambitious exploration program to counteract a 9 percent production drop due to well depletion. Housing and transportation each absorbs about one-fifth of the investment budget. 24. Private fixed investment has grown by more than 10 percent annually since Analysis of the incentive system, confirmed by numerous interviews in the private sector, could detect no major policy disincentive facing either foreign or domestic investors. But wide swings in policy in the past, together with lingering memories of external instability, have left a cloud of uncertainty over investment that will only pass with time. Overall rates of investment are only now reaching those recorded in the mid-1970s; gross private domestic investment as a share of GDP averaged about 8.3 percent of GDP in compared to about 7 percent in Full recovery of investment and eventually surpassing former levels is a major challenge facing the country.

13 Financial Sector 25. The Central Bank reacted to the severe liquidity crises of private firms and banks in 1983 by introducing a subsidized debt rescheduling program, a preferential exchange rate for debt service, an interest subsidy program to retain dollar deposits, and by purchasing the bad portfolio of the commercial banks; it also placed Chile's largest private banks and the two largest corporate groups in receivership. The cumulative transfers from the Central Bank through 1986 from these rescue operations are estimated at about US$6 billion--over one-third of 1986 GDP. 26. To reduce these losses and return credibility to the banking system, the Government gradually phased out by end-1986 the preferential exchange rate for all-but-small debtors and the dollar swap and deposit subsidies by early These policies reduced the operational deficit of t!:e Central Bank to 3.2 percent of GDP in 1986; the Central Bank expects to reduce losses to 1.3 percent in 1987, and below one percent for the remainder of the decade. 27. The recapitalization program begun in mid-1985 for the two major intervened banks, the Banco de Chile and Banco de Santiago, provided for the conversion into shares of the Central Bank's emergency loans. By February 1987, the net equity position of both banks had improved, and the Government completed the sale of these banks back to the private sector through stock sales begun in All domestic banks were permitted to restructure the liabilities of heavily indebted domestic productive companies and, in some cases, to capitalize debts. By end-1986, the restructuring program was terminated. 28. These efforts helped improve the loan portfolio of the financial system. By end-1986, 82 percent of the portfolio was classified 'Al or 'BO compared to 63 percent two years before, largely a consequence of the Central Bank's purchase of the bad portfolio. Recapitalization and reprogramming measures allowed the financial system to make an overall profit in 1985 for the first time since 1982 and to renew lending to viable firms. Net profits of the financial system rose slightly in The longer-term profits of the banking system will depend on the continued growth of the economy so that the size of the bad portfolio will shrink relative to income-generating business and on greater operating efficiency of the banks. The system is still vulnerable to interest rate shocks and recession. Social Policies 29. The depression forced the Government to compress all outlays; by 1986, expenditures of the central government were 5 percent lower than in The Government's strategy was to maintain expenditures in the productive spheres, minimize cuts in social security, and reduce health and education to make room for emergency employment programs. Social security expenditures fell in 1983 but surpassed their 1982 levels in 1986, and by 1987 stood 10 percent higher than in Other social expenditures fell 9 percent in real terms. The Government sought to maintain the

14 quality of social services by targeting expenditures on low income groups, and most of the cuts were obtained by holding wages and salaries at or below the rate of inflation. This strategy managed to preserve basic health status, but at the cost of deteriorating infrastructure. Also, it should be recognized that the massive increase in unemployment and the severe cuts in the Chilean standard of living have meant unavoidable hardship and a postponement of improvements in the health and other conditions of the absolute poor. 30. Employment. The employment problem became acute with the onset of the depression. By 1983, the Government's emergency employment programs provided employment to nearly 500,000 persons, about 13 percent of the labor force. After this peak, the employment situation improved substantially because of restraint on wages and reactivation of the economy. Public employment in the emergency programs had decreased to about 150,000 by During the first quarter of 1987, the rate of unemployment fell to under 9 percent, though seasonal factors, the slightly more restrictive monetary stance at the beginning of the year and reductions in public employment programs have pushed it above 10 percent in the second and third quarters. The strong growth expected for most of the productive sectors during 1987, particularly construction, industry and agriculture, should translate into a continuation of medium-term trends toward reductions in unemployment. 31. Housing. Although expenditures on housing fell between , they were subsequently increased, regaining 1981 levels by 1985, where they have since stabilized at about US$120 million per year. These subsidies have progressively been focused on the poor. The housing program provided an additional 120,000 houses to low-income families during , reducing the housing deficit to about 400,000 units. With a Bank loan in support of the program, more than one-half million people below the urban poverty threshold may obtain new housing during the next three years. 32. Education. The 18 percent fall in real educational expenditures of the central government between was accommodated through wage and salary cuts and continued transfer of schools to municipalities. Some portion of these cuts was offset by increased municipal expenditures, increased user fees for universities, and the largely self-financed private sector. 33. Social Security. The Government undertook a profound reform of the Chilean social security system in Prior to that time, the Government administered a highly fragmented set of pension programs, each with its own set of rules and system of financing supervised by six different government agencies. By 1973, privileges, exemptions, and high pension increases eventually led this pay-as-you-go system to absorb nearly 17 percent of GDP (one of the highest in the world). Financial pressure had led to a progressive impoverishment of those programs attempting to benefit the lower income strata of the working population. Several changes were introduced after 1973 to accommodate the exigencies of stabilization and bring order to the system; these included a uniform minimum pension, equal tetirement ages, elimination of special privileges for pensions (except the military), and uniform adjustment of increases. Even so, the system remained financially unsound.

15 The 1981 reform sought to transform the pay-as-you-go system into a privately administered, capitalized system. The purpose of the reform was not only to put the system on sound financial footing, but also provide the basis for private savings mobilization and the development of capital markets, in the process providing funds for the privatization of several companies then in the public domain. The large fiscal surpluses of the late were thought to provide the cushion necessary to finance the reform, since the reform transferred the younger contributing workers to the new system, while the Government picked-up the pensions for the older workers and existing pensioners. The new system was built around competing private pension fund administrators (AFPs); workers are allowed to choose their funds based on service and return. In reality, a mixed system has evolved from the reform in which the state plays an importint role in providing coverage under the old system (now about 17 percent of insured), closely regulating the AFPs, and guaranteeing a minimum pension for lowincome workers under the new system. The latter may entail percent of pensioners, depending on the performance of the economy and pension investments over the next several decades. The reform has had a substantial fiscal cost, estimated at about 5 percent of GDP (i.e. 18 percent of government revenues) in 1986, and it will remain at this level until 1990, when it will begin to decline. 35. Despite the tumultuous financial times that surrounded its Inauguration, the new pension system has grown and deepened. Coverage of the combined system has increased from 60 percent of the labor force in the high unemployment years of the depression to 72 percent at present, levels approximating the peak years of coverage under the old system. The size of the pension funds have quintupled in real terms to nearly US$2 billion and augurs the mobilization of consistently high levels of savings; the return to workers' savings has averaged more than 15 percent in ; and the survival and disabled pensions paid out have been almost double those of the old system. Moreover, the new system is relatively equitable and transparent; it is financed with a lower contribution rate, implying lower labor costs to employers and greater incentives to create jobs. 36. While the system is essentially sound, some problems remain. First, the funds are overly dependent on indexed instruments, rendering them vulnerable to shifts in Government policy and lessening the credibility of the reform. Second, the combined system's coverage, while the highest in Latin America, has potential to be yet higher. Third, the system can increase its efficiency through improved administration and collection. Finally, and perhaps most important, the reform does not enjoy widespread public support, raising questions about not only its long-term viability but also the underlying strategy of savings mobilization and investment of the adjustment program. These are discussed in detail below as part of the SAL III program. 37. Health. The Government enacted a major health reform in 1981 with the objectives of promoting a private health care system and decentralizing the public health service to be more responsive to local needs. Shortly thereafter, the crisis ushered in an era of fiscal austerity. Public

16 sector health care revenues fell by 18 percent in constant terms between 1981 and 1986 as a consequence of changes in the system's two primary sources of finance: the payroll deduction earmarked for health and revenues from the national budget. The development of the private health care system syphoned off a disproportionate share of payroll deduction revenues since the middle and upper classes channelled their wage tax contribution into the private programs (which many were using anyway); thus, 8 percent of the participants left the system, taking with them 40 percent of the sector revenue from the health wage tax. At the same time, because of fiscal constraints, the Government was forced to cut back public health allocations from the national budget by 36 percent in To offset these declines, the payroll deduction was increased from 4 percent to 7 percent, increasing revenue from this source by 20 percent in the same period. However, this was not enough to compensate for the effects of lower budgetary support and the exit of higher income contributors from the system, so total sectoral expenditures fell 18 percent. 38. This adjustment was accommodated by capping salaries, cutting investment, and restraining sick leave benefits paid by the national program. In 1987, salaries remain low, but health investment, after being slashed to one third its 1981 level, was increased steadily after 1984 to regain 72 percent of its 1981 level; nonetheless, it has not kept pace with growth in the population served. 39. Despite these cuts, improvements in efficiency--and particularly the targeting effort and emphasis on maternal and child health care--have prevented major deterioration in traditional mortality and nutrition indicators. Rates of infant mortality, child mortality, and maternal mortality have continued to fall or at least hold constant despite the depression (Figure 4). In the space of two decades, Chile has gone from one of the highest infant mortality rates in Latin America to one of the lowest. After temporary contractions in 1983 and 1984, distribution of milk and cereal to children under six and to pregnant and nursing women reached a peak in These programs, dating back to the 1920s, have kept malnutrition in check. Malnutrition in children under six enrolled in the program dropped from 15 percent in 1977 to 8 percent in 1985 and then increased slightly to 9 percent in 1986.

17 Figure 4 LLr u~aawc"wuctrwrwf 1 9,6-6 6 D lnfa.it b,rtalts (pop 1.00 ") S _ tf~~~~~ Infadet Diarrhea Over I,WW, 3 o w~~~31afornitv 14ortatlts (por 1,009) 4 0 Ch;1 1e gorttatg at(er j,000) S 1986 INFANT MORTALITY: 1965, 1973, m W3 19l6 a/ 60 SD Dule BrilC atoc lwuce ilwo~~~~~~~~~~~~~~~~~~~~hl Unt Llwl#l Brzi CR LL.o3lu X1.x OR ku Am Col. Ecuar Peru A. Col. cuckr Peru Av. Col. Ecur Peru It Or met recent eetinate. Souree: Worid bau. Socio-"eooaic Indicators 40. But health problems--especially an apparent deterioration in adult health--remain. Recent improvements in overall life expectancy seem to have stalled. The disease profile of the country has come to reflect more advanced countries where cancer, cardiovascular problems and other chronic diseases are prevalent. Fifteen to 18 percent of the adult population suffers from high blood pressure; 80 percent of adult women in the Santiago metropolitan area have never been tested for cervical cancer. The apparent deterioration in adult health affects mostly the poor and the 80 percent of the population which depends on the public sector for their medical care.

