[INF*RES*AS]
MONETARY POLICY REPORT
FINANCIAL STABILITY REPORT
BEFORE THE
PRESENTATION FINANCE
OF THE
COMMITTEE
OF THE
HONORABLE SENATE REPUBLIC∗
Mario Marcel
Governor
Central Bank of Chile
5 June 2017
Introduction
Mr. President of the Senate's Finance Committee, senator Carlos Montes, senators members of
this Commission, ladies, gentlemen.
Thank you for your invitation to present the vision of the Board of the Central Bank of Chile on
the recent macroeconomic and financial developments, projections and implications for
monetary and financial policy. This vision is detailed in our June Monetary Policy Report and
our Financial Stability Report for the first half of this year.
In the past few months, the macroeconomic scenario has evolved in line with forecasts depicted
in our March Monetary Policy Report. On one hand, inflation has brought no surprises,
consistently with an exchange rate that has changed little since mid-2016 and gradually
expanding capacity gaps. First-quarter activity growth was virtually flat in annual terms, largely
affected by downtime in Escondida mining company, in a context of still very weak performance
of sectors linked to construction investment.
In contrast, consumption shows a more stable outlook, driven by significant growth in demand
for durable goods, which has offset the poorer performance of the other components. The external
scenario, beyond recent volatilities, continues to signal higher growth in the developed world,
with favorable financial conditions for emerging markets and commodity prices without major
changes, after having begun a recovering in late 2016.
Thus, although important external and domestic sources of uncertainty remain, prospects for this
year and next are in line with forecasts. Accordingly, the projections in the baseline scenario that
I will be sharing with you in a moment, assume that monetary policy will remain expansionary
throughout the projection horizon, so that inflation will fluctuate around 3% during much of the
period, and activity will recover higher rates of expansion, especially towards the second half of
2017 and into 2018.
Let me now present the details of our vision about the macroeconomic scenario and estimates
contained in our Monetary Policy Report.
The Monetary Policy Report
Recent evolution of the economy and our projections
The inflation outlook shows no substantive changes. Annual CPI variation has been at 2.7% since
February, while core inflation-the CPIEFE-has decreased slightly (figure 1). The baseline
scenario estimates that the real exchange rate will not change much and that capacity gaps will
begin to close some time next year. In this context, core inflation will continue to decline for
some months, to around 2%, to then approach values of the order of 3% towards the end of the
projection horizon. The prices of the most volatile items (food and energy) will increase more
than core inflation, so headline inflation will converge to the target sooner than the core measure.
Thus, the baseline scenario continues to estimate that in the coming months headline inflation
will decline to levels near the floor of the tolerance range, and will return to 3% at the end of the
year and hover around this figure until the end of the projection horizon, mid-2019 (figure 2).
First-quarter data confirmed the strong impact of the Escondida strike on the sector's output,
aggravated by reduced production in other mines (figure 3). Thus, mining activity fell by nearly
14% annually in the period, dragging along power generation and some local activities, according
to various respondents to the May Business Perceptions Report (IPN) survey. Moreover,
recovering former production levels has taken longer than expected, so the effect in mining
output has extended into the second half. After considering these elements, the mining sector is
projected to drop this year by nearly 2.5%, compared with the 1.5% increase we expected in
March.
Other sectors' activity continues to show two trends. On the one hand, the weakness of
construction activity and related services; on the other, the more stable performance of private
consumption, driven strongly by growth in durable goods. Thus, first-quarter numbers showed a
contrast between the fall in construction sectors and business and real estate services on one side,
and growth in trade and the recovery of manufacturing lines that produce consumer goods on the
other (figure 4). The improvement in investment in machinery and equipment-excluding
uncommon transport equipment-is also worth noting, which, like durable consumer goods, has
benefited from the need to replenish stocks after several years of low growth and exchange rate
elements (figure 5). Finally, the greater execution of public spending contributed to increase
government consumption, which also had a positive impact on activity.
