José De Gregorio: Policy responses to the global crisis
Presentation by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
conference "Monetary Policy and Central Banking in the Post Crisis Environment", Santiago,
17 January 2011.
* * *
In the last years economic policymakers have had to deal with many unprecedented
challenges. The severe inflationary shock that began in 2007 was followed by the worst
financial crisis since the Great Depression and the deepest worldwide economic recession in
the postwar period. Currently, even though recovery is underway, the rebound in economic
activity has been characterized by a dichotomy: whereas emerging countries are posting
strong growth rates, in the developed world activity is sluggish, with high unemployment
rates and excess capacity. This bifurcated economic scenario has brought many tensions to
the global economy.
In Chile, to the shocks that have affected the world economy in this period, one has to add
the earthquake and tsunami that hit our country almost a year ago and that had both short
and medium-term effects on our economy.
One of the main lessons we have learned these years is the importance of having a robust
policy framework. In the case of Chile, institutional developments, low level of public debt
and high availability of liquidity allowed unusual vigor in monetary and fiscal policy to confront
the negative effects on demand and output of all the shocks that have affected us.
Macroeconomic stability was preserved and performance of the Chilean economy was much
better than in previous world recessions (figure 1). Also, the financial system endured the
global financial crisis with no setbacks, no systemically important financial institutions
experienced major stress, and macroeconomic policies set the stage for the healthy recovery
we are witnessing now.
The macroeconomic framework of the Chilean economy was very important in attaining
these results. This framework rests on four pillars. First, monetary policy management is
based on a flexible inflation-targeting regime, conducted by an autonomous central bank and
supported by a floating exchange rate system. The inflation targeting scheme considers a
3% annual inflation target, with a two-year horizon to correct deviations and a ±1 percentage
point tolerance range.1 The floating exchange rate regime includes the possibility of
intervening in the foreign exchange market under exceptional circumstances, which has
happened four times since September 1999. Second, a fiscal policy that is accountable and
predictable thanks to a structural balance rule.2 The significant amount of savings
accumulated during the run-up of copper prices was a crucial factor in bolstering the
resilience of the Chilean economy and in providing a countercyclical fiscal boost. Third, a
high degree of commercial and financial integration with the rest of the world. Although
copper still accounts for a relevant portion of Chilean exports, an important number of new
markets for a variety of products have been opened thanks to both the unilateral efforts of
trade liberalization and the significant spread of bilateral trade agreements with the major
economic countries and zones. Finally, a sound financial system, with globally integrated,
well-capitalized, and adequately-regulated banks. Actually, the regulation of the domestic
banking system prevented some of the most notorious credit excesses that happened in
advanced economies, or in the past of many emerging markets, including Chile.
I will continue my presentation speaking about how all the shocks we have seen the last few
years have affected the Chilean economy and the policy responses we have put in place.
Then I will describe the recovery process and I will finalize presenting some thoughts on the
lessons that can be drawn from our recent experience and some challenges I see for the
future.
The run-up to the financial bust
By March 2008, Bear Stearns had already gone bankrupt and the risk of a higher stress
episode at the world financial markets had increased greatly. Due to the risks of a potential
sudden stop if the financial crisis should worsen, and in a context of a severe appreciation of
the Chilean peso, in April, the Central Bank decided to start accumulating reserves through
sterilized intervention.
In Chile, domestic demand grew rapidly in the run-up to the crisis. During 2004-2007, the
average annual growth of output was 5.3%, while the average growth rate of domestic
demand was 8.1%. Private consumption grew 7.2% and investment 12.1%. The faster
growth of demand than output is explained by a significant improvement in our terms of trade
on the back of higher prices for copper and other commodities.
In 2007, Chile, like many other economies in the world, suffered a significant inflationary
process, which only worsened during 2008 (figure 2). Perhaps the most remarkable
component of this inflationary process was how strongly the increase in international food
prices was transmitted domestically. This may have partially been due to Chile's high degree
of commercial openness and little distortions in the price setting mechanism. Another factor
underlying inflation pressures, and a deceleration of growth, was the higher cost of energy
(especially electricity) that hit the Chilean economy with particular strength (figure 3). Not
only thermoelectric power plants had to operate with more costly inputs, but also unfavorable
hydrological conditions and a severe shortage of natural gas implied that these more efficient
sources of generation had to be replaced by diesel, in the context of rising oil prices.