18 Several factors are impeding improvements in the country's health: reductions in total public sector health expenditures on a per capita basis, the absence of screening for and treating chronic diseases, the minimal investment in maintenance, buildings and biomedical equipment, and spot shortages of medical supplies and drugs. These problems are addressed in this operation. Adjustment Priorities 41. Chile managed its adjustment by sacrificing current consumption in favor of savings, interest servicing, and long-term growth. The lynchpin of this strategy was maintaining creditworthiness in the face of one of the hemisphere's heaviest servicing burdens. As long as copper prices remain relatively low and the enormous debt burden continues to absorb one-third of export earnings and more than half of domestic savings, there is little scope for changes in policy and room for only moderate increases in consumption. A deterioration in the international environment, particularly increases in interest rates, will render this strategy unviable, and leave no alternative to suspension of interest payments. But the adjustment process in Chile entails more than bringing expenditures into balance with income; it also entails the medium-term structural changes diversifying the economy away from copper and building new sources of dynamic comparative advantage while increasing savings and investment beyond traditional rates. These objectives can only be accomplished through maintaining the current policy framework for some years and institutionalizing new patterns of savings and investment. PART III - PROPOSED PROGRAM FOR SAL III 42. The proposed third SAL would continue Bank support for maintaining the sound framework of economic policy; in addition, it would place special emphasis on long-term capital markets, social security, and health. The social security system is pivotal to the mobilization of private savings and channelling them into productive private investment; health expenditures are a large share of the budget and central to the long-term productivity of the Chilean work force. Both directly affect the social sustainability of the program. The program then would support the Government efforts to: (i) maintain macroeconomic policies that preserve international competitiveness and promote diversification of production and exports; (ii) increase public sector savings and improve the efficiency of public investment; (iii) complete the rehabilitation of the financial system and develop more fully long-term markets, with special attention to the pension funds to better allocate long-term savings for growth; and (iv) improve the pension program and efficiency in the health care system to contribute to public and private savings and help protect low-income groups during the adjustment as well as maintain investments in human resources. The following paragraphs describe the components of the SAL III program summarized in Annexes III and IV.

19 Actions Taken and to be Taken Macroeconomic and Export Promotion Policies 43. The Government intends to permit only moderate increases in domestic consumption so as to raise savings over a sustained period. It also intends to maintain an incentive framework favoring diversification into new export activities and efficient import substitution. While the current policies were put in place in 1985 with the support of the first two structural adjustment loans, history suggests a rising copper price (or prospect of any additional foreign resources) and three years of growth will soon translate into increased demands for consumption and pressure to change policy. This is even more true in light of the politics attendant to the plebiscite in 1988 or The Bank's efforts to help the Government consolidate the macroeconomic adjustment policies thus have particular importance. 44. The Government's program contains measures to maintain the competitiveness of nontraditional exports and import-substitution activities, measures to offset the 20 percent uniform tariff, and measures to promote nontraditional exports. To maintain competitiveness, the Government will (a) maintain and strengthen the copper stabilization fund, established in 1985 as part of the first SAL-supported program; under its provisions, changes in budget resources due to movement in copper prices outside a predetermined band are partially sterilized to avoid undesirable exchange rate changes and inhibit or supplement public consumption. The fund will become active in the third and fourth quarters of 1987 when as much as US$35 million will be deposited because of recently increasing prices. The Government has decided to strengthen the fund in 1988 by narrowing the band around the reference price which activates the fund. At present, 50 percent of revenues from copper prices of between 5 US cents and 12.5 cents per pound higher than the reference price are sterilized, while those above 12.5 cents are completely sterilized; in 1988 these bands will be narrowed to 4 and 10 cents, respectively, and the annual averaging procedure will be abandoned. 45. The Goveranment will also (b) maintain current exchange rate policy of daily adjustments in the nominal exchange rate directed at preserving the real exchange rate; and will (c) review the whole export incentive framework if nontraditional exports fail to grow in real terms by at least 6 percent in 1987 and a projected 7 percent in These are conditions of Board presentation and second tranche release. In addition, the Government will (d) provide evidence that its program of external financing is being adequately implemented to assure continuity in the adjustment program. 46. The Government has (e) already taken specific measures to offset the uniform tariff through improved drawback facilities. The Government revised Decree Law 1226 to allow for a 15 percent fiscal credit for domestic purchases of capital goods used in export production to put domestic producers of capital goods on equal footing with foreign suppliers; capital goods can be imported free of tariffs when used in export

20 - 15 production. It will permit indirect exporters to have access to the benefits for capital goods purchases under DL 1226 as well as modify Finance Decree 409 to grant exporters rebates for an amount equal to the tariffs paid on imported inputs used for export production, independently of who has actually imported the product. Authorities have also modified the automatic rebate system for small exporters (under Law No )-- which can now receive 10 percent of their value of sales in rebates--to include partial tariff rebates for slightly larger exporters (i.e. from US$7.5 million in exports to T'S$11.3 million) of 5 percent. 47. Furthermore, the Government intends (f) to promote actively nontraditional exports through an export insurance program and availing small firms of export financing. It will establish a privately run and unsubsidized export credit insurance program; the Government will change the insurance law to provide for specialized firms in this business line. The Government also will enhance the access of small- and medium-sized firms to investment credits with partial guarantees from a new fund worth US$4.4 million; this fund would cover risks associated with working capital loans of up to US$150,000. The fund will be administered through the Banco del Estado and will only cover 50 percent of each credit. These measures to offset the uniform tariff and promote nontrad-tional exports are conditions of Board presentation. 48. These measures maintain and refine a technically sound incentive system for exports. As long as current policy remains in place and world economic growth continuee apace, Chilean noncopper exports could continue to grow at 6-8 percent annually in real terms. Public Finances and Investment 49. Increasing domestic savings requires a concerted effort of the Government to continue increasing public savings. This will require continued austerity, especially in the public sector wage bill, and efficiency in certain costly sectors, including the social sectors (paras ). The Government wills (a) increase public savings to 5 percent of GDP in 1988 (from 4.8 percent in 1987 and 4.4 in 1986); and (b) limit the overall public sector deficit to 1.6 percent of GDP in 1987 and less in Its monetary and fiscal program will include provisions for absorbing the cost of the recapitalization of the banking system. 50. Public investments will also have to increase to contribute to the required increase in overall investment, and they must continue to have the highest social return possible. The Government will (c) program investment equal to about 7.5 percent of its GDP in 1987 and At present there appear to be no major distortions in its US$1.3 billion investment budget. We have communicated some minor reservations in selected sectors; for example, the Government has budgeted approximately US$10 million for housing subsidies on middle class families; this represents about 0.8 percent of the public investment program. The investment program in railroads is under review, and is being addressed in a railways loan. Similarly,

21 the state-owned petroleum firm, ENAP, had proposed expensive investments in exploration and refining; after consultation with the Bank, the Government decided in September 1987 to postpone its mild hydrocracker and oil refining investments, and reduce its four-year petroleum investment program by US$100 million. As with previous SALs, the Government vill (d) prepare a investment program and review with the Bank the execution of the 1987 program as well as the progress-of the program in the last quarter of This would be a condition of the release of the second tranche. The IMF EFF program would continue its monitoring of conditionality of the overall public deficit through mid Financial System 51. Banking System. The Government has made considerable strides in placing the financial system on firm footing since the collapse. While the cost of the rehabilitation was high, these efforts have now begun to pay dividends in the form of renewed growth. Aware that the banking system is now stabilized but still vulnerable to external shocks, the Government will continue the financial reconstruction. It has refused requests for additional debt reschedulings, maintained collections of previously reprogrammed debt, and continues to restrict payments of profits to pre-crisis owners still having repurchase obligations with the Central Bank. It will enhance these efforts by augmenting its monitoring of the collection of debts sold to the Central Bank, and exploring ways to increase competition and thereby improve the operating efficiency of the banks; greater efficiency would permit more rapid repurchases of bad portfolio sold to the Central Bank. Prior to Board presentation, it also will make clearer to depositors the low limits to state guarantees so as to avoid creating the false impression of complete guarantees. 52. With the rehabilitation of the banking system on the verge of completion, the Government can now turn its attention to medium-term financial issues affecting savings and investment. The most pressing concern is the problem of channelling private savings mobilized in the private pension funds and other institutional savers into private investment through equity and private debt markets. A related concern is the security of the pension funds, which are now almost solely dependent on indexed securities of the Government and commercial banks; in this sense they have an undiversified portfolio. 53. apjital Markets. Over the next several years, a sharp imbalance in long-term financial asset markets could develop between a growing demand for corporate-issued securities and their short supply. On the demand side of asset markets, the private pension funds, which today comprise nearly 60 percent of private savings, face severe restrictions on where they can invest funds. Because the system was designed to rtminimize risk, speculation, and related-party trading, the funds may hold only assets classified as least-risk. The Government set up stringent tests for risk classification of security-issuers, including a five-year track record for earnings (except for the privatized state enterprises); only a few private firms have been given the "least risk' designation. The pension funds will be

22 _ 17 - permittc-d to place 30 percent of their assets in private equities issued by the nonfinancial sector by 1991; but the companies in which they invest cannot have any one stockholder with more than 20 percent control and its articles of incorporation must satisfy certain conditions; and they cannot place any more than 5 percent of their zapital in any single firm. Most of their funds are held in government securities (45 percent), mainly Central Bank bille, and commercial bank instruments (49 percent), mostly mortgage bonds, and the prospects of diversification seem limited. 54. On the supply side, the number of firms issuing quoted stock is only about 130. While the capitalized value of the open corporations is a reasonable 26 percent of GDP, the amount of stock actually traded is far less. In 19.l6, the ratio of transactions to capitalized value was 7.3 percent in Chile, compared to 31 percent in Brazil and 53 percent in the United States. In part this is because many of the traded firms are still tightly held within particular families or groups (including the Government); in mid-1986 for example, the 12 largest shareholders held more than 85 percent of the equity in half of the open corporations. Low trading volume is also related to the high cost of obtaining equity funds; after two years of improvement following the depression, pricelearnings ratios still averaged only about 5 in 1986 and the average market value of quoted firms relative to their book value was only 69 percent. The Government's program of privatization has partially offset these factors and stimulated market deepening. Twenty-three public enterprises with a capitalized value of about US$300 million have been sold since 1985 and another US$300 million in shares will be issued in the next two years; in fact, 7 of the 10 most actively traded firms in 1986 were privatized enterprises. Nonetheless, the supply of new issues coming onto the market is limited. 55. Similarly, the bond and other debt markets are very thin. Even though bond trading has grown rapidly in recent years, the impetus has come from the issuance of Central Bank bills and Treasury debt as well as instruments from financial institutions (mainly mortgage bonds). There are virtually no corporate debt instruments or instruments with an intermediate status between debt and equity (e.g., convertible bonds, bonds with options for share purchases, or preferred shares). No legal obstacles prevent this market from emerging, but companies have not yet chosen to create these issues. 56. This situation creates an anomaly in long-term markets: the potential supply of investment capital will increase with the increased domestic private savings, and the potential demand for investment funds will grow with the continued expansion of the economy. But the bulk of the new savings may continue to be funnelled into Government paper and mortgage bonds because of unnecessarily rigid regulation and the reluctance of private firms to open their companies. 57. The latent dangers of having the bulk of new savings funneled to the public sector are twofold: First, the funds are heavily dependent on indexed securities that are vulnerable to Government policies which, for whatever macroeconomic reason, may eventually hold the index below the actual inflation rate. (This has been the case in several other countries