The increased stability in consumption occurs in a context where consumer expectations,
although still in pessimistic territory, have improved somewhat. The labor market continues to
adjust as expected, with the unemployment rate low by historic standards, but with salaried
employment still weak and still decelerating wages. The downturn of salaried employment has
been echoed by a rise in self-employment. As we show in a box in the MP Report, considering
workers of equal experience and skills, a person that is self-employed or works in the informal
sector, earns around 20% less per hour than a salaried employee. If we consider that the informal
and self-employed work fewer hours per week, their income ends up being 30% to 40% less.
Although the share of non-salaried employment in total employment has risen in the past few
months, it has not diverted far from its historic indicators. Actually, the figure for the last moving
quarter, February to April 2017 (25.9%) is a perfect match to the 2010-2017 average and
significantly lower than the average from 1986 (27%) and of periods of economic crises (figure
6).
Thus, the increase in self-employment has cushioned the decay of the labor market's impact on
the wage mass. The reduction of inflation has also helped, leading the wage mass to grow a little
above the forecast, returning to a range between 2.5% and 3% annually. However, as detailed in
the FS Report of the first half 2017, the evolution of the labor market may be influencing the
repayment behavior of households, which has seen some deterioration recently. All in all, we
foresee that total, private and public, consumption will grow around 2.5% this year and 3% next
year.
Another determinant of consumption, such as credit cost, shows that cuts to the monetary policy
rate (MPR) have been passing through to the interest rates. Beyond specific fluctuations due to
composition effects, interest rates on consumer, commercial and mortgage loans are in low levels
(figure 7). Despite some marginal improvement, credit growth remains tight, with supply-side
and demand-side constraints combined. The former matter more for consumer and mortgage
loans, in particular because of the higher risk associated to the labor market and the increase in
some delinquency indicators, plus the effects of regulatory changes in the real-estate market.
Demand-side factor are especially important for companies, which attribute their low demand
for credit to the shortage of investment projects (figure 8).
Considering the usual revision to the growth projection range for the current year that we must
do in this MP Report, the Board estimates that GDP will expand between 1% and 1.75% in 2017,
while for 2018 it foresees a range between 2.5% and 3.5%. The changes owe mainly to the fact
that mining activity fell more than expected in the first months of this year and that its subsequent
recovery has been slower, as the growth prospects for the rest of the sectors have not changed
much. Thus, it is still believed that the return to growth rates in line with potential growth and
closing gaps, is consistent with an economy that shows no major imbalances, a gradual
dissipation of some of the factors that have hindered a better performance in the past few years-
such as the sharp drop in mining investment in the last three years-and the recovery of
confidence indicators. Plus a more expansionary monetary policy and a greater external impulse
than in recent years. As for fiscal policy, it is assumed that the consolidation announced by the
Government will continue (table 1).
On the external front, the data of recent months do not show great divergences with respect to
forecasts. Developed economies continue to show signs of recovery in a context in which their
inflation indicators have stabilized and their monetary policies remain highly expansionary. At
the same time, beyond recent episodes of volatility, financial conditions remain favorable in
perspective, particularly for emerging economies. This, together with still low risk premiums,
stock markets that have held on to positive returns, capital flows that are sustained, as well as the
withdrawal of the monetary impulse by the Federal Reserve that has caused no major disruption
in the markets. As shown in a box in the MP Report, volatility indicators have remained low
during the period, contrasting with persistently high political and economic uncertainty indices.
The gap between these indicators has caused some concern, as it could indicate that markets are
not properly reading the risks associated with the present economic and political environment.
However, the fact that the two indexes capture elements other than uncertainty, could justify this
situation, so they must be taken as complements. China's growth outlook remains stable,
although incoming information has created doubts regarding its growth pace for the rest of the
year and has increased preoccupation about the stability of its financial system, especially in a
context of internal and external monetary normalization.
It must be noted that in Latin America, several economies have seen activity weaken beyond
expectations, but lower inflation has allowed to normalize monetary policies faster, which should
help regain better numbers. Brazil, the main economy in the region, is still in difficulties.
