[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
4 December 2017
Introduction
Mr. President of the Finance Committee of the Senate, senator Carlos Montes, senators
members of this Committee, ladies, gentlemen,
Thank you for your invitation to present the vision of the Board of the Central Bank of Chile
(CBC) about the latest macroeconomic and financial developments, prospects and
Monetary Policy
implications for monetary and financial policy. This vision is detailed in our
Report (MP Report) of December 2017 and Financial Stability Report (FSR) of the second
half 2017.
I would like to start by noting that these are the last institutional reports presented in the
format that has prevailed since the time of the severe Great Financial Crisis. As we explained
to the Honorable Senate last September, as from January 1st, the CBC will begin to apply a
new calendar and format for the Monetary Policy Meetings as well as for the presentation of
our two Reports.
In particular, the MP Report has been programmed for pre-established dates that will coincide
with the monetary policy meetings of March, June, September and December of each year.
Thus, the presentation to the Senate will no longer be an extensive description of the Report,
to become an institutional appearance where the Bank's Board will deliver a synthesis of the
messages in its reports, explain the reasons behind its policy decisions and answer the
questions and comments that may arise. This will be a challenge for both parties. At the
Board, we will try our best to be up to it.
Another element of change is that this is the last presentation to this Committee with the
participation of Deputy Governor Sebastián Claro. It has been ten years since the current
President of the Republic appointed him in her first presidential term and was approved by
this Senate. Since then, Sebastián has served his position with commitment, capacity,
accountability and team work, as I am sure you have observed. On behalf of the other Board
members and the staff of the Bank, I want to take this opportunity to thank him for his
enormous contribution to the Institution and the country.
Alongside these elements of change, however, many more continue. As usual, we come to
report on the recent macroeconomic developments and share with you our vision about future
prospects and risks facing the Chilean economy. This institutional continuity is important
when we are only a few months away from a new Congress and a new Administration, a
transition that always involves challenges and in which it is important for the newcomers to
be familiar with the prospects for the economy.
In the past few months, domestic activity has evolved as expected. The stronger external
impulse has consolidated, with still favorable financial conditions, trading partners that, on
average, are somewhat more dynamic and better terms of trade.
Nonetheless, inflation has stayed below the forecasts of the September MP Report. Most of
the difference is related to the more volatile items in the basket, as core inflation -which we
measure with the so-called CPIEFE1- is near expected levels. The projections that I will
present to you in a moment assume that the convergence of inflation will take somewhat
longer than we anticipated in the last MP Report.
This considers the effect of the recent surprises and the evolution of the exchange rate up to
statistical cutoff. It also assumes that activity
the Report's growth will gradually speed up its
pace, from its bounded present levels to above potential in the second half of 2018, yielding
the way to close the output gap that will help inflation to converge within the projection
horizon.
In any case, there are still significant risks surrounding the baseline scenario depicted in this
MP Report. On the one hand, some sectors still lag behind in the recovery process, especially
some relating to investment. On the other hand, a scenario in which the economy does not
return to higher growth rates in the coming months, can affect the recovery of growth in the
medium term. In particular, because even though expectations have improved in general, they
have done so by anticipating a better future economic performance rather than by current
results.
In this context, we have held the Monetary Policy Rate (MPR) at 2.5% since May and we
expect that, if the baseline scenario comes true, we will keep the monetary impulse near its
current levels, to begin withdrawing it only once the economy begins to close the activity
gap. Anyway, it is important to carefully monitor any downward deviations of inflation in
the short term, because in the context of a weak economy, low inflation and some measures
of medium-term inflation expectations remaining somewhat below 3%, the convergence of
inflation could be affected, in which case it would be necessary to make the already
expansionary monetary policy more so.
The financial conditions have helped to shape the macroeconomic scenario described above.
Borrowing remains accessible and inexpensive, in line with the orientation of monetary
policy. The local financial market has seen no major disruptive events and the internal and
external payment systems have functioned normally. Non-financial companies maintain their
levels of profitability and indebtedness, while the increase in household debt is concentrated
in mortgage credit, which covers long periods, at fixed rates and with a prudent loan-to-value
ratio, which keeps the financial burden fairly constant. For its part, in the residential real
estate sector, sales of new homes stabilized and prices continued to rise, albeit modestly.