23 -~ 18 - of Latin America, probably including Chile in ) Diversifying away from indexed securities into equities and other issuies offers protection against this risk. Moreover, this is important to enhance the credibility of the reform. 58. A second danger is that newly mobilized savings may be diverted to consumption. For example, the Government at some point in the future might yield tc public pressures to increase spending, and finance these expenditures with bond issues to the funds. In either case, savings mobilized through institutional investors would be eventually consumed rather than saved. 59. The Government's program to stimulate capital markets and remove impediments to investment in activities of acceptable risk includes: fiscal measures to encourage equity investment and the growth of intermediation; changes in the all-important r*sk classification procedures; and liberalizing the restrictions on the pension funds and other institutional investors that impede diverse investments in activities of acceptable risk. These measures are all consistent with maintaining reasonatle security for the pension funds. 60. Regarding fiscal measures, the authorities vill (a) ehange the personal income tax law to permit more symmetrical treatment of capital losses and gains on quoted stock trarnsactions, to increase exemptions of minority shareholders from capital gains tax, and to permit deductions of purchases of mutual funds subscribing to primary issues. These measures, in the context of an otherwise supportive and undistorted tax system favoring savings, will constitute an additional incentive for individuals to invest and, by adding to demand for equities and creating an incentive for companies to go public. In addition, the Government will reduce the stamp tax from 2.4 percent to 1.2 percent on credit and bond issues to reduce intermediation costs, with the effect of stimulating financial innovation. 61. The Government intends (b) to stimulate the development of capital markets by creating a new and more flexible system of risk classification. At present, the Superintendency of tanks classifies loans and investments of the banking system, and the Superintendency of Pension Funds classifies marketable debt securities and equities as to their eligibility for pension fund investments. The latter system is rather rigid, and government appointees dominate the classification committee. The Government's program is to facilitate the creation of a new private system of risk classification regulate*whrough the Superintendent of Securities; this will involve private evaluators, be more flexible, and more forward-looking in regard to the designation of "investment grade* equities. The absence of credible private evaluation firms and the need to avoid destabilizing institutional changes indicate a medium-term economic program; the Government will, after a trial period for the new system, pet a timetable for merging the pension system with it, and so moving to a unified system. In the interim, the Government will change the composition of the existing risk classification committee to give private sector representatives a majority.

24 The Government is also (C) taking steps to strengthen prudential regulation in securities markets. It has passed new legislation to prevent mutual funds from investing in shares of related companies and to provide for portfolio diversification. As the new risk classification system is introduced, it will also ensure that the portfolios of the insurance industry are diversified (through ceilings on composition of various instruments) and consist of the stocks of reputable companies. 63. The Government also intends (d) to permit greater participation of the pension funds and other institutional investors in capital markets. Besides permitting the share of equity holdings in the AFP portfolios to rise to 30 percent by 1991 in current law, the Government has amended the law to relax the ownership concentration limits restricting AFP investments to firms with less than 20 percent majority control; the new limit is 50 percent control. It will also permit pension fund investments in "investment grade" mutual funds which will enable greater diversification for the pension funds, clarify the conditions for pension fund participation in primary issues and new instruments, and provide a full evaluation of these changes by November This latter is necessary because it is not possible to foresee how many private firms under the new rules and classification system will be eligible for pension fund itnvestment. Social Sectors 64. Efficient pension and health systems are important to both public and private savings generation, workers' productivity and hence the macroeconomic program. The efficient administration of the private pension funds is essential for realizing their large potential for mobilizing private savings. Health expenditures and the publicly funded portion of the pension system accounted for one-third of the non-interest current expenditures of the general government in 1986, and efficiency in these sectors can affect public savings. Both programs are essential to the social sustainability of the adjustment program--they directly affect the social situation of Chilean workers, and are especially important to the poor. 65. Social Security. The Government intends to undertake adjustments to its 1981 social security reform. These are intended to protect the security of the funds, increase the efficiency of the system, increase the long-term coverage of the system, and enhance the acceptance of the program among affiliates and the public at large. The Government intends to amend the Social Security Law 3500 as well as enact administrative changes to achieve these goals. (These are conditions of the release of the first tranche, except where noted below.) 66. To enhance the security of the funds, the Government will (a) adopt those measures described above to diversify the investment opportunities of the pension funds (see paras ) and affirm existing principles of portfolio management. Affirming principles of portfolio management appears necessary because there is a groundswell of public opinion that favors investment of funds in mortgages, privileges extant under the pre system. No less of a danger is earmarking funds for investment in specialized assets marketable only to the pension funds; this could take the form of special government paper or special stock issues of the

25 privatized public companies. These proposals could undermine the viability cf the reform by reducing the flexibility and earnings potential of the funds while raising risks. The Government will therefore ensure that pension fund assets should only be invested in marketable assets, investments should be in a diversified portfolio, pension funds will not lend directly to members (e.g., in mortgages), and they will not invest in securities restricted to particular investors. 67. Increasing the efficiency of administration of the system could pay substantial dividends in terms of higher returns to workers' savings in the long run. One important measure is the unification of collection of social security contributions; as it stands, employers may have to fill out up to 40 different forms monthly for each of the AFPs, health and insurance companies. Unifying and computerizing this system would speed up payments, strengthen control of evasion and reduce administrative costs--with an annual savings for employers and insurance companies of about US$15 million. It would also reduce costs of those AFPs with a large number of lowincome insured, increasing the return to these workers. The Government will (b) therefore introduce a simplified and uniform system before the end of Increasing competition will also maintain pressures to seek maximum efficiency. The Government will (c) therefore encourage entry into the pension administration business with several measures: reduced capital requirements from 20,000 UF (US$330,000) to 5,000 UF (US$83,000), with required equity contributions increasing in proportion to the numbers of affiliates; encouraging formation of pension funds for individual firms; and permitting members to buy pension shares. 69. To help increase the coverage of the system, the Government will (d) amend the social security law to ensure an automatic continuation of disability and survival insurance to qualifying temporarily unemployed or part-time workers. Workers who are temporarily unemployed will have coverage even though they are not actively contributing. This cost will be borne by the other affiliates in the AFPs. The Government will (e) also study the efficacy of encouraging affiliation of the self-employed. Only onefourth of the self-employed (constituting about 20 percent of -the employed labor force) are covered. This requires careful study because the costs of widening coverage could be high, and direct support from the fiscal budget may be more cost-effective. 70. Perhaps the most serious remaining problem facing the system is the lack of public acceptance of the reform. A May 1987 survey revealed that more than half of the respondents had more confidence in the old system to provide them a pension than the new one; when given a choice among institutions to administer their funds (i.e. the state, themselves, or private enterprise), only nine percent chose the private pension funds. While care should be taken not to read too much into one (perhaps ambiguous) survey, AFP managers have themselves expressed concern about this problem. The problem stems in large measure from the misperception that the old system was viable. Also, the public does not understand the Syst.m, affiliates do not identify with their pension funds, and they may perceive the system as unfair.

26 To improve public understanding, the Government will (f) introduce new measures to ensure greater consumer knowledge through simplified commission structures to increase entry, and to increase choice of insurance companies. Specifically, these include: simplifying the pension commission system to permit greater transparency and choice; improving presentation of information to the public to provide clear comparative information on commissions and returns; and permitting members rather than the funds to choose their insurance company for disability and survival coverage. The private sector is also about to undertake an educational camprign through media advertising. 72. To address the problem of encouraging more participation and identification with their funds, the Government will (g) introduce a voluntary savings account to be managed by the pension funds and automatically deducted from payroll checks. This may have several added advantages: it might deflect the demand for mortgages, increase the responsiveness of the pension funds to depositors, and also increase savings of low-income groups. It will implement these measures in such a way to ensure that the program does not cause dissavings from the financial institutions as well as protect the integrity of the funds; supplementary accounts will receive equivalent treatment to those in the banking system with regard to taxation and guarantees and assets of supplementary accounts will be regulated in the same way as those in the pension fund. 73. To address concerns about equality, the Government will (h) study ways to reduce operating costs so as to reduce or even eliminate the fixed commissions charged for administering the system. The fixed commissions entail a CH$180 monthly charge per account in addition to the retention of part of the health commission (about 1.4 percent) and charges on outstanding balances (.5 percent). Even though the amount is relatively small, it implies that low-income contributors may receive percent less in pension relative to the highest income contributors per peso invested. (This varies according to assumptions about growth in real wages and yields on investments.) This problem is complicated by the fact that the pension funds have different compositions of affiliates by income group; any direct elimination would mean that those pension funds with a disproportionately high share of low-income workers would receive lower incomes and, unless workers shifted to respond to the new earnings positions, they would receive lower incomes in any event. 74. Health. The Government intends to increase current nonpersonnel outlays for health in real terms by 15 percent in Over the course of 1988, it will undertake several efforts and seek to increase output for this level of expenditure that will be conditions for the release of the second tranche. It will (a) concentrate on consolidating progress it has already made in improving preventive health care and broadening its preventive actions to include chronic diseases. Specifically, in primary and preventive health care, the Government will maintain the present level of rood distribution in maternal-child programs on a per capita basis and improve targeting; expand preventive care to adults to decrease the incidence of chronic conditions through increased efforts at health education, screening, and community education. The latter will include new programs on smoking, cervical and breast cancer, and cardiovascular diseases. In addition, the Government will tax cigarette advertising to supplement the already high sales tax on cigarettes (69 percent).

27 The Government in 1981 began transferring to municipal administration the national public health service, which serves about 80 percent of the populace. To date about 60 percent of the 2,484 facilities--mostly rural clinics--have been transferred to municipal administration. By end- 1987, all primary health care facilities should be under the control of the municipalities. Hospitals and their specialty outpatient clinics will remain under central control. Nonetheless, the Government will (b) implement administrative changes to increase the efficiency of the decentralized system. Specifically, it will improve the incentive system for cost containment embedded in the reimbursement system to regional organizations, while continuing the practice of channelling resulting savings into health programs where the savings are realized; improve the financial accounting system through the implementation of a computerized data collection and control system for all hospitals; provide incentives to service providers to classify beneficiaries more correctly by income group; and develop a mid-term training program to upgrade management skills of current hospital directors (most of whom have no training in hospital administration). 76. The 1981 health reform also transformed the informal private sector transactions into a formally organized private system, and adopted measures which favored the expansion of the private sector as a viable alternative to the Government run health system. The Government created private health insurance plans (known by the acronym ISAPRES). The law allows the ISAPRES to receive directly the percentage of the payroll deduction earmarked for health from those workers who are willing to purchase insurance, now 7 percent. In 1986, 8 percent of the population was enrolled in one of 20 ISAPRES. Nonetheless, many private insurers offer only policies which are cancellable in the event of chronic illness or old age. This has sometimes led to consumer misunderstanding and dissatisfaction. Also, current regulatory powers for the private sector reside with the National Fund for Health (FONASA), the executive financial agency of the national health system. The Government wishes to eliminate any obstacles that might impede the growth of the private sector. The Government will (c) take measures to strengthen regulation of the private health insurance system and clarify its relation to the public system. Specifically, it will improve rules regarding cancellation of policies for chronic illness by permitting multi-year contracts and longer time periods to give notice of nonrenewal by the contributors; separate the regulatory role of FONASA from its financial role; and allow the public health service to contract with the private providers to service their enrollees and allow the public health system to charge for the full cost of treatment in its fa 1 cilities. 77. The contraction in Government expenditures was felt most heavily in investment and maintenance budgets. As a result, by 1986, many of the facilities and machinery had fallen into disrepair; a survey conducted in 1986 determined that percent of basic medical machinery was out of service. Putting this equipment back into service would require an investment of about CH$3 billion. The Government now sees this as a major priority and it will (d) undertake a rehabilitation program of equipment and repair of major facilities over two years. It will also undertake a maintenance training program for technicians in the hospital system.

