1

Copper Booms and Fiscal Responsibility in Chile

Eric ParradoMinistry of Finance - Chile

10th Annual GDN Conference

KuwaitFebruary 5, 2009

Agenda

Motivation Importance of copper Fiscal stabilization

– Counter-cyclical nature– Competitiveness– Risk premium

Fiscal policy and the objectives of the funds

Institutional arrangements and investment policy

A commitment to transparency Concluding remarks

Motivation: What is the paper about?

Motivation

From 2005 up to the last quarter of 2008, the price of copper was over US$2 per pound, reaching US$4 per pound in the second quarter of 2008.

In contrast, the average nominal price in the last two decades was close to US$1.3 per pound.

During those years, the windfall copper earnings were saved using a fiscal policy framework based on formal mechanisms to manage both fiscal flows and stocks.

Real copper price: 1990 – 2004

124,7

0

50

100

150

200

250

300

350

400

450

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US

cent

s per

pou

nd (D

ec. 2

008

USD

)

Real copper price: 1990 – July 2008

July 2, 2008407,8

0

50

100

150

200

250

300

350

400

450

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US

cent

s per

pou

nd (D

ec. 2

008

USD

)

2005 - June 2008:168% increase

Real copper price: 1990 – January 2009

January 30, 2009146,2

0

50

100

150

200

250

300

350

400

450

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US

cent

s per

pou

nd (D

ec. 2

008

USD

)

Motivation

The current global crisis is testing the Chilean fiscal policy framework with a price of copper rounding US$1.77 per pound in the last quarter and US$1.46 in January 2009.

The counter-cyclical policy scheme allows using the accumulated resources in sunny days to support the economy in rainy days.

Motivation

And now, Chile is in better position to whether the external shocks relative to other Latin-American economies and relative to its history.

Thus the objective of this policy paper is to shed light the key role of a responsible fiscal policy, formal arrangements, and institutional aspects to manage a commodity boom focusing on the Chilean experience with its main export: copper.

The successful management has avoided the destabilizing consequences traditional observed not only during the booms episodes but also during commodity price downfalls.

Importance of copper

In terms of GDP, copper represented more than 6% of GDP in the period 2004-2008, while the mining sector accounted for almost 7.5%.

In terms of exports, copper contributed with almost 30% of total exports in the same period.

In terms of fiscal revenues, copper accounted for more than 17% of government’s revenues.

Internationally, Chilean copper production represented more than 35% of global production.

Fiscal stabilization: Chile’s fiscal policy framework Flow management:

– The fiscal structural surplus rule

Stock management: – Fiscal asset funds:

• Pension Reserve Fund (FRP)• Economic and Social Stabilization Fund (FEES)

11

Fiscal stabilization: the fiscal structural surplus rule The fiscal rule aims to protect Government

spending from the effects of the economic and copper price cycles

Structural (i.e. medium term or trend) government income is calculated for the following year

This requires the input of three key parameters: the medium term price of copper, the economy’s long term output, and the returns of financial assets

Yearly fiscal expenditure is then set so that Structural Revenue – Fiscal Expenditure = 0.5% of GDP

12

Fiscal stabilization: the fiscal structural surplus rule

-4%

-2%

0%

2%

4%

6%

8%

10%19

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

% G

DP

0

50

100

150

200

250

300

350

Copp

er p

rice

(US

cent

s pe

r po

und)

Effective Structural Copper Price

Fiscal surpluses and copper price

Fiscal stabilization: the fiscal responsibility Law Complements Fiscal Rule by focusing on the

management of the stocks of financial assets generated by the Rule

Provides for the creation of two funds: – the Pension Reserve Fund (Dic. 08: US$ 2.5 billion) and – the Economic and Social Stabilization Fund (Jan. 08:

US$ 20.2 billion)

These government funds are separate from Central Bank reserves, which are managed by the independent Central Bank