Although short-term indicators continue to show signs of recovery, solutions are expected to be
slow. Private projections point to GDP growing between 0.5% and 0.7% this year, after the
recession of 2015-2016. Inflation has dropped further, which has allowed to continue
normalizing monetary policy. In any case, political uncertainty is the biggest risk in the short
term. In Argentina, activity shows incipient signs of recovery after the recession of 2016, while
inflation has accelerated, posting 27.5% annually in April. The Argentinean Central Bank has
raised the policy rate this year so far, and it now stands at 26.25%. In Colombia, activity
weakened in the first quarter, but some rebound is expected in what remains of the year, to reach
annual growth of 2.0%. Inflation began to decline in the middle of last year, so the Central Bank
has further reduced its policy rate, which is now at 6.25%. In Peru, activity also weakened early
in the year, affected by temporary shocks, like the El Niño phenomenon and to some extent also
by corruption scandals that have paralyzed a few infrastructure projects. Also noteworthy is the
weakness of domestic demand, which shrank 1% in the quarter. A different case is Mexico, where
activity has outperformed expectations with growth of almost 3% annually. Inflation, however,
continues to accelerate, reaching almost 6% in April, due to the depreciation of the Mexican peso
and the increase in agricultural prices. The Central Bank has continued to reduce the monetary
impulse, with its policy rate reaching 6.75%, i.e. a 100 bp hike since December (figure 9).
Thus, world growth is expected to average 3.5% in 2017-2018, with trading partners that will
grow 3.3% in the same period, significantly matching the March forecasts. The copper price is
also expected to remain at USD 2.55 per pound this year and USD 2.5 next year, and the oil price
will average a little over USD 50 per barrel in the same time span (table 2).
In the baseline scenario, monetary policy will remain expansionary through the entire projection
horizon. Estimates use as a working assumption that the trajectory will be consistent with the
various measures of expectations as of the closing of the Report (figure 10). As always, it must
be stressed that this is a working assumption, not a commitment. Therefore, the conduct of
monetary policy and possible adjustments to the MPR will be contingent on the effects of
incoming information on the inflation outlook.
Risk scenarios
Abroad, the main sources of uncertainty remain linked to the factors identified in previous MP
Reports. On the one hand, there is the conduct of fiscal and monetary policy in the United States
and its impact on the global economy and on financial conditions. Also uncertainty about the
political environment. In Europe, recent election results have been dissipating some of the
political risks, in a context where growth has consolidated and data has been higher than
expected, so a new boost from the region on the global economy cannot be ruled out. China
remains a concern, either because short-term data has cast some doubt on the future growth
trajectory or because of imbalances in some markets that still need to be corrected. Latin America
lags behind in the recovery of its economies and some of them still require fiscal and monetary
adjustments and, to a lesser extent, of their external sector. Recent political developments in
Brazil could generate greater effects on the financial conditions facing the region.
At home, inflation and activity have evolved in line with expectations, with no significant
changes in prospects. The same is true of the labor market. However, after several years of slow
growth, the risk remains that companies may need to further adjust their wage bills, especially
if the expected recovery fails to occur, taking a toll on the wage mass and on expenditure.
Conversely, both a stronger external impulse and improved expectations could prompt a stronger
reaction from investment, especially in a context where monetary policy has become more
expansionary and both external and local financial conditions are good.
In this context, the Board estimates that the risk balance is unbiased for both inflation and activity.
Of course, this does not mean that we see no clouds on the horizon, but that the probability of
occurrence is the same in one direction or the other. To the extent that these signal a change in
the scenario going forward, the Bank will respond and adjust its decisions.
Our track record of the last year and a half provides a good example of how flexible our monetary
policy is to respond to significant changes in economic conditions. In hindsight, monetary policy
remained expansionary with a stable MPR between October 2014 and September 2015, despite
the increase in inflation resulting from a sharp exchange rate depreciation, rightly interpreting
that it was a transitory phenomenon derived from supply-side pressures on prices. Towards the
end of 2015, a normalization process began, sustained on a scenario where growth was projected
to equal potential, and with bounded capacity gaps. This adjustment, however, occurred
gradually and prudently, with an increase of 25 basis points in the MPR in October and December
2015.
This prudence, accompanied by a vision focused on the future prospects of the economy, allowed
the monetary policy orientation to be adjusted quickly when the macro scenario began to change.
Indeed, the exchange rate appreciation and signs of weakening in the first half of 2016 led the
Bank to revise its inflation and growth projections. As these adjustments revealed a new
macroeconomic scenario, characterized by weak economic activity, greater exchange rate
stability and a faster deceleration of inflation, the Bank successively adjusted its monetary policy
options and bias, culminating in four 25-bp cuts in the policy rate in the last five months.