28 ImDact of the Structural Adjustment Program 78. The economic prospects of Chile will depend heavily on the performance of the world economy as well as the continuity of its own economic policy. The following projections are based upon a moderate annual average growth of OECD countries and only slightly higher nominal interest rates, increasing about 1.2 percentage points over their current annual average by 1989 where they would stabilize. Real copper prices are, according to Bank projections, assumed to rise at 3.3 percent annually. Near-term prices may increase more rapidly as major buyers restock, but it seems likely that underlying long-term trends of decreasing copper usage per unit of output and expected new sources of supply will render these increases temporary, returning the evolution of prices to the anticipated path. 79. With a stable external environment and the policies of the program, GDP growth rates of 4.5 to 5.5 percent over the medium term are well within reach. The scenario described below for is predicated upon an annual average growth rate of 4.9 percent, which could increase real consumption per capita at 3 percent annually while increasing national savings sufficiently rapidly to fund both debt service and required investment. By 1992, average per capita consumption, though still below their 1970 level, would be well above the 1986 level. Chile in effect would have to sacrifice potential output and consumption growth to pay interest on its debt. 80. A slower rate of GDP growth or a lower level of foreign exchange earnings for more than temporary periods would probably result in unsustainably slow growth in consumption and/or interruption in debt service. More rapid growth is feasible only if the country experiences strong and sustained gains in terms of trade; increased rates of growth predicated on higher borrowing levels than those estimated in our scenario appears neither feasible nor desirable because of the country's excessively high debt service burden. 81. This growth would be fueled by expanding exports. Noncopper exports could well grow by 6 percent annually between 1987 and 1992, but higher expected prices and new investment in copper production will hold the share of copper exports about the same over the next five years. The projected growth is predicated upon a moderate increase of copper output; public investments in a waste removal conveyor system and concentrator facilities are intended to produce a 11 percent output increase of copper in 1989, boosting exports from 1.5 to 1.7 million metric tons by 1991; in addition, the copper output of the giant copper project La Escondida would begin to come on stream, increasing output by 50,000 metric tons in 1991 and 100,000 in If interest rate assumptions materialize (namely that Chile's effective interest rate will hold at about 8 percent), then this export expansion would lower Chile's total interest payments/export ratio to 18 percent by 1992, slightly more than half the 1986 ratio.

29 Table 2: CHILE - RECENT PERFORMANCE AND GROWTH PROSPECTS (Pereent Annual Average Real Growth Rates) Actual Projected GDP GNY Consumption Total Investment Exports (GNFS) Copper 5.0 i Noncopper Goods Imports (GNFS) This export performance would permit import levels of about 29 percent of GDP until 1990 when the exhaustion of domestic oil supplies will gradually force the import coefficient of the economy to rise to 31 percent by the end of the period. Nonetheless, slightly improved terms of trade and a declining interestlgdp burden imply that the current account deficit could continue to fall from its 1986 level of 6.5 percent of GDP to near 2.8 percent in Growth in exports and efficient import substitution will require growth in investment of about 9 percent annually. The ratio of investment to GDP would have to rise from 15 percent in 1986 to near 19 percent by Moreover, private investment projects in sectors where Chile's comparative advantage exists (mining, fruits, semi-processed fish, wood, and pulp and paper) should be supported by public investments in infrastructure to increase exports and import substitution. 84. Financing this effort will have to come primarily through increased savings. National savings would need to double by from about 8 percent of GDP in 1986 to 16 percent in The corresponding increase in domestic savings would, however, be eased by the decreasing ratio of interest payments to GDP by Public sector savings--after interest payments--would haxe to increase gradually, from 4.4 percent of GDP in 1986 to 5.6 percent by 1990, an effort comparable to that undertaken and achieved in the 1970s. Private savings would need to surpass 10 percent of GDP by 1992 with the private social security system complementing the traditional banking role in mobilizing savings. The necessary increase in corporate savings may soon materialize as profitable firms increase production and reinvest in highly profitable internationally competitive sectors.

30 - 25 _ Table 3: CHILE - INVESTMENT AND SAVINGS, (As Percent of Current GDP) Investment Foreign Savings National Savings of which: Public Sector Private Sector In the meantime, a significant inflow of external savings will be required. In , the cumulative current account deficit of roughly US$1.9 billion will be financed through foreign investment (roughly US$230 million), the interest retiming from the commercial banks (US$460 million), multilateral lending (US$900 million) and suppliers' credits and others (US$500 million) *l/ 86. For , current account deficits would average roughly US$750 million per year under the assumptions above. Foreign direct investment would fill about US$120 million. The commercial banks will probably continue to exhibit reluctance to augment their exposure and, because of recent trends to provision Latin American loans, may be in a stronger position to withstand pressure to do so. Nonetheless, it is expected they would continue to reschedule principal repayment. This would leave the bulk of financing to come from suppliers' credits and multilateral institutions. Suppliers' credits could well approach $300 million per year because of the large hydroelectric and other public projects (e.g., Pehuenche, investments in mining, etc.). Given current flows projected from our lending program and the IDB, the net flows from multilateral sources will average about US$140 million in the period. The share of total debt (DOD) owed to preferred creditors (including IMF) would rise from 16 to 18 percent. Nonetheless, these efforts would still leave some unidentified financing requirements. In , the amount woula be about US$300 million for the two years; this gap could be covered with additional policy-based lending from the Bank and resources from other sources. It should be noted that some of these payments have already been rescheduled once and are part of new money packages put together in / The debt conversion program nets o';t to zero since its accounting inflow of US$800 million in 1987 is offset by an accounting outflow of the same amount of private debt, and future amortization payments are cancelled by debt conversion; the main balance of payments impact of the program is in the current account, where interest payments are reduced and new dividend payments postponed for five years under the terms of the program.

31 Continuing and strengthening the structural adjustment program will not only continue to improve the country's creditworthiness; the benefits of the program will become more widely diffused throughout the economy. Industry and services, secondary beneficiaries of this export-led growth, are now feeling the strong demand attendant to rising incomes. Increases in employment are likely to continue, eventually putting some pressure on wage rates and improving income distribution. 88. Social Impact of the Adiustment Program. Despite the onerous costs of the depression, the adjustment program is now paying large dividends in terms of stable growth and rising employment. Real wages still lag but can be expected to rise with employment gains and growth if the program can be held in place for a sustained period. Rising employment and incomes will directly benefit the estimated percent of absolute poor in Chile, as well as the near poor in the next quintile that barely are able to meet their basic needs. Increases in public revenues will permit eventual increases in social sector spending over and above those envisaged in The program will have a direct benefit in the health sectors. The continuation of the maternal and child health care system could reduce infant mortality 8 percent over five years and reduce maternal mortality 20 percent. The improvements in adult care, while difficult to quantify because of inadequate data, would certainly be comparable. Improved focusing of the milk distribution program (in which about 20 percent of program expenditures still benefit the 40 percent highest income families) could reduce malnutrition in children under the age of six by 12 percent, from 9.1 percent in 1985 to 8.0 percent in Nonetheless, it should be noted that continued strong growth and increased employment will--by increasing incomes of low-income groups and their access to food and shelter--be a dominant force for improvement of these same statistics. 90., Alternative Scenarios: Higher Copper Prices. In recent months nominal copper prices have jumped up, suggesting a substantial improvement in terms of trade for Chile. If this trend were to presage a new and higher price floor over some years--and not be matched by rising oil prices, other prices, and interest rates--chile would be in a much sounder economic position. A US one cent increase in copper prices yields US$32 million for Chile, and prices in the third quarter of 1987 have risen about 10 US cents. If prices were to be an average of 75 cents in 1988 (as compared to the 71 cents assumed in the base scenario) and 80 cents in 1989 and hold, the resulting foreign resources could provide for a very rapid near-term expansion; growth could be as high as 8 percent in the near term without requiring additional financing. However, even at this higher level of nominal copper prices, these high growth rates would be unsustainable, and balance of payments constraints pull down growth in to near 3 percent annually; the effect might even be more severe because the exchange rate could well appreciate and drive out capacity of noncopper exports. On the other hand, if the near-term gains in terms of trade are for the most part put into reserves, the exchange rate held in check, growth rates of 6.0 percent are conceivable, since accumulated reserves could be used at the end of the period when the pressures from falling domestic oil reserves and eroding real copper prices begin to be felt. Nonetheless, containing a boom may prove as difficult as managing the recession.

32 Alternative Scenarios: High Interest Rates, Slow OECD Growth. A less felicitous set of policy alternatives emerges if interest rates (e.g., LIBOR) rise abruptly to more than 10 percent and if OECD growth were to turn to recession. The growth rate in Chile would be cut to less than 2 percent with no increases in private per capita consumption. Even with the best of policies, it seems unlikely that the country could avoid immediate suspension of some portion of its interest payments. The Government may seek cofinancing with this SAL to protect itself from this scenario. The Bank, as part of its country strategy and recent initiatives on the debt problem, will examine the various problems this would present not only to Chile and other countries, but to the international community. Immediate prospects for terms of trade, interest rates and OECD growth appear more sanguine. Benefits and Risks 92. The main benefits of the program will derive from the support it provides to the country's continuing adjustment effort at both the macroeconomic and sectoral level. To achieve a maximum growth in consumption and output over tle medium term, given the constraints imposed by the debt burden and exigency of reducing it, Chile will have to increase domestic savings more rapidly than investment as well as increase exports relative to imports. However, increasing savings sufficient to finance both required new investment and external interest payments--particularly when present consumption cannot not be compressed further--takes time. It also takes time for trade incentives to have a full e'ffect on export growth and efficient import substitution. In effect, this operation provides external finance to buy time: it allows the country to bridge this transition period during which investment must grow without further sacrifices in consumption while creditworthiness indicators gradually improve, until the country can resume normal relations with external creditors. By supporting reforms in export promotion policy, public finance and capital markets, the loan helps augment the savings and export surpluses; by supporting new efforts in the social sectors the loan supports efforts to protect the most vulnerable groups from the costs of adjustment. 93. Nonetheless, there are substantial risks tc the base-case scenario of modest growth and enhanced creditworthiness sketched out above. The external environment continues to be precarious. As noted above, interest rates, OECD growth, protection, and commodity prices are all key forces which make a difference on whether the Chilean strategy is ultimately viable. For example, an increase in international interest rates of one percent costs Chile US$180 million per year, and a three percentage point increase would erase the entire improvement in the trade balance achieved in the adjustment program thus far. The situation would be further complicated because of the effects on the fragile domestic financial system. 94. Similarly, a decrease of US 3 cents in the nominal price of copper costs Chile US$100 million per year; while copper prices have risen lately, the medium-term price may be less than the 25 cent nominal rise projected by 1992 (equivalent to a 2.5 percent average annual real increase) in our scenario. If the industrial countries do not maintain their current rates