Nonetheless, some financial risks identified in past reports are still important. At the external
level, the relevance of a long-term external rate rise scenario stands out. At home, the lost
dynamism of recent years has reduced the financial strength of firms, eroding the quality of
the commercial portfolio in certain economic sectors. Stress tests for the banking system
show less capital leeway to confront adverse scenarios.
Likewise, issues are arising that should be considered in the analysis of risks threatening
financial stability. A normalization of risk aversion in international markets could increase
1
Consumer Price Index excluding food and energy components.
credit costs in emerging countries, including Chile. Locally, mitigating the deterioration of
the commercial portfolio's quality by demanding greater guarantees rather than making
provisions or capital aggravates the vulnerability to systemic events.
These risk factors make it possible to appreciate the importance of our coherent
macroeconomic policy framework, where fiscal and monetary policy can operate
countercyclically and the exchange rate acts as a buffer against external shocks. The need to update
banking legislation is also evident, to incorporate modern standards of capitalization and
mitigation of systemic and cyclical risks, as well as to have good systems of consolidated
debt information, all of which are part of the legislative agenda now being discussed at the
National Congress.
The Monetary Policy Report
Headline inflation has been more volatile in recent months, accumulating a negative surprise
that placed it at 1.9% in October, close to 0.4 percentage points below the September forecast.
The CPIEFE has evolved in line with projections although with significant ups and downs.
As has been the trend of the last few quarters, its evolution has been closely related to the
exchange rate (figure 1). The surprise in headline inflation came mainly from foodstuffs
(particularly fresh fruits and vegetables), whose prices showed atypical behavior for the
season, very different from historical patterns. As a reference, between August and October
these prices -which represent 2.9% of the CPI basket- averaged an annual variation of
around -9%, which compares with roughly +7% in the last ten years.
The baseline scenario assumes that headline inflation will remain around 2% during the first
half of 2018, and will return to 3% during the first half of 2019, somewhat later than we
expected in September. Core inflation will also remain low in the coming quarters, to
converge to 3% in the second part of 2019, somewhat later than headline inflation (figure 2).
The projected behavior of prices in the medium term is mainly based on a gradual closing of
the activity gap, a process that is expected to begin during the second half of 2018. On this
point, neither the recent data nor the projections of the baseline scenario have changed much
from September.
In the third quarter, non-mining activity-used to estimate the gap-continued to show
limited annual growth (which reached 1.7%), below the potential of the economy (which we
continue to estimate around 2.5%) and aggregate GDP (2.2%). It is important to note that, as
from this MP Report, for the purposes of the conjunctural analysis of activity and the
measurement of the gap, the concepts of "natural resources GDP" and "other GDP" have
been replaced by "mining GDP" and "non-mining GDP". A box in the Report explains the
reasons behind this change. There we note that the sectors that we discounted from GDP until
now (i.e. mining, fishery, and electricity, gas and water) are actually more volatile and less
persistent. It is also shown that, in general, its relationship with the rest of the economy is
limited. However, in line with the change that I have just commented, it is concluded that
only the exclusion of mining activity has significant effects in the analysis of the dynamics
of the aggregate economy, because of its important effects on the variance of growth. In such
circumstances, and considering that broad measures are better to work with than narrow ones,
we adopted the distinction between mining and non-mining GDP to substitute for natural
resources GDP and other GDP. Moreover, this change allows the analysis in the MP Report
to be aligned with the publication of the mining and non-mining Imacec2 that we introduced
a few months ago.
Returning to the recent evolution of activity and demand, the sectoral composition of
nonmining GDP shows better figures for sectors linked to consumption than those related to
investment, particularly construction. On the demand side, while private consumption
maintains annual increases of 2% to 3%, investment in construction and other works falls
more than expected. The tradables-related expenditure lines, such as consumption of durable
goods and investment in machinery and equipment, have strengthened further, supported by
an appreciating peso over recent quarters and financial conditions favoring inventory
restocking after several years of low growth (figure 3).