Inflation rose from an annual rate of 2.6% in December 2006 to 9.9% in October 2008, when
the rise of food and energy prices had also propagated to the rest of consumer goods.
Hence, the risks of inflation remaining above the target beyond the policy horizon grew
strongly. Consistently, monetary policy had a strong reaction. The Monetary Policy Rate
(MPR) was increased by 200 basis points in just four months, starting in June. By September
2008, before the collapse of Lehman Brothers, the Central Bank estimated that it would be
necessary to increase the MPR further, even above market expectations.
Monetary and fiscal policy during the crisis
As in most of the world economies, financial tensions in Chile were severe after the collapse
of Lehman Brothers. Interest rates in both peso and dollar markets posted substantial
increases in the most stressful times from mid-September to mid-October 2008 (Figure 4).
The Central Bank acted quickly, providing peso and dollar liquidity facilities to the financial
system to mitigate liquidity tensions, but also to ensure financing in foreign currency should
foreign loans become scarce. Also, the foreign exchange reserves accumulation process
was cancelled. Local money market conditions normalized rapidly, over a period of weeks.
The additional liquidity facilities put in place were not used extensively by financial
institutions, reflecting their sustained access to external markets.
Beyond the stressful episodes in local money markets, the global confidence crisis that
swept around the world was very important in Chile. The events of developed financial
markets prompted a deep and widespread revision of investment and spending plans of
businesses and households, bringing expenditure to a halt. Domestic demand and economic
activity dropped significantly and lending standards tightened (figure 5).
The inflation outlook changed radically, and monetary policy reacted forcefully. First, by
communicating a change in outlook and the bias of monetary policy, inducing an important
decline in market rates at all horizons. Then, in January 2009, with a clearer assessment of
the reduced inflationary pressures, the MPR was lowered by 100 basis points. Later, with the
evidence of alleviated inflationary pressures and a sharp contraction in demand, the Central
Bank decided to cut the MPR by 250 basis points at both its meetings of February and
March. The monetary easing process continued and completed 775 basis points in seven
monthly meetings, bringing the MPR to 0.50% in July 2009, the minimum level deemed
adequate for a normal functioning of money markets (figure 6). In addition, the Central Bank
also announced that the MPR would be held constant at this minimum level for a prolonged
period of time. In order to strengthen the commitment to this announcement, which goes
beyond the regular monthly MPR setting, the Bank adopted some non-conventional
monetary policy measures, extending the overnight liquidity facility for banks at the MPR to
180-day term through a term liquidity facility (Facilidad de Liquidez a Plazo, FLAP). The
extraordinary liquidity measures provided during the crisis extinguished in mid 2010 and their
withdrawal did not generate stress in the money market.
The shift to a countercyclical policy stance was also taken forcefully on fiscal policy. In
January 2009, the government announced a sizable fiscal stimulus package, amounting to
US$4 billion for that year, equivalent to 3% of GDP.
The recovery process
The economic recovery was faster than expected. In the second half of 2009, activity grew at
an annualized rate of around 6%. Key factors in this trend included the increase in private
consumption and the recovery of investment. Initially, the recovery of private demand was
due mostly to the rebuilding of inventories, it continued with the dynamism of consumption
and gross fixed capital formation. This contrasts with the situation in advanced economies
where after inventories recovered, private demand has been sluggish due to the very weak
financial position of households. Several indicators available until end February of 2010 were
pointing to a consolidation of the consumption and activity trend. But then, on February 27th,
the fifth strongest earthquake ever measured hit our country.
The huge initial contraction of aggregate output was largely concentrated in manufacturing.
The immediate disruptions of the productive processes due to 27-F dissipated quickly and by
the second quarter of the year output exceeded the levels prior to the earthquake. The
economy remained on a growth trend and inflation has been below expectations, owing to
lower imported inflation and some specific factors. The baseline scenario of our December
Monetary Policy Report assumes that the Chilean economy grew 5.2% in 2010 and that GDP
growth will stand between 5.5 and 6.5% during 2011. Median private expectation set the
growth rate for 2012 at 5.5%. Economic growth projections assume that output gaps are near
exhaustion and will stay thus over the whole policy horizon.