33 of expansion (and already the present US recovery is the second longest in post-war history), the effects will be felt with the price and volume of all Chilean exports. Potential trade-restricting measures in the industrial countries, such as the US action on Chilean table grapes and cut flowers, have as yet had marginal impact on Chilean exports, but this situation could change. Finally, a more entrenched reluctance on the part of the commercial banks to provide additional finance or at least rescheduling would precipitate a substantial balance of payments problem. 95. A second set of risks concerns the problem of amortizing the foreign debt of the Central Bank, which accounts for 22 percent of the total debt. To date, the Central Bank has met its foreign obligations through domestic and foreign borrowing to pay interest and rescheduling its principal repayments. In the long run, the Treasury must generate resources to transfer to the Central Bank to meet operating expenses and amortize its foreign debt. If the Treasury cannot generate a surplus and the Central Bank has to borrow indefinitely, domestic interest rates might follow an explosive path and speculation about monetization of the Central Bank's debt might reach a critical level. 96. The political situation also constitutes risks. The constitution of 1980 provides for a plebiscite before March of 1989 to vote on the candidate unanimously proposed by the commanders of the four branches of the Chilean military. If the proposed candidate loses the plebiscite, the constitution provides for direct elections within one year. Whatever the outcome, elections for a limited number of legislators in a reopened but controlled Congress are also provided for in The political campaign could threaten the policy framework as the Government strives to mobilize a majority in the plebiscite; the demands to increase consumption, especially if copper prices are rising, will be loud. 97. Regardless of the politics of the transition or even the actual course of policy, uncertainty itself surrounding these events may affect private savings and investment in ways sufficiently strong to derail the adjustment process. For the growth scenario to materialize, the private savings rate must double during precisely this period and private investment must grow by about 10 percent annually. Some private commercial political risk evaluators perceive a substantial risk that a smooth growth scenario might not occur. 98. The Bank's exposure under the current lending program is to increase from its end-1986 position of US$808 million to nearly US$1.7 billion at end This would mark a rise from 4.9 percent of total outstanding and disbursed debt (excluding IMF) to 9.5 percent. The IBRD share of total debt service would rise from 1.6 percent to 9.8 percent over the same period. Bank disbursements would amount to about one quarter of all gross disbursements in , falling to about half that level in the out years. If events unfold as in the growth scenario, these numbers would be acceptable as the ratio of medium- and long-term debt to GDP would fall from 98 percent to 74 percent by 1992, and the interest burden (MLT) on exports would fall from 33 percent to 16 percent.

34 This operation therefore entails high risks since the base-case growth scenario is surrounded by uncertainties. On the other hand, it is clear that without continued strong policy efforts to attack structural problems and support from the international financial community, Chile would almost certainly not be able to avoid recession andlor an interruption of debt service in the next few years--with all the hardship that implies. Loan Amount and Tranching 100. Because of the steady progress made by the Government in implementing the policies supported in SAL I and II, the magnitude of Chile's requirement for quick-disbursing capital to finance the adjustment program, we recommend a SAL of US$250 million. The size would assist the Government in financing the significant near-term imports gc-nerated by the ongoing export-led investments in the agricultural, forestry and industrial sectors. A first tranche of $125 million would be disbursed upon effectiveness, which is expected to be shortly after Board approval in December This first tranche disbursement is part of the external financial package. According to the rescheduling agreement with the commercial banks, if the World Bank approves a third SAL before January 1, 1988, Chilean compliance with the structural adjustment program as evidenced by disbursement of the first tranche would be a condition of effectiveness for the 1988 restructuring of commercial bank loans. A second tranche would be expected to be disbursed in December 1988, pending fulfillment of the conditions listed in Annex III, Section III. Disbursement, Procurement, Administration and Auditing 101. Procurement would be in accordance with the Bank's Procurement Guidelines. Contracts for goods estimated to cost the equivalent of less than US$5 million each and contracts for petroleum products will be awarded following the normal procurement procedures of the purchaser. Private firms would follow normal commercial practice. Public sector imports would be in accordance with standard government practices, which ensure reas3nable prices. Unless otherwise specified by the Bank, all purchases, except petroleum imports, exceeding US$5 million vould be through international competitive bidding The loan would finance the CIF cost of eligible imports, subject to documentary evidence that they have been paid for on or after loan signing. However, retroactive financing will be permitted for those eligible imports made before the date of agreement but not before July 1, 1987, up to an amount equal to the loan's first tranche. Public and private sector imports would be eligible, except for military equipment and luxury consumer goods. The Central Bank would be responsible for the coordination and collection of relevant documentation and preparing withdrawal applications under the loan. The applications would be submitted to the Bank using statements of expenditure, with the detailed documentation retained by the Government for review by the Bank as required.

35 I MF Extended Fund Facility 103. The IMF, as noted above, is supporting Chile's adjustment program with a three year Extended Fund Facility of SDR 750 million, initiated in August This followed a two year Standby Arrangement in Both the IMF and the Bank share the goals of export promotion, a more efficient public sector, and improved intermediation of larger amounts ;f savings and investment. The EFF includes specific fiscal, monetary and reserve targets for 1987; discussions on the 1988 program will be conducted in November The EFF will end in August 1988, but the Government has indicated to the Bank that it will seek a new arrangement with the Fund to continue their ongoing relationship. During the preparation of this operation--as with the previous SAL--Fund and Bank staff cooperated closely to ensure consistency between stabilization and structural adjustment measures. PART IV - BANK GROUP OPERATIONS AND STRATEGY 104. By September 30, 1987, the Bank had made 41 loans to Chile amounting to US$1,673 million (net of cancellations) of which 10 were not yet fully disbursed. Two other loans totalling US$116.5 million, for the power sector, had been approved but not yet signed. IDA has also extended a US$22.9 million credit to the country for a road project. IFC gross commitments in Chile as of the same date stood at US$130 million Of total Bank and IDA lending to Chile, 37 percent has been for infrastructure (water, irrigation, power, transportation), 32 percent for structural adjustment, 24 percent for productive sectors (industry, mining, agriculture) and the balance (7 percent) for social sectors (education, housing) and technical assistance Historically, the volume of Bank lending to Chile has fluctuated widely, depending on the country's economic needs and policy performance and the availability of suitable projects. The Bank did not lend to Chile in FY78-79, but in FY80-85 the Bank approved eight loans totaling US$531 million, including innovative sector loans for housing and roads. The Bank also modified existing operations over the last three years to permit almost US$50 million in proceeds to be used for earthquake- and flood-related emergency repairs and reconstruction. In FY86-87 Bank lending significantly increased with the approval of the two SALS, together with two important industrial loans aimed at rehabilitating that sector. Additionally, the US$300 million B-Loan was approved to complement the Road Sector Loan Execution of Bank-financed projects in Chile has been satisfactory. Disbursement of Bank loans to Chile declined to US$22.3 million in FY83, when Chile's depression was at its nadir. They rebounded thereafter however. In FY86 Bank disbursements to Chile surged above US$350 million, US$250 million of this from the first SAL and in FY87, disbursements remained high at $326 million.

36 The Bank's lending strategy is to support the Government's mediumterm economic adjustment program by focusing on: (i) maintenance of external trade policies intended to accelerate export growth and efficient import substitution based upon a more diversified economy; (ii) improvements in policy affecting the social sectors; (iii) public sector management and fiscal policies to maintain economic recovery and strengthen public savings, emphasizing better use of existing infrastructure and productive capacity; (iv) financial policies to stimulate domestic savings and to allocate funds more efficiently; and (v) policy incentives to expand productive employment The Bank intends to support the Go. ernment's adjustment program over the next two years with additional policy-based adjustment lending. Several other proposed lending operations are being considered that would complement the adjustment lending and reinforce the effort to meet the objective's of the Government's structural adjustment program. Lending for energy, forestry and mining would not only contribute to expanding output and employment, but would also increase foreign exchange earnings and savings. In addition, railway rehabilitation and port reconstruction projects now being processed would help avoid transportation obstacles to export expansion, as wull as accelerate the use of container technology. Subsequent loans for housing and water and sewerage facilities would build on the sectoral, institutional and policy improvements addressed in ongoing lending operations, and the Bank will explore new lending in social sectors The IDB has a sizeable program in Chile; it is focusing primarily on agriculture, industry, power, and transportation, sectors in which the Bank is also undertaking operations. Parallel cofinancing with IDB of a major power project was approved in PY87. Some future Bank operations may attract cofinancing from suppliers, bilateral sources as well. PART V - RECOMMENDATION 111. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments Washington, D.C. November 20, 1987

37 -32 - ANNEX I CHILE - iy ECO140M4IC IPOICATORS Page 1 of 5 Populaticni 12.07S (nid-1s tlvousends) 1985 GNP P Capita USI Actual fft. Projected s8 1r l 1092 Cro-.th Ftet (prcpot) CDP, d o , S. It.it b 5.0 C , por ct s S.5 Pr 'et* conos4mpt o' par cap;ta Debt lpd;catora../ 0D00 H91 (Pvill;on US,) 9,413 16,963 17, ,249 16, IM C;EDIT (,ll,on USS) , e Total SOC OT. ict I4 (FIion USS) e.s36 17,745 1B,3S4 17, , , DOD HLT/Exports CS (i) 100 O DOD MLT/Cur-ent CDP () S Debt servica (million USS) ,386 2,728 2,609 2,?54 2, Debt *orv.c*/curr9at CDP () , Debt sorvice/esporto CS () S SS.3 Interest MtLT (Million USS) d/ , , ,418 1,458 Interest HLT/Ewports CS (8) d Interest M4LT/Current GOP (S) d/ National Accounte as S of Currant CDP ln.ostent S Domestic Svings National Seaings C/ s.9 Public Invest.Ct Public Nat;onal Sav ga Pe.vate ;'Vatmont s Privete Nat.z'nal Savings Rati; of Publ;c/Private Investment Non Financial Public Sector as S of Current ODP Current Revenues b/ Current E.pendituros Def,cit (-) or Sjrpl.a , S6 Ovorall Deficit (-) or Surpiv, External Trade tndicstror (peent) Copper e,porta real grooth rate o Exports CNFS reaf vrowth rate s E.Vo'ts of CNFS/Current CDP Imports CtFS oeol aro*ti' rate Inl,orts of GNFS/Current COP Current Account (Mitlion Sa).. (1,970) (2,060) (1,320) (1,092) (1,004) (943) (607) (799) (734) (754) Current Account/Currant CDP Ters of T(rae Index 11i4o. 100) ? */. iecludee uwe of IMF credit, except where other.ies indicated. SrcJudo e-ffect of debt conversione. hi. Includes operational aurplus of public onterpr ^** and net transfer.. c/. Includes current trcanfere d4/ Data on M1T interest parnec t fro. lre C.,tral ft-.k of C4.J4 It include IF intoret. It. my diffor from 5 data. LA4CO. September