Consumption has performed in line with its fundamentals. On one hand, annual growth in
total employment has been steady at around 2% for several months, outperforming salaried
employment growth, especially in the private sector. On the other hand, real wages are
growing in annual terms more than they did early in the year, mainly as a result of the low
inflation (figure 4). This couples with interest rates remaining at record lows, a factor also
put forward by qualitative sources such as the Banking Credit Survey and the Business
Perceptions Report. This, despite still limited annual growth in credit in most categories
(figure 5). Finally, confidence indicators show sustained improvement, although based more
on the perception of the future performance of the economy than on the current situation
(figure 6).
Over the course of the year, the better prospects for the world economy have consolidated.
The developed economies, in general, are growing more than in previous years, as are several
emerging ones (figure 7). Furthermore, global financial conditions are still favorable, partly
because the main central banks continue to carefully and gradually withdraw their large
monetary stimuli, helping to keep interest rates and term premiums low. In addition, capital
has continued to flow to emerging markets and the prices of various assets are high.
Commodity prices, in general, remained above the levels foreseen in September, especially
copper and energy sources (figure 8). The copper price rose 3.5% to USD 3.2 per pound
during the period, to settle around USD 3.1 at the closing of this Report. This behavior is
common to most metals, in a context of still high pressures coming from financial factors
and improvements in some fundamentals. Among the latter, the increase in demand and
perspectives is worth noting, something that has occurred thanks to increased global
industrial production and the performance of the Chinese economy. This, combined with
some stabilization in output, has gradually reduced inventories. Beyond recent movements,
the weakening of the US dollar during the year has also been sustaining the copper price.
Thus, the baseline scenario in this Report adjusts it to USD 2.95 and USD 2.75 per pound on
average for 2018 and 2019, respectively. Regarding oil, the prices of Brent and WTI rose a
2
An abbreviation from its Spanish Indice Mensual de Actividad Económica, literally Economic
Activity Monthly Index.
significant 20% in the period, to near USD 63 and 56, respectively, explained largely by a
somewhat more balanced market. Globally, actual and expected demand have increased,
output has been contained and inventories have seen some depletion. The baseline scenario
of this Report adjusts the projection for the average price of Brent and WTI upwards, placing
it at around USD 59 and USD 56 per barrel in 2018 and 2019.
The combined effect of higher copper and oil prices and adjustments in the prices of other
exports and imports have led to an improvement in the terms of trade, particularly this year.
Thus, considering the period 2017-2019, the terms of trade will accumulate an increase of
around 10%, which compares with the 7% estimate of last September.
Turning to our activity and demand projections, the baseline scenario assumes no major
changes from September. This year, the economy will grow 1.4%, inside the range expected
in September. For 2018, the growth projection in the 2.5% to 3.5% range is maintained. Part
of the improvement with respect to 2017, particularly during the first half of the year, owes
to the low comparison base of the mining sector. This same scenario assumes that non-mining
GDP will have a more paced recovery. The gradual return to higher GDP expansion rates
leans on a favorable external scenario, the end of the adjustment of mining and housing
investment, the absence of significant macroeconomic imbalances and a clearly expansionary
monetary policy stance. A working assumption is that in 2018 the economy will receive a
fiscal impulse in accordance with the approved budget. Going forward, it is assumed that
fiscal spending will follow a path of consolidation.
On the expenditure side, as I just said, some salient characteristics of recent quarters have
been improved consumption and weaker investment, which have led to revisions to our
baseline forecasts. In private consumption, the better numbers so far, especially the
dynamism of durable consumption, translate into higher figures for this year and next. On
the investment side, there is a clear difference between the behavior of the machinery and
equipment and the construction and works components. The former, with a more favorable
evolution, has responded to the necessary inventory replenishment after several years
stagnant, and has benefited from the exchange rate appreciation and low credit costs. The
latter has continued to contract beyond expectations, primarily because of reduced spending
on building and engineering works, amplifying the drop in gross fixed capital formation
(GFCF) estimated in September for this year. In addition, we estimate that this expenditure
component will take somewhat longer to recover. Towards 2018, it is still assumed that the
adjustment cycle of mining investment will come to an end and that it will very gradually
begin to reflect the effects of the copper price rise. Meanwhile, non-mining investment is
slightly revised down, mainly reflecting that the downsloping trend of housing investment
has been longer than we thought before. With this, as a percentage of GDP, in 2018 the GFCF
will reach 21.1% and 21.4% in real and nominal terms, respectively, compared with averages
of 23% to 24% in 2013-2017.