The normalization process for monetary policy started in June with a 50 basis point hike and
continued the following four months at the same speed. Between October and December the
normalization pace was slowed down to 25 basis points. In January the Monetary Policy
Rate was kept unchanged, but the Board has stated that it will be necessary to continue to
reduce the monetary policy stimulus in the coming months.
But, important risks persist on this scenario. As I mentioned at the beginning of my
presentation, the risks in the external scenario are high, especially due to the fact that global
recovery has been imbalanced between developed and emerging economies, with high
commodity prices, low interest rates, a sluggish recovery of developed economies and a
depreciated US dollar. Relevant risks include escalating financial tensions in Europe,
persistent high unemployment rates in developed economies and sharper adjustments in
some emerging economies that are facing inflationary pressures. Considering this risks and
the fact that the real exchange rate had appreciated significantly, the Board of the Central
Bank decided, on January 3rd, to start a program of foreign currency purchases aimed at
strengthening its international liquidity position. Thus, the Central Bank will hoard additional
international reserves amounting to US$12.0 billion over the year 2011, via periodic
purchases of foreign currency until the end of December of 2011. This program will take the
Central Bank's international liquidity position to the equivalent of 17% of GDP, which is
comparable with those of other economies similar to Chile (figure 7).
The monetary effects of this measure will be sterilized in order to keep a liquidity provision in
pesos in the market in line with the target for the monetary policy rate. The hoarding of
international reserves entails financial costs for the Central Bank associated to the differential
between the return on investments and the cost of financing them. The level proposed for the
international reserves is consistent with the Central Bank's financial sustainability, although
additional leeway is limited. The initial reaction to this announcement was a nearly 5%
depreciation of the peso.
Nonetheless, the intervention does not pursue a specific level for the exchange rate. Our
immediate target is to achieve the stated level of reserves, about 17% of GDP, and to
alleviate exchange rate tensions. We remain committed to a floating exchange rate system,
and the exchange rate will keep floating during the intervention period.
For an economy like Chile, which can encounter significant changes in external financial
conditions and in the terms of trade, foreign exchange flexibility is an essential ingredient of
its macroeconomic and financial stability. Within a volatile environment like that of the past
few years, the inflation targeting regime with a floating exchange rate has displayed its
benefits in terms of allowing a smoother trajectory of the Chilean economy. Our floating
regime admits interventions in exceptional situations, like the one announced at the
beginning of the month.
Nonetheless, it is important to consider that beyond the evolution of the dollar in international
markets, there are some more long-lasting elements underlying the real appreciation of the
peso, such as improved terms of trade, the accumulated increase in the ratio of public
expenditure to GDP and the reduction in our net debtor position relative to the rest of the
world. The effects of these factors on the real exchange rate and the competitiveness of
some sectors goes beyond the horizon of the effects of this intervention. Those sectors need
to improve their productivity and reallocate their exports to growing emerging markets in
order to remain competitive.
In any case, additional reserves available will allow to better deal with the contingency of a
significant deterioration of the external environment. Foreign exchange markets are under
stress and currencies are adjusting asymmetrically. There is also the risk that GDP growth
decoupling between advanced and emerging economies will persist longer than expected,
thus intensifying the pressure on the exchange rate. Accordingly, the effects of this measure,
although temporary, should open room for smoother real adjustments in the domestic
economy.
Final thoughts and challenges
The ability of macroeconomic policies in developing economies to react swiftly was essential
to reduce the impact of the global crisis. The answer of monetary and fiscal policies and a
sound and well regulated financial system were key factors in the ability to withstand and
recover from all the hard times we have had to face in the last few years.
The Chilean economy has picked up strongly. Expansionary policies applied have paid off.
The current recovery process has posed two main challenges to emerging market
economies. The first one has to do with the appreciation of currencies and the resumption of
capital inflows. And the second, with the need to control inflation in an environment of rising
commodity prices.
Massive capital inflows are not a problem in Chile, as we have a current account surplus;
therefore, in net terms we are lending to the rest of the world. In contrast, some other
countries see this as a problem as economies grow strongly and current account deficits
widen despite gains in terms of trade. Some economies are using capital controls to temper
the pressures. Despite the fact that this is not a relevant issue now in Chile, in a longer-term
view, the effectiveness of this type of measures has to be carefully evaluated. At least, the
evidence for Chile shows that the effects of capital controls during the 1990s were very
limited at best.3
Overall, the currencies of most emerging and commodity-exporting countries have been
appreciating, regardless of the presence of net capital inflows. It is possible to mitigate
transitorily its effects on the real economy, but longer-term actions need to be taken to
support competitiveness. But, in a world scenario with greater importance of emerging
market economies, their currencies will be stronger than in the past. A more balanced
recovery of the world economy should alleviate tensions.