38 PopIlation 12,075 (id-los5 tbound.) 198S GP per Copita: U!#,4.40 (Millont U S8) -33- ANNEXI 41LE - 9CE OF PA4TS Page 2 of 5 Actual ft. Projected Export of Ogods &1WF5 S ,009 4, ,494 4, ,629 8,421 9,169 l4archendies (F.0.8). 4,706 3,837 3,706 8,831 3,650 3,804 4,199 4,847 6,371 6,094 6,466 7,137 7,770 Non Factor Servicea. 1, ,097 1,164 1,285 1,899 lnort af Coded & NFS. (7,122) (8.386) (5,134) (4.095) (4,635) (3,984) (4,328) (5,257) (5.880) (68503) (6,915) (7.557) (8,23) Merchandise (F.O.8). (5,46q) (6,613) (3.643) (2,845) (3,357) (2,955) (3.090) (3,87) (4,353) (4,821) (3,144) (5,644) (6,176) Non PsCtor Se rvic... (1,653) (1,973) (1,491) (1,250) (1,278) (1.030) (1,229) (1.390) (1.524) (1,682) (1.771) (1,913) (2,057) Resource tanc... (1,1S3) (3,377) (492) 634 (141) S1S Not Factor T^com.(930) (1,463)(1,921)(1.748)(2.018) (1,901)(1,88) (1,633) (1,522)(1,82) (1,640) (1,726)(1.819) Factor Receipt F%ctor Payment. (1,238) (2,069) (2,433) (1,950) (2,338) (2,098) (2,109) (1,795) (1,786) (1,915)(1,896) (1,937)(2,026) (4L.T interest) /.. (932) (1,434) (1,750) (1,349)(1,793) (1,702) (1,740) (1,447) (1,417)(1,804) (1,430) (1,418) (1,456) Not Current Trenefer.113 1oe Transfer Pecipts f8 i61 16S 125 1a Transfer Payments.(81) (85) (77) (64) (66) (64) (46) - Current Account SIefnce.(1,970) (4,732) (2.304) (1,117) (2,060) (1.329) (1,092) (1,004) (943) (807) (799) (734) (754) Direct Foreign Investments., Debit Conversion */ Not Tt Loans.. 2,073 3,220 1,297 2,283 1,142 1, Other Net M.LT,,(1) (3) 0 (40) 0 (235) (701) (1,006) (S40) (0) (0) 0 0 Not SFort Term Capit l / ,119 (466) (1,867) Error. and Omie;ions (76) (3) (49) Change n Rserves (() * inres... 1, (1,165) (541) 17 (4) (154) 135 (235) (50) (50) (50) (50) Net Credit from I F -. (52) (64) (40) (39) (100) (271) (315) (74) (89) Shares of current MP (Percent): Resource slnc "LT Interest Payments ej S.7 -S5. Current Accourt Selnce S S Total MCIY Capital Inflow Net Cradit from IMF OS For;gn Exchange Reserves: International Reserve. (US$ million) 4,074 3,775 2,578 2,023 2,056 1,867 1,778 1,643 1,878 1,928 1,978 2,028 2,078 Reserves as Months of Imports 6, Croso Res inc. Cold (USI million) ,873 2,471 2,630 2,843 2, ' Eacxhnse Ret..: Pe*so per USs (period average) , Pesos per SDR (Deceber) , Real Effective X-Rate (1980=100) c/ COP in Currant USS ( ;o d/ ,S ,339 19,758 19, ,675 20,576 22,665 23, ,644 a/. Includeo conver,ior, of osternel liabilities to doseatic *assts (articles XIX and related transactions) and prepayment of debt throuah purchas abroad of Ch;lean xiternal debt (article XVIII and related transact;ono). The contra-account of the debt conversion entry is reflected in the increase of amortization paymento under Other Net HIT Loane. b/. Fro 1985 on, e.cludwo short tear external lieb;lit;** of the C-ntral ank. c/. Trade e.;ghtd real *ffoctive *echange rate using period averagee nominal eachange rate. end period everagoe coamer p,-cice ;ndiea. Trading partners inelude: US, Canada, France, Cermany, Italy, Spafin, lt, VAnueaula., Japan, Argentina, Brazil, Peru and Ec,ad,o d/. Translated froe pooo to US$ using average annual noiniet ichenge rates. D Oate on MILT interet payment from the Central qsrk of Chile. It includes IMF interest it may d;f4or fro ODRS data. LA4CO, September 30, 1987

39 population: 12,075 (mid-1985 thousands) i CNP par Capite: USS t.S - sco'a4c VVItAcRo Page 3 of S Pro. Actual Pro. Projected mil i ons) 1980 ln ? M* NATIONAL ACCCUNr4S 1986 S/ Re-alo Annual Growth Ra..--- ~ cross Oo.wstic Product..2, I Agricult.ur if Industry end I4ining Bernicou bl , S Cot~eupt~o.18, a Cross Investment , $ ~ ESPort. of Goods and NFS Imports of Goode, and NFS.... (4.328) I ! 6.1 Cross Doe,est;c So.ing I PRICES CDP Deflatw. ( ) , Enchagse Rate Index - ljs$/ch. Paso , NATIONAL ACCOuNTS AS I OF GOP s1 Gross Iloseatic Product M Agriculture Industry and Mining W Services b/ Cons,sePtion,.6...II i Cr~oss In.oats,nt.... I Exports of Goods and NFS Import* of Goods and WFS Gross Dom,estic Sa'-.gs CONSOLIDATED NON FINANCIAL PUBLIC SECTOR PINANCE AS S OF CDP Current Rerenue&: s C.r,.ant Eivendltu.rez S Public Sector Sa inga/doficit (-) Capital Formatio Oneroll Surplua/o.f.cit OTHER INDICATORS COP Grcwth Rate (S) rj4p Par Cepits Growth Rat. (S) ICOR (lapsed) Marginal Ss,.ngs Rate (GNS/aY).5, Import Elasticity d n,.8~ a/. Industrial origin CDP based on contsnt..trices; expendl;ture MOP based an~ current. Pr~ice.s. b/. Includes, imputed bank service charge and import duti.s. Cl Include. Operational o.rplus of public enterpriage and not transfer.. d/. Includes imports of non-factor oer.ices. 5 Yr. Point elasticities, using compounded growth rates. LA4CO, September 80, 1967

40 Papylstioni (.1d-1955 thoweende) ef Ca.lte: UBSI 1, ANN=CI Page 4 of - 6M,MI2 OP PAlWu. 661&IJ. CAPIAL No V ActUal Plre. Pr.e#be6 P.ANMJC OF PA l(bvs t lug Net Exports of Goods & NF.... (1. 163) (8,877 (492) 554 (141) s Ezporte of Goods a*.f , , , tiports of Goods 4 WS3 (11.2) ( ) (5,28) (4,095 (4,685) (5,8964) (4.68W ( (86 (6.105 (695)(.B51 (1.255) NoAt Trmf~ i lo St t0 127 i2n Current Account bliance......i (1,970) (4.78) (2.3064)(I.117) (2,060) (1.829) (1.092 (1.004) (948) (607) (7991) (784) (754) 0.rect Foreign Innastent. & Obt. Conv.a/ no 185 Not. M41. (Loan.) * I., all SW Other Copicl toibf c/ (149) (1,271) (824) I Chang* in Reeerv*s (C) increase), (1,186) (541) 17 (4) (154) lo5' (28 (50) (50) (50) (80 Internotional Ranervee (not)... 4, ,023 2,055 1, , , Reeervesas omnth. of imports , ` OR=S OIS84S S@O! 8/ Officat Crant Grown Disburseaments of 11T Loans.... 8, , , , ? Pu.bl ic S Publl.cly Gurorntead.... 0S ,470 1,215 1, ,801 1, mu.tt; lateral M no0 0/0 IRM ' Si lateral t Private Guaranteed A Unidentifiev! 262 1, ,576 1, *4 S ,584 1,692 Ptivate Non O.uarante, d TOITAL lilt WCTS4l.051 OM f9,415 12, ,682 16,985 17,279 15, ,100 18,692 15,249 16,550 17,854 17,86 PublIi c A Pub 11 aly Guaranteed f/....4,720 4, , ,942 18,625 14,151 14,785 18, ,5856 Mu Iltilo to re l ,425 1,905 2,885 2,510 8,095 8,286 5, O/e lod O ,566 1,442 1,882 1, a/* IDA to 17 La 16 is Di loterol a S Private Guaranteed A Unidentified. 8, ,951 5,244 8, , *09 11, Private Nont Guaranteed a/. ~ ,185 6,685 8, , , TOTAL SHORTER OM DT.... 1,671 2,159 8, ,848 1,874 1,681 1, ,207 OE81r SBIVICE Total P.bilic and Privatei MLT Debt Sarvi4e Paymente.1/ # , , , , ,002 2, /a Interest j/.i ,434 1, ,702 1,740 1, ,504 1, ,4588 Debt Sep, ice so U of EnoteQt GaS a Totsal Short Tore Debt Sor. ice Payoente , Short Term. Payments as S of Exporte GAS Avg. Int. Rote on Loon.. IN / Avg. Loon Maoturity (yre.) el I Officiol SAW( OROUP EXPOSIJRE (3) 1TM DOD/TotalI IOFt Die./Total Gross Disbursements S ,4 IRV0 Debt Ser,vice/Total Dobt Service i/ a IDA DOD/Tots I DOD el. Froe 1958 on, includes debt conversion Chapter XIX end related transaction.. b/ Includes e,traordinary an.ortizotion Contra-account to debt converoeione, Chapters IIVIII and XIX. t/. Includes other not lilt capital, Debt Conversion Chapter XIX, not short-term capital. retiming (1965), and errore, end oeieeion.. Eveludso, IN? 8/. Eexcl..deo DIP disbursements. Actual data source: ORS e4? in e/. Fxcludas use of IMF credit, includle. reduction in 0OM due to debt Conversion schemes. f/. In , the Chilean Gave"ma.nt guaranteed a largle portion of the Private financial ey.tom external debt, a. 4port of renegotiation., with its Commercial creditor.. p1. Includee the S3.34 bililion reduetion in 00W from debt convercion under Articles XVIII. XIX and related traneactiors. S/. Includoe short term debt A interest paymenta. Includee average epread. i.includes 1MA debt eervic.. U.Date on 141. infteret payeent from. the Central Bank of Chi le, It includoe IlMF intereet.. It my differ free OM5 data. LA4C0, September 80, 1987

41 Popui*tio,n: 12,076 (~-9Stoim*) JP P,ar Capita: 1.15S 1, ANNEX I CHIL - OfOWLTRAMPage 5 of ~ w. -- -~t (UNS cts Pr.. ProJoct.d MHRCHWMISE TRADE low Herchvndi,. Exports, Hinig coods.... 2, ole Copper.... 1,757 I Agricuiturol004 God , , q.4 Manufset~.,'d Goods a.5 Me.,chand,ds, Importo Ft L T.4.8. Conasuer Coeds I e '. 4, c/a, Foo Intermadiato Gocod.... 1, Cepitel Goods PRICES AND TEFMs OF TRADOE ( ) Export Price index Import Price Index Terms of Tradle Index C EXTERNAL TRADE AS PERCeRT OF TOTAL (3) Mscado E,port.s M,finfl Goods o/. (cpp*r ,3 4S Aqricv1t,,xoJ Goods , Manufact,red G-oods M*rchandizo Imports ClF Cor,Ourer Goods o/w Food Intermed,sts Goods Cspitsi Goods DIREC'TION OF TRADE AS I OF TOTAL Period Averuge, Dir*ction 04 Exports Unit.*d States Jeopn E E C Cc..rt-.av A Germ-an , Ital... Frv~~~~ca ~ I. 4.3 L.A.F.T.A Co,.tres l rez, , I. 6.0 Argentine&..I Othe,rs I Direction of Imports United Stntes I , Japn ~ I E E.C Couetries , i6 5 Germany j Italy ~ france, P L.A.F.T.A Countries Breuil I Argantinv Other I LA4CO, Sr.ptombar

42 ANREX II Page 1 of 2 THE STATUS OF BAR GROUP OPERATIONS IN CHILE A. STATNIER OF BARK LQANS AND IDA CREDITS (as at September 30, 198') Loan or US$ million Credit Amounts (less cancellations) Number Year Borrower Purpose Bank IDA Undisbursed 29 loans and one credit fully disbursed / Chile Water Supply Chile Highway Recon. II Chile Agri. Serv./Credit Chile Housing Chile Public Sector Mgt Chile Road Sector Chile Ind. Fin. Rest CORFO Small & Ned. Ind EMOS Sant. Wat. Sup ESVAL Val. Wat. Supply CORFO Hydroelectric / 1987 ENDESA Power Transmission Total 1, of which has been repaid Total now outstanding 1, Amount sold 7.2 of which has been repaid 7.2 Total now held by Bank and IDA 1, Total undisbursed / Includes exchange rate adjustments. The original amount of the credit was US$19.0 million. 2/ Not yet signed.