About our external scenario, incoming data show improved performance of exports across
sectors (figure 9). Still, examining numbers of the first half, we foresee that the export
volumes will contract during the year. However, by 2018 they should recover thanks to
improvements in the world economy, which coupled with better prices increase our estimated
trade balance for next year. The low comparison base due to the Escondida mine strike
downtime early this year will also result in higher mining exports in 2018. Thus, in 2018, the
current account deficit should be lower than we expected in September, close to 1% of GDP,
similar to our 2017 projection. At trend prices, the current account deficit remains at 2.6%
on average in 2017-2018 (table 1).
Aside from the scenario I have just described for domestic activity and spending, the
convergence of inflation to the target also considers a mild depreciation of the real exchange
rate that will cause it to converge from where it was at the closing of this Report to its
longterm equilibrium within the projection horizon. The baseline scenario also contemplates that
the prices of foods, particularly fresh fruits and vegetables, will return to their normal
patterns, so their annual inflation will be rising over the course of 2018.
About monetary policy, the Board estimates that in the baseline scenario the surprises that
have pulled inflation down below expectations do not compromise the convergence of
inflation to the target. This, both because by their nature they should not propagate much,
and because the arguments for the closure of the activity gap remain fully in force. In this
context, as a working assumption, the baseline scenario does not alter the monetary impulse
considered in the September MP Report. In other words, that the policy rate will remain
stable and start rising towards neutrality only once the economy begins to close the activity
gap. In any case, the Board recognizes that in the current scenario -with still limited activity
growth, inflation staying near the lower bound of the tolerance range for several months and
some measures of medium-term inflation expectations still short of 3%- any downward
deviations of short-term inflation should be monitored with special care. The latter because
the convergence of inflation could be affected, in which case it may call for even more
expansionary monetary policy action.
As usual, there are risks to these projections, both internal and external. Abroad, how and
how fast the developed world will carry out the withdrawal of their monetary stimuli is still
a concern. So far the process has been implemented very carefully and has succeeded in
keeping financial markets calm. However, the discrepancies that still exist between market
expectations and the adjustment trajectory announced by the Federal Reserve as the most
likely scenario continues to be a source of significant tension. There is also the fact that in
different markets, prices are high by historical standards, which could see abrupt reversals if
global financial conditions tighten more than foreseen.
Inflation in the developed world continues to draw our attention, as it has remained low
despite stronger activity and higher energy prices. In addition, elements of uncertainty persist,
in fiscal matters and commercial policy in the United States and political issues in Europe,
compounded by growing geopolitical risks in Asia and the Middle East. In any case, we
cannot rule out that, given the results of recent quarters, greater global growth may be
observed, which could boost trade and trigger a more significant increase in global
investment.
In the emerging world, like in recent years, the main source of risk remains the Chinese
economy. On one hand, it still needs to resolve many imbalances in several crucial markets.
In addition, the nation recently began a monetary adjustment that is not free of risks, and
there is uncertainty about the direction that the reform agenda will take after the Congress of
the Chinese Communist Party and its impact on the economy. In any case, its growth
deceleration has been somewhat milder than anticipated, so maybe its dynamism will hold
longer.
The baseline scenario assumes that the copper price will decline gradually in the coming
quarters. However, we do not rule out a sharper reduction because part of the recent increase
may be related to financial phenomena. On the other hand, neither can we rule out a
strengthening of copper supply and demand factors that would allow prices to remain high
for longer, according to some market analysts.
Regarding domestic activity, we expect GDP to gradually regain faster growth. Several local
factors pose risks to this projection. For now, the lack of synchrony between different
expenditure components persists, with sectors (especially investment-related) that still lag
behind in the recovery process. Lower than expected short-term dynamism could threaten
the robustness and sustainability of the recovery of growth in the medium term. In particular,
because the improvement in the consumer and business confidence indicators owes more to
expectations of better conditions going forward than to the present situation, and because the
financial market, within a generally favorable scenario, contains segments of greater
vulnerability in consumer and commercial credit. In contrast, borrowing costs remain at
record lows and international conditions have been better than we anticipated, which could
add momentum to investment and speed up its recovery.