Thus, in response to changes in the medium-term macroeconomic scenario, the MPR has
accumulated a decline of 100 bp since January of this year, to 2.5%. With this, the MPR is
between 150 and 200 bp below its levels considered neutral. The speed with which we have made
this reduction responds to our conviction that the medium-term inflation outlook was revealing
a scenario that jeopardized the fulfillment of the policy goal. All this, because of the implications
that the evolution of the macro scenario, in particular weak activity, had on them.
Considering the cuts already made, we believe that monetary policy is now highly expansionary
and consistent with inflation at 3% over the projection horizon. Within this horizon we will see
in the coming months that annual inflation will fall again, approaching 2%. We will also see
months of poor activity, as shown by the latest Imacec. But the improvement in external
conditions, the disappearance of specific factors that have affected activity and prices, and the
monetary impulse itself, will allow the economy to regain more growth in the second half of this
year and in 2018, with capacity gaps that will begin to close in the course of 2018 at the same
time that inflation will converge to the policy target.
This, by the way, does not mean that the MPR will not be adjusted again, but that in the most
likely scenario no new changes are needed, and that the most important thing will be to let the
monetary impulse permeate the economy for as long as necessary in order that, combined with
the other mentioned factors, it will generate a visible convergence to the policy target. Again,
this is not a promise, it must be crystal clear that the Central Bank will not react to one-time
events, but to discernible and material changes in the future macroeconomic scenario that could
compromise compliance with its objectives.
The flexibility of Chile's monetary policy is a very important feature that responds to the
macroeconomic policy framework of the country. In particular, because monetary policy is based
on a forward-looking inflation targeting scheme. Also because the floating exchange rate allows
it not to be tied to defending the exchange rate. The same as the commitment of public spending
to the fiscal rule, which gives the Central Bank leeway to smooth out business cycle fluctuations
that affect the achievement of the inflation target. The sum of these elements allows the Chilean
economy to have a more expansionary monetary stance than other Latin American economies.
In fact, in a cross-country comparison of the policy rates, the Chilean rate is the lowest by far in
the region. Even deflated by inflation, the real effective MPR ranks also the lowest (figure 11).
Now let's take a look at the subjects we developed in our Financial Stability Report.
The Financial Stability Report
In the Financial Stability Report we publish on a semi-annual basis (every June and December),
the recent macroeconomic and financial events that could affect the financial stability of the
Chilean economy. In contrast to the Monetary Policy Report, the Financial Stability Report is
not articulated around a baseline scenario, but focuses on the most important financial risks.
In this FS Report, we emphasize that in recent times the Chilean financial system has seen no
major disrupting events, and the information at hand indicates that it is in a good position to
withstand the impact of stress scenarios. Both domestic and external payment systems have
operated normally, while credit risk indicators have remained low. However, recent
developments indicate a gradual increase in the latter. One important risk is that, if the economic
slowdown continues as it has for some years, this deterioration might deepen.
On the external front, the risks identified in the FSR are similar to those I just described for the
Monetary Policy Report. Note that global uncertainty is still high, so going forward, the risks of
revisions to the world economic outlook cannot be ruled out. Note also that possible increases in
long-term interest rates in international markets, besides entailing a forex effect, might be
transmitted to local rates and translate into higher funding costs for local agents.
As I just said, the cost of local short- and long-term financing reached record lows, in line with
market expectations for the MPR and the environment of low long-term external rates. In this
context, institutional investors made moderate changes in the composition of their portfolios. In
particular, the assets in layer 1 mutual funds continued to grow relative to the other funds; Life
insurance companies continued to increase their positions in real estate investment; and pension
funds increased their exposure in local bonds. Also, at the statistical closure of this FS Report we
did not observe any significant changes between the funds managed by the AFPs, in contrast to
the significant transfer of affiliates to the E fund documented in the previous Report.