43 ANX= II Page 2 of 2 B. STATRE#N 0F IFC INVETMSTS (as at September 30, 1987) Type' of Amount in USS million Year Obligor Business Loan Equity Total 1958, 1959, Empresa Minera de 1966, 1984 Mantos Blancos Copper mining , and Fideos y Alimentos 1965 Carozzi S.A. Food products , 1961 and 1965 Cemento Bio-Bio S.A. Cement Cia. Manufacturera de Papeles y Cartones Pulp and paper Minera Sagasa S.A. Copper mining Inverchile Money and capital markets 1986 Signal Methanol Chemicals & Petro- Chemicals Compania de Carbones Mining de Chile (COCAR) 1987 Arauco Pulp and Paper Total gross commitments less cancellations, terminations, repayments and sales Total Commitments now held by IFC = - == Total Undisbursed

44 ANNEX III Page 1 of 2 THIRD STRUCTURAL ADJUSTMENT LOAN SUPPLEMENTARY LOAN DATA SHEET Section I: Timetable of Key Events: (a) Time taken by the Country to Prepare Project: 2 months (b) Project Prepared by: Ministries of Economy and Finance and the Central Bank (c) First Presentation to the Bank: May 1987 (d) Departure of Appraisal Mission: July 1987 (e) Completion of Negotiations: October 30, 1987 (f) Planned date for Effectiveness: December 1987 Section II: Svecial Bank Imolementation Action: None. Section III: Special Conditions: The following conditions have been established for the release of the second tranche: 1. Macroeconomic and Ex=ort Policy (a) strengthen Copper Stabilization Fund; (b) continue present policy of frequent and regular adjustments in the nominal exchange rate to maintain the real effective exchange rate; lc) modify incentive framework if nontraditional exports are projected to grow by less than 7 percent in real terms in 1988; and (d) provide satisfactory evidence that the Borrower's program of external financing will continue to be adequate.

45 ANNEX III Page 2 of 2 2. Public Finance and Investment (a) increase public savings to at least a projected 5 percent of GDP in 1988; (b) prepare a public investment program for the years , including investments in 1988 of about 7.5 percent of GDP, and review with the Bank the execution of the 1987 and 1988 public investment program; and (c) maintain current program of public expenditure restraint to limit overall deficit of nonfinancial public sector to less than 1.6 percent of GDP for Financial System (a) modify tax law to encourage investment and the development of capital markets through revisions in the tax treatment of income from securities and reduce stamp tax by about 50 percent; (b) improve system of risk classification to stimulate capital markets; and (c) carry out studies on (i) banking efficiency and competition among financial institutions; (ii) broadening the range of available financial instruments; and (iii) means to encourage companies to develop into open corporations (Sociedades An6nimas Abiertas). 4. Social Security (a) introduce administrative and collection procedures to increase efficiency of private pension funds; (b) complete a study of (i) ways to augment the participation of the selfemployed in pension system and (ii) ways to reduce operating costs so to reduce fixed commissions; and (c) take measures to increase public understanding of reform. 5. Health (a) improve preventive health care and broaden preventive action to include adult chronic diseases; (b) implement administrative systems to improve cost contaiunent, accounting, user fee collection, and hospital management; (c) strengthen regulation of private health care industry (e.g.: cancellation of policies) and clarify contracting relations witn public sector; and (d) undertake Ch$3 billion two-year program to rehabilitate machinery and hospitals starting January 1, 1988.

46 CHILE - PIIIPOSEP STRUCTURAL WUSTIWI PIUMs ISSUES AN D E tllb IV Page I of 3 Structural lsu he#au Taken by Cnitoni of Prior to Secnd Test Ibfnrf t bard Prntetation Trenche Disburtemt Para. uwaacuuic An EIPORT PO0ION Iaintain coptitiveness of eneal of Copper laintain Coppr Strangthen Copper Stabilization 44 exports, speially non- Stabilization Fund Stibiliation Fund. Fund in 198 by narrowing traditional experts. nt'blisbe in 15. bans that activate ftund and substitute quarterly for nnual averaging. Attractie real tichaqn rate. Continue present policy of nominal adjustents in the exchange rate to imintain the real effctive exchne rate. Continue presnt policy of reglar adjustents in the noninal enchag rate to mtintain the real effctive exchange rate. 4f Promote nontraditional exports Legislation that provides odify incentive traork if Nodify incentive framer it 45 to continuefforts of incentivn to waell nontraditional exports are projected to nontraditionar aports are prodivtrsification. nontraditional e%porters. grow by less tha 61 in real term in jected to grow by les than n in real term in m8. Evidence that Chile's progra of 45 external finaning will continue to be adequate. offset disdvantae of tariff systn for exports. Unified 201 tariff rate Revis DKer Lan 1226 and for imports. Established to expand;tariff rebate syste to lisited drawback prograe include indirkct exporters in for emports. drawback system. Promte nontraditional exports 47 by ntablishing legal fraewrk for etport credit insurance systea and partial gurantes for small exporters.

47 CHILE - PIWUPUSED U M IDUSTIMI PIUHi lits AND w lii IV Page 2 of 3 Structural ssus awrn Taken by Coition of Priort o ceknd Text sovrnant Sard Presentation Tranche Dishorsent fare. PJIC FINAlES IID INVEST Increase thw contribution of Publication of Increas public savings to a pro- Incruu puelic uvings to a pro- 49 th public actor to d loplt program. JKtd 4.81 of 1 in 1M. jkctd 5.0 of GP in 11. dometic uvings. Maintain erform o Of overall pblic sector consistent with sustainable growth. Impro social returns to public invtm nt. Ibintain current program of 4 public expenditure restraint to liait overall deficit of nonfinancial plic sector to 1.6 Z of SUP for 1997 ad Ins for 19M1. Prepared public invntant Prp an invetmet progra with Prepre a public inetmtnt 50 program invntmnt lenvls of 7.1t of UP progra for the years 198-0, in 19" consistent with sustainable including investmnt of 7.1 of UP increas in overall invstmnt. in 11; revie with the Onk the exkution of the 1981 an 195 publit invstment rogr". FINIALIM. SYSTEN Continue rehabilitation Ruapitalization procns for Continu banking sector rehabilitation, Coplete a study of banking 51 of tte banking system. intervened banks. aum ting mitoring, and inproving sktor efficiency and coptition. public disclosure of Cospleted privatization of depoit limits. intervented banks. Enacted nef banking la of 199, including depsit insurance schm. Improvefficiency of Incou tan refore in 194 to Modify tas I to entcurage 60 intermdiation in long-term encourage reinvestment of equity investmns and tincial mrkets, enhance corporate profits and reuce stp tax from 2.42 security of pension funds, private svings. to 1.21 and deelop capital urkets. New cortprate legislation Amnd DL 3500 to Create more flexible syste of 61 isproving transparency of permit enhanced participation risk classification for secritin 63 controlling stockholders and of pension funds in equity to stiulate capital urrets. reucing cros-participation mrkets. twten fires. Strengthen regulation of 62 insurance companies and mutual funds with prudent portfolio guidelin for divenification and lisits to related-party investments.

48 CHILE - PIWOPSE STRUCTUL ADJUSTIENT PROIRAlK ISSUES AND SCIIPE Awll IV Page S.of ~-_. --,..._ Pg3etS~~~~se S" Structural Isom Neasueu Tan by Conditions of Prior to Second Text kvwentmt Saud Presntation Tranche Disursent Pars. SOCIAL SECTORS SCial Security Systei Protection and seurity of pension funds. Pension systen refora of MiI. odify social security law to 66 pmit greater investmts in equity markets (noted above) and affirm principles of portfolio manmot. Reduce costs and increase lacrean cepetition among Introduce administrative and 47 coeptitivems of ARPs. pension funds by loering capital collecton prordurff to 68 requirents for entry and increas efficiency of private rncouragiag n fire-bae funds. pension funds. Increase long-tere coverae of systn. Increase tht coverage by extending autmtic disability and survival benefits to tempirarily unemployed workers. Complete a study of the coverage 4N of self-emplyed. Encourag widespread knoeiedge of ne system and enhance vorkers identification vith their funds. leprove presentation of Complete study of ways to cut 71 information on AFP yields, operating costs so as to reduce 72 commissions and benefits is fixed coseisions. 73 quarterly reports to affiliates; perait voluntary savings accounts. Health Systemt Consolidate gains of past health instuents, especially in primry and preventive health care Focusing program on lowest income groups. lprove preventive health care 74 and broaden preventive action to include chronic diamses of adults, including cancer, cardiovascular and other disca es. lprov efficiency in us of Partial decentralization nd lpleent adeiaistrative systems 75 resurcs allocated to MSIIS. municipalization of to isprove cost containmnt, health syste oeginning in m. accounting, user fee collection, and hespital sanageent. Improvefficiency of the private health core system. tmprovefficiency of investmnt in health. Strengthen regulation of private 76 health care industry (e.g.: cancellation of policiesl and clarify contracting relations with public sector. Undertake ChDO b. tw-year program 77 to rehabilitate machinery & hospitals. 1 1/2/87

49 _44 ANNEX V Page 1 of 9 November 2, 1987 Mr. Barber B. Conable President The World Bank Dear Mr. Conable: 1. The Chilean economy has undergone a profound process of change in its structure. Starting in 1975, the country's economy has been liberalized and opened up, with the virtual elimination of nontariff barriers to imports, the unification and substantial reduction in customs tariffs, the lifting of price controls and deregulation of domestic markets, the gradual reduction in the size of the state through privatization of public enterprises and the curbing of public outlays, together with the application of responsible fiscal and monetary policies. 2. As a result of this strategy, economic activity grew steadily between 1975 and 1980, with GDP showing an average yearly rate of increase of 7.5 percent. This growth was led by exports of goods and services, which increased 15.1 percent in volume, while at the same time displaying ever greater diversification in terms of products and markets. Economic expansion was accompanied by a strengthening of the public finances, a gradual reduction in inflation from 340 percent in 1975 to 30 percent in 1980, and a 23 percent decline in real net external debt between 1975 and The deterioration in the terms of trade that occurred in 1981 (estimated at 21 percent), plus the rise in international interest rates on external financial markets, put an end to this period of expansion and created the need for a drastic adjustment in domestic expenditure. The impact on the Chilean economy of these changes in the external economic environment was particularly severe, as the period from mid-1980 on had witnessed a massive influx of external funds to the private sector, favored by the high worldwide liquidity prevailing at the time, the deregulation of the domestic capital market, and the application of a fixed exchange rate policy. The resultant adjustment led to a sharp recession in , with a drop in GDP, increased unemployment, and a proliferation of financial problems within companies and banks.