In this context, the Board estimates that the risk balance for both activity and inflation is
unbiased. However, it reiterates its intention to monitor any possible downward deviations
of inflation in the short term that could jeopardize its convergence to the target within the
forecast horizon. Accordingly, the Board reaffirms its commitment to conduct monetary
policy with flexibility, so that projected inflation stands at 3% over the two-year horizon.
The Financial Stability Report
In our FSR, we communicate every June and December the recent macroeconomic and
financial developments that may influence the financial stability of the Chilean economy. As
opposed to the MP Report, the FSR is not articulated around a baseline scenario, but rather
focuses on the most significant risks threatening the financial system.
In this FSR, we note that in the second half of this year the Chilean financial system has
suffered no major disruptive events and the data at hand indicates that the sector continues in
a strong enough position to withstand the impact of stressful scenarios. We also observe that
the internal and external payment systems have worked normally, while the traditional credit
risk indicators have remained low up to this moment. However, some alternative risk
measures show increases in certain sectors. As we warned in the MP Report, if the local
economy's slowdown of recent years is further prolonged, this situation could deepen. In the
external scenario, as usual, the risks identified in the MP Report's baseline scenario that I just
presented are very similar to those considered in the FSR, particularly those relating to a
sharp increase in external interest rates and their impact on our local financial conditions.
The FSR notes that the good financial conditions abroad have been mirrored locally.
Likewise, we emphasize that the cost of short-term bank financing has remained coherent
with the MPR and that the cost of issuing long-term debt for companies and banks has been
compressed lately. Interest rates on local sovereign instruments have also remained below
their historical averages. However, compared with the previous FSR, there has been an
increase owing, to a large extent, to lower demand for local sovereign bonds by pension
funds, as a consequence of affiliates migrating to higher-risk funds. Meanwhile, in the course
of this year, non-resident investors doubled their share in the local market, although within
relatively low ranges compared to other emerging economies.
As I have just pointed out, steep rises in external interest rates are still a risk worth
monitoring. In this sense, increases in the benchmark rate and the reduction in developed
central banks' balance sheets would push up the term premiums, triggering a rise in local
long-term rates. According to our estimates, this increase could amount to as much as 80%
of the change observed in the external benchmark. In this context, potential changes in the
assets managed by medium- and long-term debt mutual funds -the FM3s- are one
vulnerability to be watched closely. This could become more complex if other market players
-such as pension funds and non-resident investors- also liquidate their fixed-income
positions, which could imply temporary disruptions in local debt markets, amplifying interest
rate movements.
A normalization of risk aversion levels would have an impact on the cost of foreign credit to
emerging countries, including Chile, above the possible increases in the base rate. In the face
of such normalization, Chile's risk premium would tend to increase, affecting entities needing
to refinance their short-term liabilities. About the financial situation of companies, their
aggregate debt decreased in recent quarters, to 113% of GDP as of the third quarter of this
year (figure 10). In one year it diminished 0.9% in real terms, explained mainly by the
exchange rate effect in the valuation of the external component. This trajectory owes largely
to the fact that the increases in corporate bond issuances observed since mid-2016 have not
translated into more borrowing. On the contrary, the low cash flow assigned to investment
suggests that these funds have been oriented to the refinancing of liabilities, consistently with
the lower interest rates.
On the other hand, delinquency indicators, while still low, show a marginal deterioration with
respect to the previous FSR. In the case of services, this increase has concentrated in some
real-estate firms. As for the productive sectors, marginal rises are observed in several
industries such as construction, transport and telecommunications, and electricity, gas, and
water. Meanwhile, in others such as mining, trade, and manufacturing, the declines identified
in the last FSR continue.
Residential market figures have shown more stability in recent quarters. After the adjustment
process described in previous Reports, the sale of new homes in Santiago has remained stable
for several quarters. At the same time, in the second quarter this year, the various home price
indicators -in the Metropolitan Region and nationwide- show positive but modest growth.