It is also worth noting that the financial position of local companies presents no big diversion
from previous Reports, despite the fact that local economic activity has performed worse than
expected. Total debt to GDP declined slightly, largely explained by external financing sources
(figure 12). Meanwhile, the greater dynamism of bond issues has focused mainly on the
refinancing of liabilities, while the growth rate of commercial loans remains low. The group of
companies that report to the SVS increased their profitability at the end of 2016. However, about
70% of this increase has its origin in non-operational sources. Finally, those firms in productive
sectors that do not report to the SVS and have no external debt, posted a decrease in their bank
debt recently. This, combined with information from the Bank Credit Survey, reflect lower
financing needs of these firms, which is consistent with the evolution of local economic activity.
The less dynamic economy has marginally affected the repayment behavior of firms, increasing
the credit risk of the commercial portfolio. Although delinquency levels are fairly low, since the
last FS Report some NPL indicators showed increases. This, coupled with the fact that the
fraction of loans rated sub-standard remained relatively high, has worsened the quality of the
commercial portfolio (figure 13). Going forward, a less favorable macroeconomic scenario
would lead to some these credits being defaulted.
The evolution of the labor market has begun to reflect in deteriorated economic and financial
indicators of households. Thus, since the last FS Report, bank consumer loans posted an increase
in non-compliance. Meanwhile, mortgage default ceased to decline as it had for some years
(figure 14). Meanwhile, households' aggregate indebtedness continues to rise, most of all the
mortgage component (figure 15). Most recently, survey responses reveal an increase in the
financial burden over income, which, together with the increased non-compliance in the
consumer portfolio, calls for follow-up. Actually, any further deterioration in the labor market
could deepen households' non-payment behavior.
The housing market continues to adjust. Sales of new homes in the Metropolitan Region have
slowly recovered, while the prices of both new and used homes decelerated in the second half of
2016. At the same time, the launching of new projects has slowed, in line with the reduced growth
outlook for the sector. All in all, different indicators of the residential real estate sector-
including mortgage credit-show a slowdown, reflecting both the economic situation and the tax
and regulatory changes discussed in previous FS Reports (figure 16). Lastly, cancelled home
purchase agreements have remained bounded, but may increase in the face of a further
deterioration of the labor market. This could affect real estate companies lacking sufficient cash
flows to cover the costs of putting a cancelled sale unit back on the market.
It should be noted that although the economic outlook has deteriorated in recent years, the
capitalization of the banking sector has not changed significantly. The system's capital adequacy
ratio (CAR) stands at 13% since mid-2016, close to its historical average, but still below
international standards. Stress tests show that the banks' capital gap has narrowed over the last
few years. Thus, the fraction of banks with a CAR above 10% after a severe stress scenario would
go from representing 85% of the system's assets in 2011-2014, to 50% in the last two years (figure
17). This is so because the banks that are most exposed to the economic slowdown have not
adjusted their capital levels accordingly. In this context, the new General Banking Law would
contemplate a gradual convergence towards the Basel III framework, which has implicit higher
capital requirements for the banking system.
I would like to end this presentation with some thoughts.
Concluding thoughts
The two reports I just presented (i.e., the Monetary Policy Report and the Financial Stability
Report) provide us with a full overview of the Chilean economy, that includes not only its most
likely trajectory, but also the risks that might push it away from it. This illustrates the fact that
monetary and financial policies are two important complements in Chile's macroeconomic policy
scheme.
One important dimension of this short-term complementary nature is the transmission of changes
in monetary policy to the cost of credit, and the spending decisions of individuals and companies
rely on a sound and strong financial system. As I just commented, market interest rates are now
at or very near record lows for the different types of loans, as well as for long-term instruments.
This adequately reflects the transmission of the MPR cuts that we have made in recent months
and, certainly, a monetary policy that has been kept expansionary for quite some time and will
continue to be so in our baseline projection scenario.
However, this transmission of the expansiveness of monetary policy and external financial
conditions would not be possible if it did not interact with a financial policy focused mainly on
the proper functioning of the system and the access of the Chilean economy to the international
financial markets.
There is a clear relationship between economic activity and the financial market's performance.
On the one hand, economic activity has a direct impact on the results of the financial sector and
possibly its stability; on the other, performance indicators of the financial sector can signal the
future behavior of the economy.