50 -45- ANNEX V Page 2 of 9 4. Since then, the Governnent has applied an economic policy combining the short-term objective of encouraging the maximum expansion of economic activity compatible with a gradual diminution of external financing requirements, and the longer-term objective of laying the foundations for sustained growth through intensification of the structural adjustment initiated in The first of these objectives was given concrete form in a macroeconomic program for , supported by an IMF Extended Fund Facility. The second objective has been pursued through a program of structural adjustment, supported by the World Bank through SAL I in , SAL 1I in , and the proposed SAL III in The program also received support from the international creditor banks and the official creditor agencies through flinancial packages negotiated in 1985 and The aim of the structural adjustment program is to promote increased exports, improve the quality and quantity of investment, and expand domestic savings. In this way it is expected to lay the foundations for sustained growth in output and employment, in conjunction with a gradual improvement in the credit worthiness of the Chilean economy. Progress of the Structural Adjustment 6. In accordance with the program objectives, the Government's economic policy has constantly sought to promote increased exports. The following measures have been taken in this regard: (a) A realistic exchange rate policy, allowing a 97 percent increase in the effective real exchange rate (defined as the peso price of foreign exchange) between the final quarter of 1981 and the same period in (b) Moderate and virtually uniform customs tariffs set at the 20 percent level, with the sole exception of products subject to proven unfair competition from imports from any trading partner. (c) Establishment of an efficient mechanism form returning indirect taxes paid on small-scale export transactions, defined as those with a value of less than Us$7.5 million, taking the form of a drawback equivalent to 10 percent of the export value. (d) improved system for returning the Value Added Tax to exporters, making the regulations both more flexible and less time-consuming. (e) Elimination of stamp duty on export credit transactions. (f) Increase in individual bank credit margins to exporters from 5 percent to 10 percent for loans without real collateral and from 25 percent

51 ANNEX V Page 3 of 9 to 30 percent with such collateral. (g) Extension of the period within which exporters are required to convert the proceeds from their foreign sales into pesos. 7. The structural adjustment program seeks to create a favorable environment for increasing and making good use of savings and investment. Particular attention has accordingly been paid to strengthening the financial sector, which had been severely shaken by the economic crisis. In order to lessen the effects of that crisis, the Government between 1982 and 1984 took over certain financial institutions and liquidated others; in addition, small and medium-sized domestic debts were rescheduled with Central Bank support, a preferential exchange rate was maintained for the servicing of debts in foreign currency, and the Central Bank purchased -with a repurchased agreement- that portion of the banks' portfolio deemed to be uncollectible. These measures helped the system overcome the worst moments of the crisis. However, as indicated in the SAL I program, initiated in 1985, sound fiscal and monetary policy management required that the Central Bank refrain from any new subsidy programs and, wherever possible, gradually eliminate existing programs of that nature. These commitments were faithfully implemented during 1985 and 1986, with the elimination of the preferential exchange rate and other subsidy programs. 8. During 1986, thp situation of the private banks improved in terms of net assets and results from operations. The same year saw the introduction of a new Banking Law, designed to increase the transparency of banking operations and to facilitate supervision of banking institutions. With the strengthening of the banking system, financing operations expanded significantly, as evidenced by a healthy growth in the various monetary and financial aggregates. Finally, the first quarter of 1987 brought to a close the process of reprivatization of the banks that had been taken over earlier, with the transfer to private ownership of Banco de Chile and Banco de Santiago. In both cases, the Government employed privatization procedures that encouraged wide spread ownership. 9. In pursuing the goal of raising saving and investment rates, the structural adjustment program has assigned a major role to the public sector. The program proposed that public savings be increased from 0.6 percent of GDP in 1984 to 4.5 percent in 1986 and to 4.8 percent in The actual rate achieved in 1986 was 4.6 percent, and the 1987 target is again expected to be exceeded. Public investment amounted to 7.1 percent of GDP in 1985 and 7.6 percent in 1'386: the projected figure for 1987 is 7.5 percent. It should be noted that sizable shareholdings in such companies as CAP, Endesa, Ecom, Chilmetro, Chilquinta and Soquimich were privatized in This process of privatization, seeks to transfer important savings and investment decisions to the private sector. It should also be noted that the increase

52 -47 - ANNEX V Page 4 of 9 in public savings has been brought about largely by holding down current outlays. The period has witnessed the progressive implementation of a major tax reform that has reduced the double taxation of individual savings and partially exempted undistributed business profits from income tax. 10. The structural adjustment program currently being implemented has achieved significant results in terms of the pattern of exports, savings and investment. Between 1984 and 1986, the physical volume of non-copper exports expanded at an average annual rate of, 13.4 percent. Exports of goods and services, measured as a percentage of GDP at constant prices, which had represented only 11.5 percent of GDP in 1970, grew from 20.4 percent in 1981 to 27.7 percent in The gross domestic savings rate, rose from 12.5 perceni of GDP in 1984 to 18.5 percent in This increase made it possible to raise the gross national savlngs rate (the fraction of domestic savings used to finance investment) from 3 percent in 1984 to 8 percent in The investment rate rose to 14.4 percent in 1986, compared with 13.6 percent in The aforementioned results have been accompanied by encouraging results in economic growth, employment, real wages, social indicators, inflation and external debt. GDP groifth average 4.7 percent per annum between 1984 and 1986, while a 5.5 percent yearly average growth in employment took place over the same period, making it possible to bring the unemployment rate down to approximately 10 percent, from the more than 20 percent figure it had reached during the worst periods of the recession. It should be noted that the number of persons enrolled in the emergency employment programs (PEM and POJH) has fallen from 9.5 percent of the labor force at the end of 1984 to 4.5 percent at the end of Meanwhile real wages grew by 2 percent in 1986, after declining Social indicators such as the infant mortality rate, professional care during childbirth and programs to increase coverage of basic services all continued to improve. The rate of inflation remained moderate, averaging 23 percent a year over the period Lastly, mention should be made of the decline in the country's external debt ratios. As a multiple of exports of goods and services, the external debt outstanding fell from 4.3 in 1984 to 4.0 in The debt conversion mechanisms first introduce in mid 1985 played a crucial role in reducing the country's debt indicators. These mechanisms not only helped reduce the magnitude of the country's financial commitments, but also (among other beneficial effects) strengthened the net assets situation of banks and other enterprises, thereby facilitating an effective increase in the level of activity and investment. Economic Program for The economic program for is consistent with the structural

53 ANNEX V Pag 5 of 9 adjustment strategy described above. The program calls for a 4-5 percept average yearly increase in GDP over the two-year period, and an annual inflation rate within the percent range. As regards the balance of payments, the program projects a current account deficit of approximately U$$900-1,000 million per annum, stemming essentially from the payment of interests on the external debts; excluding this item.and other non-factor services, the trade balance is expected to record a surplus of some US$900-1,000 million. Net international reserves are expected to show a slight increase. 13. The financing of the program takes account of the resources obtained in the 1987 negotlations with creditor banks, multilateral agencies and government lending institutions. The international banks will be participating as follows: (a) change in the frequency of interest payments from a semiannual to an annual basis ('retiming") effective January 1, 1988; (b) reduction in the rate of interest effective January 1, 1987 ('repricing") by eliminating the prime as the basis for determining the cost of "new money" borrowed by the Central Bank and reducing the spreads above LIBOR both for "new money' and for old debt; (c) restructuring of loans in a total amount of US$12,486 million, as a result of which no payments will be required before 1991 on all bank loans outstanding in 1983 plus all new money negotiated since then; (d) finally, it was agreed to extend the availability of shortterm credit lines, representing a minimum amount of US$1.7 billion, until the end of The financial package is completed with the refinancing of public sector loans with official agencies (Paris Club) and an additional World Bank participation in the amount of US$250 million under SAL III. SAL III Program 14. The SAL III program largely seeks to consolidate the gains made since 1985 in adjusting the structure of production and expenditure in the Chilean economy. In each of the main areas of focus -exports, investment, and savings- the program also provides for specific policies to improve and strengthen the incentives offered. The program also places particular emphasis on the social sectors, to ensure that efforts toward structural adjustment will continue to be accompanied by constant improvements in living conditions, particularly for the poorest segments of society. 15. As regards exports, stress will continue to be laid on maintaining a systeia of macroeconomic conditions designed to promote balanced development of sectors with export potential and providing tax and other measures to offset the disincentives stemming from customs tariffs and ohter distortions. The policies and measures envisaged include the following: (a) Maintenance of the exchange rate policy that has been in effect since

54 -49- ANNMEV g 6Of , which takes the form of a daily devaluation of the peso reflecting the difference between domestic and external inflation, in order to maintain a realistic exchange rate. (b) (c) (d) Maintenance of the current policy with regard to customs tariffs, involving a virtually uniform 20 percent tariff. Maintenance and enhancement of the Copper Stabilization Fund, set up under SAL I to lessen the impact of short-term fluctuations in the price of copper on the country's international reserves (and hence on the exchange rate), as well as on the national budget. The strengthening of this mechanism is particulary important in light of the recent rise in copper prices on international markets, as a means of demonstrating yet again that the country's exchange rate policy will continue to be governed by long-term considerations. The enactment and/or implementation of various statutory measures designed to improve the system of drawbacks for small-scale exporters, to include "indirect exporters" under the system for refunding customs tariffs on imported inputs and capital goods, to establish the legal framework for an export credit insurance scheme, and to set up a partial guarantee fund for small and medium-scales exporters. 16. As regards fiscal policy, the program will continue to stress higher public savings and maintenance of a high rate of public investment. The rate of public savings and maintenance of a high rate of public investment. The rate of public savings (the surplus on the consolidated nonfinancial public sector's current budget) is expected to grow from 4.8 percent to 5.0 percent of GDP. Public investment is expected to remain at about 7.5 percent of GDP, with projects subject to rigorous socioeconomic evaluation to ensure that they are of optimum quality. 17. The policies designed to promote private sector savings and investment includes, as in previous years, the maintenance of a macroeconomic climate conducive to this goal (stable rules of the game, adequate relative prices, prudent management of aggregate demand policies) and a tax system with the smallest possible disincentives for savings and investment. In addition, given their obvious impact on the volume and quality of investment, the structural adjustment program has devoted special attention to institutional aspects of the capital market. The following measures are envisaged in this area for : (a) Full application of the provisions contained in the recent Banking Law reforms, in particular as regards supervision by SIB, of the system of government guarantees for deposits, and regulations affecting the services provided by banks and other financial intermediaries, in order