Permits the re-capitalization of the Central Bank over 5 years

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Fiscal stabilization: the virtues of the fiscal policy framework Counter-cyclical effect on the business cycle:

under the rule Government spending is counter-cyclical

Ensures the financial sustainability of government policies, allowing for long-term planning, reduced spending volatility, and secure financing of an ambitious social agenda

Protects export competitiveness during copper price booms by avoiding unsustainable fiscal spending increases and the resulting transitory exchange rate appreciations

Boosts public saving, reducing the need for historically volatile external financing in times of crisis or recession, thus eliminating a source of macroeconomic risk

15

Fiscal stabilization: counter-cyclical nature The current fiscal policy framework allows

having a counter-cyclical role by construction. – Surpluses are saved and deficits are financed to avoid

sudden changes in fiscal expenditure. – Consequently, fiscal policy contributes to reduce

macroeconomic volatility, particularly economic growth. Since the introduction of the structural balance rule in 2001, GDP growth has been quite stable, reaching in average 4%. In 2009, Chilean fiscal policy is expected to be in deficit, while GDP growth is projected to be between 2 and 3%. Obviously, the fiscal sector cannot contribute to maintain the same levels of economic growth, but it would offset part of the downward trend in the private sector consumption and investment.

GDP growth and central government balance

2,0%

0,4%

-2,1%

-0,7% -0,5%-1,2%

-0,4%

2,1%

4,6%

7,7%

8,8%

5,2%

-4%

-2%

0%

2%

4%

6%

8%

10%19

97

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Effective Real GDP growth

Fiscal stabilization: competitiveness

Another intrinsic feature of the current fiscal policy framework that saves during copper booms is that helps to maintain the competitiveness of the non-copper export sector.

The Dutch disease has been a characteristic in several experiences dealing with commodity booms. However, the Chilean fiscal policy tries to avoid strong exchange rate appreciation.

Moreover, the copper boom has contributed to substantial incomes in foreign currency relative to pesos income. The recent local debt strategy oriented to introduce benchmarks in the fixed income market has helped to avoid the use of US dollars to finance pesos expenditures in the government sector.

Fiscal stabilization: competitiveness

In addition to avoid excessive fiscal expenditure, the management of the savings through the Sovereign Funds: the Pension Reserve Fund (PRF) and the Economic and Social Stabilization Fund (ESSF), has helped to avoid pressures on exchange rate appreciation.

In particular, the current investment policy of the two funds restricts all type of investments in Chile, contributing not only to avoid currency appreciation, but also to circumvent domestic financial bubbles. During the copper boom (2005-2008), the two Sovereign Funds have accumulated resources for almost US$23 billion

Evolution of Chile's sovereign funds: EESF & PRF

0

5.000

10.000

15.000

20.000

25.000

Dec

-06

Feb-

07

Apr

-07

Jun-

07

Aug

-07

Oct

-07

Dec

-07

Feb-

08

Apr

-08

Jun-

08

Aug

-08

Oct

-08

Dec

-08

US$

MM

ESSF PRF

Fiscal stabilization: risk premium

The copper boom (2005-2008) also allowed repaying earlier central government debt. In 2002 gross government debt was almost 15%, whereas debt in 2007 was drastically reduced to 4%.

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2000 2001 2002 2003 2004 2005 2006 2007

% G

DP

Gross government debt as % GDP

Fiscal stabilization: risk premium

Responsible fiscal policy has also contributed to reduce to keep the risk premium in low levels and lower volatility.

Evolution of sovereign spreads

0

200

400

600

800

1000

1200

1400

2000 2000 2001 2002 2003 2004 2005 2006 2007 2008

Chile Latin America

Fiscal policy and the objectives of the funds The purpose of the Pension Reserve Fund is to

supplement the financing of future contingent liabilities related to public pensions. The fund is, therefore, intended to support the financing of public obligations that arise from government guarantees of, and contributions to, old-age and disability (or solidarity) pensions.