In this sense, the incipient deterioration of the non-payment indicators of households and firms
that this FS Report shows is important. Not only is it necessary for the cost of credit to be low,
but also for households and companies to have access to it and to meet their financial obligations,
because it is important not only for themselves but also for the soundness of the financial system
as a whole.
The importance of this interaction between the functioning of the financial market and economic
activity is not limited to the short term. As we have stressed on several occasions, Chile faces an
important challenge in terms of improving productivity and medium-term growth. To this end,
the support of a stable, deep, liquid, efficient and inclusive financial system is of the essence.
From a monetary policy standpoint, this is achieved by having stable, controlled inflation, in a
context where the economy successfully smoothes business cycle fluctuations. From a financial
policy perspective, there are many instances in which regulatory amendments can improve the
efficiency and efficacy of the national financial system.
Considering a broad set of developed and emerging countries, Chile shows increasing levels of
depth and access to its financial system according to various indicators, such as the loans to GDP
ratio, market capitalization or number of bank accounts. However, there are always important
challenges to be addressed, so we cannot overestimate the importance of recent or pending
regulatory changes that will potentially help Chile to improve in this regard.
A first series of measures has to do with the Law that defines actions to boost productivity,
including some initiatives to deepen the financial market. Among these, I can mention the
amendments to the Constitutional Organic Law (LOC) of the Central Bank to perfect the
regulations applicable to payment systems established in the country and recognize payment
infrastructures in foreign jurisdictions involving local financial institutions. Other points include
raising the limits for foreign investment of insurance companies, making it easier for
international custodians to settle in Chile, expanding investment alternatives for the Pension
Funds and the Unemployment Fund, as well as moving towards a risk-based model of supervision
for such funds.
About financial inclusion, one noteworthy regulatory change has been the Law that allows
nonbank entities to issue prepaid cards (Law No. 20,950-2016), aimed at promoting the
development and massification of electronic payments and increasing financial inclusion, along
with boosting competition in means of payment. Its implementation requires that the Bank (and
the SBIF) issue the rules that will regulate this activity. These, besides regulating the
implementation of prepaid cards, will incorporate another series of normative improvements on
the payment system in general, which should contribute to favor the development, competition
and incorporation of new technologies in the field.
A final change worth mentioning is the Law that will create the Financial Market Committee,
which will bring about a very significant change in our country's financial regulation and
supervision structure, and whose implementation poses a major challenge for public politics.
Despite these significant advances, big challenges await us. In the immediate future, a new draft
for the General Banking Law has been sent to Congress, with a focus on three areas: Corporate
Governance of the regulator, Basel III capitalization rules, and Banking Resolution. Progress in
these three areas is of paramount importance. In particular, a greater convergence with the
international standards on banking capital requirements defined by Basel III would solve a lag
that has pulled back the banking system for several years. Equally important is to strengthen the
security network of the financial system by improving the mechanisms to administer banks in
financial problems (bank resolution). Once this project is sent by the Executive, it is desirable
for it to receive the necessary attention and be able to advance in the formalities bypassing the
political processes that will characterize the last months of this year.
Another much debated topic internationally are the potential effects of technological innovations
in financial markets (Fin tech)1/. These innovations have the potential to trigger major changes
in the financial system, which would provide great opportunities for the agents, but would also
threaten its stability and safety. Addressing this matter in a proper and timely manner is another
challenge for financial regulators.
Likewise, an area with important recent developments is the regulation of derivatives markets.
This is a significant point of interaction between the stability of the financial system, monetary
policy and economic growth. In the context of a flexible exchange rate, access to forex hedging
with the proper regulation and supervision is certainly important for the various players. Chile
has made great advances in this area with a derivatives market that has increased as a fraction of
GDP, being above the average of Latin America and other emerging economies. In this context,
it is important to expand the information system of derivatives, which allows to further approve
the internationally accepted standards to "Transaction Repositories", which are currently
considered as important as other types of financial infrastructures, such as Central securities
depositories, counterparty entities and payment systems.
Summing up, we believe that there is a series of legal changes that will enable the Chilean
financial system to improve its efficiency and stability, providing the necessary tools for agents
to make better decisions and foster growth. This, together with monetary policy oriented at
keeping inflation stable over the me