Residential building activity remains weak and different sources of information see no
recovery anytime soon. Moreover, the adjustment of the sector must be monitored before
Law 20,958 on Contributions to Public Space comes into effect, aimed at making real estate
projects accountable for the impacts they have on local mobility. Regarding housing credit,
the stock of mortgage loans showed a rebound in the last quarter (figure 11). The number of
bank mortgage debtors with more than one housing loan continued to grow, reaching 29% at
the statistical close of this FSR. A subset of such debtors are investors who buy properties
for rent.
Household financial indicators show no change in the risks identified in the last FSR, which
are mostly related to the future evolution of the labor market. Since the last Report, bank
mortgage debt increased, while consumer debt with banks decelerated, and accelerated with
other sources. Thus, as of the second quarter this year, the aggregate debt of the sector stood
at 45% of GDP (figure 12), placing Chile in the upper segment of a sample of emerging
countries but below developed economies. However, the median financial burden has
remained stable at around 20% of income due to lower interest rates. In terms of financial
gaps, there was a greater use of credit and rolling lines, reflecting tighter conditions in some
households. Non-compliance indicators have remained relatively stable at low levels for
mortgage loans and have risen for consumer loans. In particular, consumer credit write-offs
and delayed repayment of retail lending have both increased (figure 13).
Going forward, a deteriorating labor market would affect the sector, particularly those
households with less financial capacity to face an income shock. Meanwhile, a scenario of
higher rates would have a smaller impact on households' outstanding debts -as they are
granted mostly at a fixed rate and long term- as opposed to new borrowing for buying a
new home or refurbishing one. All in all, the aggregate impact of this scenario on the sector
is greater if the macroeconomic effects of an in interest rate rise are factored in.
The banking system's financial indicators remain healthy, although capitalization is lagging
behind international standards (figure 14). Banking stabilized profitability and solvency
indicators, keeping liquid and currency mismatches within bounds, and without making
significant changes in its dividend policies. In terms of credit risk, quality has deteriorated in
the individual evaluation of the commercial portfolio, which has been covered with increased
collateral. Although this strategy allows reducing the idiosyncratic risk of each bank
individually, it causes vulnerability of the banking industry to systemic events that
simultaneously reduce the payment capacity of enterprises and erode collateral value. This is
a risk factor that must be monitored considering that 45% of total bank lending belongs to
this category.
Stress tests indicate that an adverse scenario of a slight but prolonged fall in activity would
pose a risk to banks comparable to one of a more severe scenario but with a faster recovery.
Thus, in the adverse scenario described above, the fraction of banks that maintain their capital
adequacy ratio (CAR) above 10% would represent 57% of the system's assets. Under the
severe scenario, the figure would be 50%. There is a contrast with 2012, when the fraction
of banks with CARs over 10% accounted for 85% of the system's assets in the severe scenario
(figure 15).
All this points to the need to enhance the sector's resilience via higher capital levels, a
situation that has been acknowledged in other jurisdiction. Along these lines, the bill that
banking legislation contributes to the strengthening of domestic banks'
modernizes capital
requirements.
As a matter of fact, one of the main milestones in terms of financial regulation was the
sending to Congress of the bill that modernizes banking legislation. This incorporates
international standards and expertise. One of its proposed tools is the cushion of
countercyclical capital, which seeks to increase the resilience of the banking system to absorb
potential losses and reduce the volatility of financial cycles. In this sense, it is essential to
identify local financial cycles, taking into account not only external factors but also the
idiosyncrasy of the Chilean banking system. These elements are addressed in a special
chapter of this FSR.
Because the Central Bank of Chile will be in charge of implementing this policy, the Board
will continue to focus its efforts on its proper application, taking into account both its benefits
and the potential direct and indirect costs of this tool. However, these efforts depend on the
approval of the bill.
Institutional advances
A year ago, when I presented these same reports before this Committee, I emphasized how
important it is for a central bank to have the capacity to face new challenges. On that
occasion, I stressed that the accumulated achievements of the Central Bank of Chile over the
years did not suffice to take charge of the transformations that occur in the economy, markets,
technology and society. Every central bank has the obligation and responsibility to anticipate
these changes and respond to them in an organized, efficient and timely manner.
Accordingly, since 2004, and every time a new Gove