On the other hand, the main objectives of the Economic and Social Stability Fund are to finance potential fiscal deficits and to amortize public debt. In this way the fund will contribute to the stability of public spending by reducing dependence on volatile government revenues.

Fiscal policy and the objectives of the funds

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

-0,5% 0,2% 0,9% 1,6% 2,3% 3,0%

Effective Fiscal Surplus (% GDP)

Cum

ulati

ve C

ontr

ibuti

ons

(% G

DP)

ESSF Central Bank Capitalization PRF

Transfers of prospective fiscal surpluses

Institutional arrangements and investment policy The Ministry of Finance appointed the

Central Bank as the fiscal agent responsible for the management and investment of the funds’ resources on behalf of the government. – The central bank performs these functions in

accordance with specific instructions issued by the ministry in the form of the “investment guidelines” for both funds.

Institutional arrangements and investment policy The fiscal responsibility law also

established that the minister of finance must be assisted by a specially appointed Financial Committee in order to decide on the investment policy for the funds’ resources and the implementation thereof. – The committee consists of independent

experts with significant experience in the area of economics and finance. The appointment of the first committee was made in August 2007.

2727

Institutional arrangements and investment policy

Investment Policy

Implementation

Ministry of Finance

Central Bank

Financial Committee

Institutional arrangements and investment policy As an initial investment policy for both funds, it

was decided in March 2007 that their portfolios should reflect that of the foreign-exchange reserves portfolio managed by the central bank.

As of January 2009, the funds invested only in short-term and low-risk financial instruments: 30% of the portfolios are invested in money-market instruments, 66.5% in sovereign bonds, and 3.5% in inflation-indexed sovereign bonds. In addition, among other restrictions, the present portfolio sets limits to currency exposure, with the following benchmark ratios: 50% in US dollars, 40% in euros and 10% in yen.

Institutional arrangements and investment policy: asset allocation

66,5%

45%

30%

5%

3,5%

15%

20%

15%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Initial Proposed

Sovereign and agency bonds Liquid assets

Inflation-linked bonds Corporate bonds

Equities

A commitment to transparency

The funds have operated in a very transparent manner since their establishment in 2006.

To ensure that the public has access to the relevant information, the ministry of finance has created an exclusive website that holds all of the funds’ monthly and quarterly reports, the legislation pertaining to the funds, and the recommendations of the Financial Committee and its annual reports.

A commitment to transparency

Chile has actively engaged in international initiatives to foster the transparency of SWFs.

In particular, the International Working Group on Sovereign Wealth Funds, supported by the IMF, reached its landmark agreement over the principles of such a framework in Santiago, the Chilean capital, in 2008.

The so-called “Santiago Principles” reflect the commitment to enhance transparency with regard to the policies and activities of sovereign wealth funds.

Concluding remarks

The successful Chilean experience to manage commodity booms has contributed to reduce economic volatility and increase the resilience of the economy.

An important general lesson of this process is that governments should avoid short-term temptations to spend significant temporary surpluses.

Paradoxically, this policy gains legitimacy in the rainy days when governments need additional resources to support their economies.

Concluding remarks

Another general lesson is that the formal implementation and management of the fiscal policy framework based on flows (structural-balance rule) and stocks (Sovereign Funds) helps to gain credibility in the policy itself.

The transparency of both the institutional arrangement and the policy investment of the Sovereign Funds have helped to legitimate the fiscal policy framework.

Concluding remarks

Challenges:– Implementation of the new investment policy

in the current global economic context:• Not only a financial issue, • But also an economic policy issue

– National consensus– Communications policy and “Active

Transparency”

If natural resource booms are well managed they must be a blessing for the country.

35

Copper Booms and Fiscal Responsibility in Chile

Eric ParradoMinistry of Finance - Chile

10th Annual GDN Conference

KuwaitFebruary 5, 2009