Commodity prices have been rising in the last few months, owing to a large extent to the
strong growth of emerging market economies. Although they represent supply shocks that
change relative prices, and in addition the supply response should mitigate this rise in the
longer term, the short-term challenges are significant. The role of monetary policy is to avert
second round effects that could contaminate inflation dynamics. For this reason, and in the
context of solid growth and closed output gaps, monetary policy should gradually tighten in
emerging markets, something we have been doing in Chile.
Today the overall challenge for policymakers is to allow for sustainable growth. The Central
Bank will fulfill its purpose and will continue to use its policies with flexibility, as proven in the
recent intervention announcement, so that projected inflation stands at 3% over the policy
horizon. This is the best contribution the Central Bank makes to Chile's welfare and growth
potential.
References
Banco Central de Chile (2007), "La Política Monetaria del Banco Central de Chile en el
Marco de Metas de Inflación," Política del Banco Central de Chile.
Central Bank of Chile (2010), Monetary Policy Report, December.
Cowan, K. and J. De Gregorio (2007). "International Borrowing, Capital Controls and the
Exchange Rate: Lessons from Chile," in S. Edwards (ed.), Capital Controls and Capital
Flows in Emerging Economies: Policies, Practices and Consequences, NBER and The
University of Chicago Press.
Edwards, S. and R. Rigobon (2009), "Capital Controls, Exchange Rate Volatility and External
Vulnerability," Journal of International Economics, Vol. 78, No. 2, pp. 257-267.
Marcel, M., M. Tokman, R. Valdés and P. Benavides (2001), "Balance estructural: la base de
la nueva regla de política fiscal chilena," Economía Chilena, vol. 4, No. 3.
Figure 1
World growth (*)
(anual change, percent)
15 15
12
129630
-3 9630-3
-6 -6
-9 -9
-12 -12
-15 -15
80 84 88 92 96 00 04 08
World at market exchange rate Chile
(*) Gray area denotes forecast published in the December's Monetary Policy Report. For Chile, considers
the midpoint of the projected growth range in 2011.
Sources: Central Bank of Chile and IMF.
Figure 2
Inflation indicators
(annual change, percent)
12 12
9 9
6 6
3 3
0 0
-3 -3
06 07 08 09 10
CPI CPIX CPIX1 CPI excluding foodstuffs and energy
Figure 3
Inflation by components
(annual change, percent)
60 60
50 50
40 40
30 30
20 20
10 10
0
0
-10 -10
-20 -20
-30 -30
-40 -40
05 06 07 08 09 10
Electricity Fuels Foodstuffs CPI CPIX1
Sources: Central Bank of Chile and National Statistics Bureau.
Figure 4
Domestic market rates in US$ and CLP (1)
(percent)
14 14
12 12
10 10
8 8
6 6
4 4
2 2
0 0
Jan.08 Jul.08 Jan.09 Jul.09 Jan.10 Jul.10 Jan.11
Time deposits ($) (2) Libor + spread on-shore (US$)
Figure 5
Gross domestic product
(percent)
9 9
6 6
3 3
0 0
-3 -3
-6 -6
03 04 05 06 07 08 09 10
Annual change Quarterly change (*)
(*) Seasonally-adjusted series.
Source: Central Bank of Chile.
Figure 6
Monetary Policy Rate and expectations
(percent)
9 9
876543210 876543210
07 08 09 10 11 12 13
Forward MP Report Dec.10 FOS 1H Dec.10
EES Jan.11 FOS 1H Jan.11
Forward 11. Jan.11 MPR
Figure 7
International reserves to GDP
(percent)
60 60
50 50
40 40
30 30
20 20
10 10
0 0
Brazil Colombia Israel Malaysia Mexico Peru Thailand Chile
2003 2004 2005 2006 2007 2008 2009 2010(*)
(*) Growth forecast and last available data of international reserves as from the IMF. For Chile, GDP growth
forecast from December 2010 Monetary Policy Report.
Sources: Central Bank of Chile and International Monetary Fund.